Who watches the watchman?
07 July 2020
As the dust settles on the collapse of Wirecard, regulators shouldn’t sweep their part in the scandal under the rug ignoring the short selling ban that protected fraudsters
Image: Romolo Tavani/shutterstock.com
The 20-year saga of Wirecard’s meteoric rise from humble beginnings to become one of the standard-bearers of German technological prowess, only to fall from grace so publicly last month, has enough colourful characters and plot twists to make a George RR Martin novel blush.
Intrigue, subversion and a host of warring factions, some of which courted an uneasy alliance only to now be pitted against each other once the status quo began to unravel and their own failings risked being exposed.
Chief among these are the short sellers which might now enjoy being characterised as plucky underdogs that have been vindicated and rightly rewarded for their perseverance in the face of overwhelming odds. The rebel alliance that took on the corrupt empire and won. David and Goliath. You get the idea. The problem with this analogy is that as far as is publicly known, there was no alliance of short sellers. The short interest appears to have come from lone actors that either did their own research or trusted the work of others that had caught a bad smell coming from Wirecard’s accounts.
In fact, the claims that short sellers were acting in concert to bring down the payment processing giant came first from Wirecard and later from BaFin, the German financial markets regulator. In the media whirlwind that engulfed Wirecard in June amid accusations of misplacing, or inventing, nearly €2 billion, this sub-plot has largely been forgotten by those involved. Concerns around how such a prominent firm managed to dodge scrutiny of its allegedly-cooked books have understandably taken centre stage so far. But, accusations of accounting fraud may ultimately prove rather humdrum compared to the more pernicious conspiracy to protect the darling of Germany’s tech sector from activist short sellers.
The ban
Wirecard was founded in 1999 in Munich with a run-of-the-mill credit card payment processing service. After a rocky start, the ship was steadied by former-KPMG consultant, Markus Braun, who took over in 2002. Braun was among the first of Wirecard’s senior management to resign last month shortly before being arrested by the Munich authorities.
Under his stewardship, Wirecard found its niche processing payments for companies in the pornography and online gambling sectors, made some acquisitions and then entered the Frankfurt Stock Exchange in 2005.
It continued to grow and first came to the attention of short sellers in 2008, who were alerted by accusations of accounting irregularities by German shareholders. EY, one of the Big Four accounting firms, was brought in to quash the claims. It now has its own questions to answer. Wirecard escaped the incident largely unscathed and continued to grow and buy-up other payments service providers around the world; mostly in Asia.
In 2015, the UK’s Financial Times newspaper began to take an interest in Wirecard’s activities and published a series of articles which brought down the wrath of Wirecard’s legal team.
A year later, short interest was renewed after new evidence surfaced of Wirecard exaggerating its earnings, international scope and bank balance. Known short sellers and journalists covering the matter became the target of cyber-attacks by unknown actors while Wirecard continued to threaten legal action.
Then, in February 2019, following another round of shorting and yet more allegations of Wirecard’s financial mismanagement, BaFin did something it had never done before. It applied to the European Â鶹´«Ă˝ and Markets Authority (ESMA) for a two-month short selling ban on Wirecard shares. At the time, BaFin argued that the intense short interest and significant share price drop the firm was battling “constituted a threat to the orderly markets and to market confidence”.
Until now BaFin had stood firmly behind Wirecard during each of the prior incidents of accusations followed by short interest and negative headlines. But, this latest action was different. No EU regulator has ever applied for a short selling ban for a single issuer outside of a major financial crisis. Even during periods of volatility such as that seen during the recent COVID-19 turmoil in Europe in February and March, national regulators only ever sought to protect floundering banks, not fintech firms, and only for single trading days at a time, not two months. Confusingly, when some European regulators imposed blanket bans on short selling in embattled equities markets under their respective remits, BaFin was one of the most outspoken critics of the restrictions.
The blame game
When it came to Wirecard, BaFin saw the growing black smoke-cloud of accusations filling the sky and prayed for wind, rather than checking on the barn.
In its request for ESMA’s endorsement of a ban, BaFin’s argument was two-fold. Firstly, it emphasised that Wirecard’s size and international prominence meant that its rapid decrease in value was a threat to Germany’s economic stability. Moreover, it argued that such concerted “attacks” on a member of the prestigious DAX 30 index (which it joined in 2018 by supplanting Commerzbank) represented “a risk of contagion to other shares of the DAX”.
Secondly, BaFin supplied evidence to ESMA that indicated that members of the media were working with short sellers for mutual gain and the downfall of Wirecard. BaFin highlighted repeated instances where short positions were increased mere minutes after new negative stories were published by the press.
This, it claimed, indicates that hedge funds were not simply reading the reports and reacting but were acting in coordination with journalists. It is worth noting at this point that, bar closely-alignment in press coverage and further short activity, BaFin has failed to produce any evidence to corroborate its claims, despite calls to do so. Around the same time, the regulator took another radical step by filing a criminal complaint against two Financial Times reporters and certain short sellers that were most prolific is asking awkward questions about Wirecard. Again, however, the regulator did not go so far as to make evidence for its concerns public. The day after BaFin filed its application for a ban on shorting Wirecard, the FT issued a statement on its legal snafu with the regulator.
“We have not been contacted by the German financial regulator or the Munich prosecutor,” the newspaper’s statement read. “Any investigation would, therefore, appear to be at the very earliest stage, with investigators not yet having spoken to those they say they are investigating.” No further action has been taken.
When asked by this magazine if the ban could still be justified in light of recent events, a BaFin spokesperson explains: “At the time of our short selling ban, we observed a) big (and growing) net short positionings, b) significant losses in share price, c) high volatility and d) specific hints on manipulation of share prices (via coordinated short selling attacks).
