Testimony of
`
`Professor Owen A. Lamont
`
`Professor of Finance
`Yale School of Management
`June 28, 2006
`
`"Hedge funds and independent analysts: How independent are their relationships?"
`United States Senate
`Committee on the Judiciary
`June 28, 2006
`Testimony by Owen A. Lamont
`Yale School of Management
`
`I am honored to have this opportunity to testify about hedge funds and analysts.
`As an economist, I am concerned with prices. It is important that we get the prices right.
`When security prices are wrong, resources are wasted and investors are hurt. In order to get prices right, we need to
`allow all information, both positive and negative, to get into the market. In the world of financial markets, just like the
`worlds of politics or science, free speech and open discussion of ideas is essential.
`
`Unfortunately, US financial markets and institutions have a substantial bias against discovery and dissemination of
`negative information. Bad news is suppressed while good news is accepted. This bias comes in many ways. One is
`the difficulty of short selling. Short selling, which today is done primarily by hedge funds, is an important channel for
`negative information to get into the market. A second and related element is retaliation against any public criticism of
`a company from anyone, including journalists, short sellers, or analysts.
`
`What happens when negative information is suppressed? Stocks can become overpriced because only optimistic
`opinions are reflected in the stock price. An example is Enron, which became massively overpriced before market
`participants realized it was a fraud. To prevent future Enrons from occurring, we need to make sure pessimistic
`voices are allowed to be heard.
`
`Short selling
`Our current financial system is not set up to encourage short selling. We have well developed institutions, such as
`mutual funds, to encourage individuals to buy stocks, but few institutions to encourage them to short. As events of
`1999-2000 made clear, the infrastructure of our system, such as analysts, underwriters, and some elements of the
`media, have an overly optimistic bias. In addition to this optimistic bias, there are technical issues with short selling
`related to our system of lending equities. Simply put, our system is not designed to facilitate short selling of equities,
`and it can be difficult or impossible to short some stocks.
`
`Constraints include various costs and risks, such as the expense and difficulty of shorting, legal and institutional
`restrictions, and the risk that the short position will have to be involuntarily closed due to recall of the stock loan. If
`these impediments prevent investors from shorting certain stocks, these stocks can be overpriced and thus have low
`future returns until the overpricing is corrected. In addition to the problems in the stock lending market, there are a
`variety of other short sale constraints. Regulations and procedures administered by the SEC, the Federal Reserve,
`the various stock exchanges, underwriters, and individual brokerage firms can mechanically impede short selling.
`Legal and institutional constraints inhibit or prevent investors from selling short.
`
`Analysts
`Part of the optimistic bias in our system comes from analysts from investment banks.
`These analysts have an incentive to curry favor with issuing firms in hopes of gaining future underwriting business
`from the issuers. There is substantial evidence that these analysts are corrupt and intentionally issue overly rosy
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`Coalition for Affordable Drugs IV LLC - Exhibit 1045
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`forecasts. This evidence comes in two forms. First, there is direct evidence gathered by the SEC and other
`authorities, resulting in 2003 in the $1.4B settlement between regulators and securities firms. This evidence left little
`doubt that the obvious conflict of interest for sell-side research analysts resulted in dishonest forecasts.
`
`Second, academics have gathered a great deal of indirect evidence indicating corrupt and overoptimistic behavior by
`analysts employed by investment banks (see Bradshaw et al, 2003). Despite the 2003 settlement and other
`regulatory changes, it appears that most investment banks continue to be overly optimistic in their forecasts.
`
`The antidote to this problem is independent research analysts, unaffiliated with any investment bank (as mandated by
`the 2003 settlement). In the case of Enron, for example, Healy and Palepu (2003) showed that independent analysts
`were less over-optimistic about Enron's prospects. Unfortunately, independent analysts also have reasons to be
`optimistic. First, if they are critical of the company they cover, they may be denied access to information by the
`company. This problem has been reduced, but not wholly eliminated, by Regulation FD (which the SEC instituted in
`2000). Second, independent analysts who issue negative reports may be sued or otherwise harassed by the
`companies they cover. Lawsuits are a particular threat to independent analysts who typically lack the resources to
`withstand legal costs.
