Profit and Ethics in Short Selling: The Case of Muddy Waters


By: Winky T. Yang


As a short selling research firm, Muddy Waters (MW) earned its reputation by successfully revealing several fraudulent Chinese firms listed in the US. MW’s combination of short selling and equity research is a clever business model, necessary to satisfy the market’s need for research analysts/firms independent of sell-side companies. This article analyzes the profit and ethics of short selling by examining the roles of research analysts and short sellers. It concludes that each MW research report should be considered individually to determine the integrity of the research and therefore, the ethics of the firm’s behavior.

  1. Muddy Waters LLC

Muddy Waters LLC defines itself as a investment research firm that publishes its research for free public consumption. Its research covers business fraud, accounting fraud and other fundamental problems. But what MW actually does is more than merely publish research reports. In its Terms of Service, it expressly states that one “should assume that as of the publication date of our reports and research, Muddy Waters, LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our clients and/or investors and/or their clients and/or investors has a short position in all stocks (and/or options, swaps, and other derivatives related to the stock) and bonds covered herein, and therefore stands to realize significant gains in the event that the price of either declines”. In other words, before MW publishes its research report, it may have shorted the stocks covered and thus profit from the decline in the stock price, a usual consequence of the negative rating in its report. Therefore, MW is actually a short selling research firm.

As of June 2014, MW rated 11 listed companies with 9 of them being Chinese firms, 1 from Singapore and 1 from the U.S. This article mainly focuses on the 9 “Chinese fraud” cases. MW aimed its research focus at US-listed Chinese companies since it first published a report in June 2010 on Orient Paper Inc (“ONP”). While ONP is still listed today, its stock price is over 50% lower than it was before MW’s “strong sell” rating. The 4 companies: Rino International Corporation (RINO), China Media Express Holdings (CCME), Duoyuan Global Water Inc. (DGW) and Sino-Forest Corporation (TRE) rated by MW as “strong sells” were delisted from the stock market. These delisted companies were later proved to be problematic as MW suggested. However, the following 3 allegedly fraudulent companies successfully defended themselves: Focus Media Holding Inc. (FMCN), New Oriental Education & Technology Group (EDU) and Olam International (OLAM:SP). But not before their share prices were negatively affected by the reports after publication and MW profited by short selling the stocks. While the stock prices of the companies rose subsequently after their successful defense, the process consumed time and money.

  1. Research, Short Sale or a Combination?

The major concern about MW’s business model is that it may be a way of manipulating the market by publishing inaccurate reports to profit from short sales. One undeniable fact is all stock prices of firms covered by short selling analysts have dropped significantly, some by over 70%, upon the release of the reports, regardless of the credibility of the reports. Most investors are cautious and conservative—they may decide to not buy that quickly upon good news, but they will sell first before questioning bad news. In other words, even if the company under scrutiny does not have problems, it is likely to suffer share price declines while the short seller enjoys profits. Undoubtedly, MW’s is a clever business model, but is its business practice ethical? Accordingly, we need to examine the status of MW as both an analyst and a short seller.

2.1 Research Analysts/Firms

Research analysts are generally categorized into three groups: sell-side, buy-side and independent. Sell-side analysts are those working for the brokerage firms, typically the investment banks. In contrast, buy-side analysts work for the money management firms, such as mutual funds, pension funds and hedge funds, which actually invest money in the markets. Independent analysts are independent from both the brokerage firms and investing institutions.

The reports of the buy-side analysts are required to be objective and accurate. The more objective and accurate the research, the more helpful it will be for the performance of the investing institution. Therefore, the buy-side analysts lack incentive to produce flawed reports and are thus less regulated.

Since research analysts are expected to function as unbiased intermediaries between issuers and investors, New York Stock Exchange (“NYSE”) and Financial Industry Regulatory Authority (“FINRA”, formerly known as National Association of Securities Dealers, NASD) have implemented rules (“SRO rules”) to improve the objectivity of research and reduce conflicts of interest. In addition, the CFA Institute, supporting the SRO rules in the U.S., recommends similar practices to research analysts worldwide in its Research Objectivity Standard (“ROS”).

Most regulations aim at sell-side analysts given the serious potential conflicts of interest between the integrity of their reports and their own financial interests. Reports by sell-side analysts affect, directly or indirectly, the issuers’ offering and thus the deals of their brokerage firms. As an integral part of the brokerage firms, compensation and bonuses of analysts are inevitably tied to the business of their firms. Although the existence of such relations does not necessarily lead to biased reports, it is reasonable to question the integrity of sell-side research and to implement rules ensuring objectivity of reports. Similar rules also apply to independent research reports paid for by brokers or dealers, who are able to put pressure on the analysts to get favorable reports. The conflicts of interest mentioned above are likely to result in a biased report favorable to the issuer, but misleading to investors. Therefore, most regulations regarding research analysts are designed to prevent analysts from producing biased reports favoring the issuers and indirectly benefiting from such reports.

There are research firms not under pressure to give positive recommendation as they run the research business in a different way. This type of independent research provides reports open to the public, rather than researching for the brokers or issuers. MW is one of these research firms i.e., independent research for free publication. There is less compulsion for the research firm to give buy recommendations, but are its opinions truly unbiased? While the company does not get paid for its research, how does it make profits? For MW, the major incentive is profiting from the short sale of stocks covered by its analysts.

