July 9, 2020

Responding to Activist Shorts: Are Internal Investigations a “Tell”?

FT’s Alphaville blog recently discussed a new study dealing with corporate responses to short sellers. Public companies sometimes decide that discretion is the better part of valor when it comes to responding to an activist hedge fund’s announcement of a “short thesis.” But many others – about 1/3rd according to the study – opt to respond. Some of those companies announce that they’re initiating an internal investigation into the activist’s allegations. If that happens, the study says investors should run for their lives:

We find that when activist short seller targets announce internal investigations, the disclosure is associated with a 383% greater chance of a fraud finding . . . and a 61% lesser chance of being successfully acquired as an exit strategy, compared to the whole sample of targeted firms.

The study suggests that initiating an internal investigation based on an activist’s allegations implies that the firm’s directors are not sufficiently confident in management to trust that the existing disclosures and management representations are accurate.

While an internal investigation may be a red flag, if allegations are credible, it may also be the board’s only option. But what’s the best way for a company to respond to a report that it knows is inaccurate? The blog points to GE’s successful efforts to refute Harry Markopolos’s 2019 short report – which focused on highlighting the errors in the analysis without trashing the analyst – as a model response.

Audit Committees: Navigating the Pandemic

Dealing with the issues presented by the Covid-19 crisis has increased the already significant demands placed on audit committees. This Sidley memo (p. 7) provides some advice to audit committees on how to navigate the pandemic. This excerpt addresses disclosure & reporting issues:

Plaintiffs’ attorneys are investigating whether COVID-19 disclosure-related issues can support opportunistic securities class actions, with multiple cases already filed. Companies that express public confidence about their general prospects or their supply chain sufficiency despite dismal news about the economy and COVID-19’s impacts face heightened risk.

As always, companies should be careful to have support for statements at the time they are made. Watch for changing circumstances and adverse trends, in particular, as those circumstances change rapidly; describe them accurately as new developments. Ensure that public reporting is consistent with what the board is being told privately.

Shareholders also may second guess board-level decisions or inaction. So, consider documenting COVID-19-related considerations and responses to create a diligence record. Shareholders looking to file derivative actions often seek books and records before filing or making demands. Having a record of board considerations and responses can be very protective. Shareholder demands and books and records demands often come by mail, so companies should be alert to incoming mail when personnel are out of the office.

Other issues addressed in the memo include the importance of the “tone at the top” when it comes to health & safety concerns, the need to stay on top of operations & risks, the importance of being in sync with management when it comes to reporting, and a variety of other matters.

Capital Markets: Converts are Having a Moment

They say that “every dog has his day,” and according to this “CFO Dive” article, that day has apparently come for convertible debt. The article says that $21 billion in converts were issued during May – the highest monthly total on record. Traditionally, it has been small caps that have been attracted to convertible securities, but some big companies that have found themselves in financial hot water have recently turned to them as well. This excerpt explains the attraction of converts to issuers & investors in the current environment – as well as some reasons to think twice before diving in:

Start to finish, an issue can take two days, compared to weeks for high yield debt. The heightened uncertainty facing companies and investors over the last several months as a result of the coronavirus pandemic has led to a doubling of convertibles outstanding, compared to the same time last year. “Given the current volatile market environment and downward pressure on stock prices, it’s no surprise investor sentiment has turned negative around companies issuing equities to raise capital, primarily because of the dilutive effect on their stock holdings,” Heather Hall, CFO of fixed income tech company 280 CapMarkets, said.

When convertibles are changed into equity, they can impact shareholder value negatively, and have adverse effects on a company’s earnings metrics and projections, she said. Companies in competitive industries might want to consider the potential future dilutive effects on their share price, and corresponding negative implications to their overall market share and earnings per share metrics, Hall said, noting the dilutive effects to shareholder value that will be much larger, proportionally, in a smaller company. “The phenomenon of an activist investor who could potentially acquire the majority of the convertible debt and ‘run away’ with the company should be contemplated,” Hall warned.

For a more in-depth look at the pros & cons of issuing converts in the current environment, check out this Wachtell Lipton memo.

John Jenkins