`
`Evidence for overpricing
`A variety of evidence suggests that when stocks are difficult to short, they get overpriced.
`One example I have studied is battles between short sellers and firms (Lamont, 2003). Firms don't like it when
`someone shorts their stock, and some firms try to impede short selling using legal threats, investigations, lawsuits,
`and various technical actions. Consistent with the hypothesis that short sale constraints allow stocks to be overpriced,
`firms taking these antishorting actions have in the subsequent year very low abnormal returns of about -24 percent
`per year. The negative returns continue for up to three years. What appears to be happening is that these companies
`are overpriced, either because of excessively optimistic investor expectations, faulty products or business plans, or
`just plain fraud on the part of management.
`
`Firms can take a variety of actions to impede short selling of their stock. Firms take legal and regulatory actions to
`hurt short sellers, such as accusing them of illegal activities, suing them, hiring private investigators to probe them,
`and requesting that the authorities investigate their activities. Targets of legal harassment also include journalists and
`analysts. Firms take technical actions to make shorting the stock difficult, such as splits or distributions specifically
`designed to disrupt short selling. Management can coordinate with shareholders to withdraw shares from the stock
`lending market, thus preventing short selling by causing loan recall. These battles between short sellers and firms
`can be extraordinarily acrimonious. The following statement from the sample I used gives a flavor of attitudes toward
`short sellers: "Your activities are mean, shameful and loathsome. They are motivated by appalling avarice and greed,
`and they will not be permitted to go unanswered." An example of the various anti-shorting strategies used by firms is
`provided by Solv-Ex, a firm that claimed to have technology for economically extracting crude oil from tar-laden sand.
`
`Short sellers claimed that Solv-Ex was a fraud. On 2/5/96, the management of Solv-Ex faxed a letter to brokers and
`shareholders: "To help you control the value of your investment...we suggest that you request delivery of the Solv-Ex
`certificates from your broker as soon as possible." This suggestion, entirely legal on the part of Solv-Ex, was
`essentially an attempt at market manipulation. The letter was an attempt to orchestrate a short squeeze using the
`stock lending system.
`
`Any shareholder heeding Solv-Ex's suggestion would have withdrawn his shares from the stock lending market,
`potentially forcing short sellers to cover their positions. On 2/2/96, before the letter, Solv-Ex's price was at $24.875.
`By 2/21/96, the price had risen to $35.375, perhaps due to Solv-Ex's attempted squeeze. Solv-Ex took other action
`against short sellers as well. Later in 1996, Solv-Ex said that it had hired private investigators to find out who was
`spreading misinformation about the firm, and subsequently it filed suit against a well-known short seller, claiming he
`had spread false information. However, in this case it was Solv-Ex which was engaged in illegal activities, not the
`short sellers. Solv-Ex delisted at 7/1/97 at $4.25, amid an SEC investigation of whether Solv-Ex had defrauded
`investors. It entered Chapter 11 bankruptcy in 1997, and in 2000 the court ruled that the firm had indeed defrauded
`investors.
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`Coalition for Affordable Drugs IV LLC - Exhibit 1045
`
`

`
`In this case, the evidence is consistent with the idea that Solv-Ex was overpriced in February 1996, since it
`subsequently fell sharply. My study, Lamont (2003), looks at long-term returns for a large sample of 270 similar firms
`who threaten, take action against, or accuse short sellers of illegal activity or false statements. It turns out that (as in
`the Solv-Ex case) sample firms have very low returns in the year subsequent to taking anti-shorting action. Returns
`relative to the overall stock market are approximately -24 percent per year. The evidence is strongly consistent with
`the idea that short sale constraints allow very substantial overpricing, and that this overpricing gets corrected only
`slowly over many months.