2.2  Short Sale of Stocks

Short selling has long been recognized as a double-edged sword. The Securities and Exchange Commission (“SEC”) appreciates that “short selling provides the market with at least two important benefits: market liquidity and pricing efficiency”. Intending to profit from the difference between the pricing and value of stocks, ethical and legal short sellers can effectively address financial frauds. The SEC lacks resources to bring it leads on companies having problematic accounting or outright fraud. Short sellers have both the incentive and capacity to identify questionable companies.

However, potential abuse exists in this practice. The SEC has taken actions to prevent and penalize the abuse, in accordance with the Securities Exchange Act of 1934. The Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) of 2010, recognizing the contribution of short sellers to the market, promotes specific reform on short sale regulations, such as more stringent public disclosure requirements and the prohibition of manipulative short sales.

2.3  Short Selling Research Firm

Given the characteristics of a short seller and a research analyst, the argument for the combination of these two is quite convincing. Firstly, the market needs independent research firms to provide objective and unbiased reports, especially unprejudiced negative ratings. Secondly, to be independent and unbiased, the research firm has to find another way to earn profits rather than selling reports to brokers or issuers. In other words, financial professionals need incentives to be independent research analysts. Profits from short selling satisfy the need. Thirdly, short sellers do function efficiently and effectively in identifying problematic companies and cleaning up the market. Although there is potential abuse of short selling, regulators are aware of this and have taken actions against illegalities. Therefore, there are good reasons for the existence of short selling research firms like MW.

Nevertheless, one big concern arises from the first reason above. When research firms are allowed to short sell stocks they cover, can they really generate reports without bias? MW first made its name by successfully revealing the problems of some U.S. listed Chinese. The firms has lost some public confidence when its recent allegation of fraud was rebutted. As MW’s reports caused a plunge in stock prices upon their release, the firm has earned sizable profits from its short positions in the stocks covered by the reports. Consequently, the objectivity and trustworthiness of MW’s reports are in doubt. There is the possibility that MW manipulates the stock price by rating the stock negatively in order to profit from its short position. The research firm is no longer under pressure to rate positively, but it now has the financial incentive to rate negatively.

The potential profit from short selling is, on one hand, the support and incentive for independent research firms, but on the other hand, the interest may conflict with the provision of an objective rating. As prescribed in the CFA Institute Code of Ethics and Standards of Professional Conduct, professionals shall “act with integrity, competence, diligence” and “place the integrity of the investment profession … above their own personal interests”. Therefore, MW’s behavior is ethical if: (1) MW analysts write a research report with integrity, competence and due diligence and (2) MW publicly discloses its short position. However, if MW produces a flawed report with bias towards profiting for itself, such market manipulative behavior is neither legal nor ethical. The integrity of the report and proper public disclosure of its short position is decisive to whether MW’s behavior is ethical.

  1. Profits and Ethics in Short Selling Research

Independent research firms are important to the market as well as investors. Short sellers contribute significantly to the health of the market, acting as watchdogs over listed companies. There are good reasons for the combination of these two, resulting in short selling research firms like MW. The need for integrity and objectivity in equity research leads to a demand for independent research firms. To provide incentive and support for research firms independent of sell-side companies, short selling should be permitted as a means to such firms toe earn profits. Unfortunately, the potential profit from short selling may compromise the primary need for integrity and objectivity. The negative rating of companies given by MW and published freely online for the public, undoubtedly causes stock price declines and affects the U.S. listed Chinese company sector in general. Apart from fulfilling the disclosure requirement of short sale, firms like MW should bear in mind the professional ethics mentioned above.

The SEC and other regulators have specific regulations against market manipulation. However, between “unethical” and “manipulative” lie vagueness and the need for sound judgment. Negatively rated companies encounter some difficulty in proving manipulation of their stock price in the short sale. The best a negatively rated company can do is to rapidly rebut the allegation with evidence to contradict negative reports. Some of the Chinese companies in MW’s research have spent time and treasure in vindicating themselves against allegations of incompetence and fraud. Even if the company is actually well-run, it usually takes some time before its stock price resumes. Therefore, an unethical short selling research report can do great damage to both the market and the target companies.








Muddy Waters LLC Official Website;

CFA Institute Research Objectivity Standards

CFA Institute Code of Ethics and Standards of Professional Conduct

Section 929X, Dodd-Frank Wall Street Reform and Consumer Protection Act

NYSE Rule 472

NASD Rule 2711

Securities Exchange Act Release No. 34-48709 (Oct. 28, 2003)

Joint Report by NASD and the NYSE On the Operation and Effectiveness of the Research Analyst Conflict of Interest Rules

“Prof. Gillis: Muddy Waters FMCN Report Attacks Crony Corporate Governance in China”

“The Impact Of Sell-Side Research”

“The Threat of Litigation Chills Analyst Independence: Observations of a Short Seller ”

“New Oriental Clears Muddy Waters”

“Muddy Waters Is Looking at More ‘Suspicious’ Chinese Companies, Block Says”