Identifying Suspicious Short Selling, But Not Who’s Behind the Trades
A new study suggests that hedge funds may be trading on insider information about companies they are lending money to. But a lack of regulation of hedge funds and short selling makes it hard to know who is involved in the trades.
Last weekend, The Wall Street Journal highlighted new academic research showing that investors may be trading on insider information after companies approach hedge funds for loans.
Researchers found that on average, in the five days before companies announce a loan from a hedge fund, the volume of short sales increases by 75 percent as compared with the 60 days before a deal is announced. There was no comparable uptick in betting against companies that borrowed money from commercial banks instead.
With short selling, hedge funds and other investors make money by wagering that a stock's price will fall. Borrowing from hedge funds rather than commercial banks can be seen as a sign of distress, as hedge funds tend to charge higher interest rates.
One of the researchers, Debarshi Nandy of the Schulich School of Business at York University in Toronto, told ProPublica that the findings pose an important question of whether hedge funds are using insider information inappropriately.
(Here's a PDF of a working draft of the paper; the final version is not yet published.)
When companies ask hedge funds to consider giving them a loan, they typically require that the funds sign nondisclosure agreements. That's because the borrowers divulge confidential financial information in the process of trying to get a loan -- information that can provide insight into a company's future performance. That, in turn, can be valuable to investors.
In looking at instances when companies made changes to existing loans, researchers found that the short sales on companies amending loans from hedge funds were profitable, whereas similar short sales on companies amending loans from banks resulted in losses.
But the researchers stop short of saying that hedge funds definitely make insider trades. It's all a little bit hazy because there is little disclosure required for hedge funds and short selling.
While the paper identifies "abnormal" shorting activity, the identity of the investors making the trades is a mystery. "If it is truly insider trading by the fund or a 'tip-ee' of the fund, it would really be good to get some further data on who is actually doing the trading," said Anita Krug, an expert in the laws governing hedge funds.
Investors are required to notify the Securities and Exchange Commission when taking large long positions, but there is no equivalent requirement for short bets. During the week that Lehman Brothers collapsed in the fall of 2008, the SEC issued a temporary order requiring investors to report large short positions, but it did not renew that requirement last summer when the order lapsed. The pending financial reform bill also would not require disclosure.
Short sellers say more regulations would discourage their trading, which they argue helps moderate market bubbles and contributes to market efficiency, says Mark Perlow, an attorney at K&L Gates who represents hedge funds.
As big banks return their TARP money, Fannie Mae and Freddie Mac continue to be a drain.
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