`
`While the underperformance of -24% per year is very large, it is similar in magnitude to the range found in other
`studies of stocks with very high short sale constraints, such as Jones and Lamont (2002), Lamont and Thaler (2003),
`and Ofek, Richardson, and Whitelaw (2003). Jones and Lamont (2002) find data for six years (1926-1933) while
`Lamont and Thaler (2003), and Ofek, Richardson, and Whitelaw (2002) studied data for a few years around the year
`2000. Each one of these four data sets has unique characteristics, and it is conceivable that any one result reflects
`chance or an unusual sample period. But taken together, the evidence shows that in extreme cases where short
`sellers want to short a stock but find it difficult to do so, overpricing can be very large.
`
`Fraud
`A notable feature of the data is that many of the firms fighting with short sellers and analysts are subsequently
`revealed to be fraudulent. A variety of other evidence suggests that short sellers are good at detecting and publicizing
`fraud on the part of firms (Dechow, Sloan, and Sweeney 1996, Griffin 2003). An SEC official testified that "many of
`the complaints we receive about alleged illegal short selling come from companies and corporate officers who are
`themselves under investigation by the Commission or others for possible violations of the securities or other laws."
`(U.S. House of Representatives, 1991, Pages 434-435). The SEC and other regulators cannot be our only line of
`defense against corporate fraud. To protect investors, we need a vibrant short selling community.
`
`The case of Enron illustrates many of the benefits of short sellers. It was short sellers who first raised red flags about
`Enron's accounting. These short sellers were able to communicate to the media, which helped publicize the
`problems. Short sellers helped detect and stop the fraud at Enron before it got any worse. Indeed, the problem with
`Enron was that there were too few short sellers and they arrived too late. Had short sellers been more numerous and
`aggressive, perhaps they could have detected the fraud earlier and prevented much of the damage done by Enron.
`Executives from Enron, in their recent trial in Houston, claimed short sellers had caused the demise of the company.
`This is nonsense; the jury didn't buy this story, and neither should you.
`
`Tech stock mania
`Even absent corporate fraud, though, short sellers play an important role in protecting individual investors from
`overpriced stocks. When informed traders are not able to go short, it will be small investors who unwittingly buy the
`overpriced stock, while the smart money stays away. For example, during the tech stock mania in 2000 there were
`some stocks that though clearly overpriced were not shortable for technical reasons. The victims were the individual
`investors who bought these stocks and suffered substantial losses. An example, documented in Lamont and Thaler
`(2003), is Palm, Inc. Palm was irrefutably overpriced in March 2000, but was difficult or impossible to borrow in the
`stock lending market, and thus could not generally by sold short. Institutions avoided owning Palm, and individual
`investors who blindly bought Palm suffered as it subsequently declined.
`
`More generally, suppose we consider the possibility that Internet stocks were priced much too high around 1998-
`2000. Perhaps many investors thought that Internet stocks were overpriced during the mania, but only a small
`minority was willing to take a short position, and these short sellers were not enough to drive prices down to rational
`valuations. As a result, billions of dollars was wasted on uneconomic enterprises, millions of investors suffered
`losses, and hundreds of thousands of workers switched jobs only to see their new companies fail. It seems to me that
`the problem was not enough short selling in 1998 to prevent stock prices from reaching untenable levels.
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`Historical pattern
`There is a natural tendency to feel that short selling is somehow inherently malevolent or un-American. To the
`contrary, it is quite positive for our economy to correct overpricing and detect fraud. And nothing could be more
`American than free speech, free markets, and a healthy competition among ideas and firms. If we are to have liquid
`markets that properly reflect available information, investors must be able to buy sell stocks as well as buy stocks.
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`Coalition for Affordable Drugs IV LLC - Exhibit 1045
`
`

`
`Governments often restrict short selling in an attempt to maintain high security prices.
`Meeker (1932) reviews the attempts by a colorful cast of characters (from Napoleon to the New York state legislature)
`to ban short selling. Unfortunately, short sellers face periodic waves of harassment from governments and society,
`usually in times of crisis or following major price declines as short sellers are blamed. Short sellers are often thought
`to be in league with America's enemies. The general idea is that short selling is bad, and when bad things happen
`(such as war) it probably involves short sellers in some way. For example, the New York Stock Exchange imposed
`special short selling regulations during World War I (in November 1917), in response to both a substantial market
`decline and a fear that the Kaiser would send enemy agents to drive down stock prices. Jones and Lamont (2002)
`discuss another historical episode following the crash of 1929. The anti-shorting climate was severe in October 1930.
`
`President Herbert Hoover met with the president of the NYSE to discuss the situation and to curtail possible bear
`raids implemented via short-selling. The FBI's J. Edgar Hoover was quoted as saying he would investigate the
`conspiracy to keep stock prices low. Numerous anti-shorting regulations stem from this period, such as the uptick rule
`and the Investment Company Act of 1940 which placed severe restrictions on the ability of mutual funds to short. This
`historical pattern has continued in recent years, as press reports indicate that authorities in Japan have sought to
`discourage shorting. Thankfully, in the past few years, Congress and the SEC have shown admirable restraint in not
`succumbing to the temptation to blame short sellers for the market decline following 2000.
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`Manipulation
`It is of course appropriate for the SEC and other authorities to investigate possible manipulation involving short sales.
`But in general, there is no reason to believe that short selling is more likely, compared with other trading activity, to be
`used to manipulate stock prices. In fact, there are reasons to believe that short selling is less likely to be involved in
`illegal manipulations. There are even certain types of manipulation (such as "cornering" the stock) in which short
`sellers are the desired victims of manipulation.
`
`Certainly, the big story from the past few years has been questionable behavior on the part of issuing firms, analysts,
`accounting firms, and underwriters. The short sellers have been the heroes of the past few years, alerting the public
`and the authorities to corporate fraud. And it has been the hedge funds which have simultaneously preserved
`investor capital and corrected mispricing.
`
`Recommendations
`My opinion, therefore, is that we need to change the current lopsided system that discourages short selling. First, in
`the narrow technical arena, we should consider ways to make the equity lending system work better. It seems
`particularly unhelpful that (sometimes fraudulent) firms are able to abuse various aspects of the system in order to
`prevent short selling.
`
`Second, in the broader arena, we should continue to encourage the development of institutions that channel capital
`into short selling. Happily, there are signs of progress on both fronts, and as more capital is devoted towards short
`selling it is likely that market forces will help improve the efficiency of the equities lending system. Third, it would be
`useful to consider ways of protecting independent analysts from lawsuits. It is important that analysts not be reduced
`to cheerleaders, but rather be allowed to express honest opinions.
`
`Congress and the SEC will continue to hear complaints from companies about short sellers. As I mentioned earlier,
`the evidence shows that when companies and short sellers fight, it is the short sellers who are usually vindicated by
`subsequent events. For example, in 1989, the House Committee on Government Operations (Commerce, Consumer
`and Monetary Affairs subcommittee) held hearings about the alleged evils of short selling, featuring testimony from
`supposedly victimized firms. Officials from three firms testified. Subsequent to this testimony, the presidents of two of
`these three firms were charged with fraud by the SEC.* Thus when youhear companies complain, keep in mind that
`short sellers are often the good guys.
`
`Thank you for this opportunity to testify, and I would be happy to answer any questions.
`* The three firms were American City Business Journals (Wall Street Journal, 1991), Carrington Laboratories (U.S.
`House of Representatives, 1991, p. 513), and IGI, Inc. (Wall Street Journal, 2002)
`
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`Coalition for Affordable Drugs IV LLC - Exhibit 1045