“This set of factors forced us to take action. Our target was neither evaluating the outstanding accusations nor shielding a single issuer, our focus was on protecting market confidence.”
For ESMA’s part, it agreed with BaFin’s analysis and issued a positive opinion on the ban.
At the time, ESMA said it believed “that the price drop, the sharp increase in the net short positions and the high volatility observed in the prices of Wirecard shares constituted a threat to the orderly markets and to market confidence if those circumstances have not been caused by the release of fundamental information related to Wirecard”.
The authority further noted that “the possibility that the large short positions and the severe declines in price observed over the last weeks might correspond to manipulative practices constitutes in ESMA´s view a clearly adverse scenario for market confidence, as it risks undermining investors’ trust in the price formation mechanism”.
ESMA also reinforced BaFin’s actions prior to the ban stating that “the coincidence in time of the building up of significant net short positions, the publication of the news reports and the abrupt price declines described by BaFin deserve further investigations, in particular since similar situations took place in 2008 and 2016, that were subject to scrutiny by BaFin and German public prosecutors”.
SFT also offered ESMA the opportunity to review the validity of BaFin’s evidence of a conspiracy or the fact its endorsement of the ban now appears to have helped block legitimate investors from expressing a negative sentiment towards a fraudulent company.
An ESMA spokesperson replied by noting that “ESMA took its decision based on the material provided by BaFin in support of their proposed short selling restriction”.
“ESMA’s role in assessing requests under the Short Selling Regulation (SSR) is limited to assessing whether there is a risk to financial stability or market confidence and on the basis of the information available at that time provided by BaFin we concluded that this was the case.”
The spokesperson also noted that the SSR only allows ESMA a 24-hour window to respond and “does not require, or provide any powers to ESMA to conduct supervisory investigations into the underlying evidence supporting a short selling measure proposed by a national authority”.
Hindsight is 20/20 and the 40 percent share price drop that Wirecard suffered in the two weeks leading up to the ban no doubt raised alarms in Bonn and Paris, but regulators should now be equally concerned that they appear to have been manipulated into shielding a firm that deserved every short position it had against it. Another feature of the SSR is that BaFin would have been able to unilaterally impose a ban even if ESMA issued a negative opinion but this would have undoubtedly have caused a headache for the German regulator in justifying the unprecedented move.
Many within the securities lending and short selling communities were loudly critical of the ban at the time and are repeating their grievances now.
Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), argued vehemently at the time that imposing the ban was unjustifiable and that if market abuse is suspected then the authorities have all the tools they need in the Market Abuse Directive.
In a note to members last week, he further stated that “what is very clear is that short selling hedge funds did not cause the demise of Wirecard. Far from it.”
He went on to state: “It takes bravery and belief to commit to short positions but at last those hedge funds who have stuck with it have been vindicated. Sure, there will be some who say it is wrong for hedge funds to benefit from corporate misery, but there would have been a lot less misery for those investors who continued to buy the shares (up to a peak of €191 in the summer of 2018) had they paid heed to the public signals being put out by the short sellers.”
Missed opportunity?
As the complex web of Wirecard’s deception unravels and those involved are able to assess the part they played, regulators initially seemed keen to learn lessons from the affair that led up to the first insolvency filing of a DAX 30 member. BaFin has found the tables turned as it goes from inquisitor to defendant. In the wake of last month’s revelations and the belated collapse of Wirecard, the European Commission has instructed ESMA to conduct a “fact-finding mission” to figure out what went wrong, including a review of the supervisory responses to the events.
However, regulators risk ignoring what could arguably be a fundamental undermining precedent of EU rules meant to protect market participants during emergency situations. ESMA has subsequently confirmed to SLT that the request “focuses on financial reporting requirements under the Transparency Directive”. This suggests that the short selling ban will not feature prominently in their investigation but it has not been ruled out entirely. Watch this space.
Short selling bans are not meant to protect fraudulent firms from facing the consequences of their actions. Wirecard, at least in its current form, is no more and yet the sky has not fallen in Germany, as BaFin feared it would. In fact, the European Commission is now arguing that BaFin’s suspected mishandling of the affair is a much larger threat to market confidence than the collapse of Wirecard ever could be.
“While we are not in a position to comment on a national investigation, we would recall that the effectiveness of EU rules depend on supervisors having a strong oversight of the activities of market players and listed companies,” a commission spokesperson tells SLT.
“Strong regulation and supervision are key to preserving trust in finance, whether for traditional or new players,” they add. “This is key in order to ensure transparency, investor and consumer protection, and financial stability in the EU.”
The European Commission’s executive vice-president Valdis Dombrovskis noted succinctly: “We need to clarify what went wrong.” Indeed we do.
Hopefully, the right lessons will be learned so that regulators can properly discern between legitimate investment strategies and predatory activities when the inevitable next Wirecard comes along.
Intrigue, subversion and a host of warring factions, some of which courted an uneasy alliance only to now be pitted against each other once the status quo began to unravel and their own failings risked being exposed.
Chief among these are the short sellers which might now enjoy being characterised as plucky underdogs that have been vindicated and rightly rewarded for their perseverance in the face of overwhelming odds. The rebel alliance that took on the corrupt empire and won. David and Goliath. You get the idea. The problem with this analogy is that as far as is publicly known, there was no alliance of short sellers. The short interest appears to have come from lone actors that either did their own research or trusted the work of others that had caught a bad smell coming from Wirecard’s accounts.
In fact, the claims that short sellers were acting in concert to bring down the payment processing giant came first from Wirecard and later from BaFin, the German financial markets regulator. In the media whirlwind that engulfed Wirecard in June amid accusations of misplacing, or inventing, nearly €2 billion, this sub-plot has largely been forgotten by those involved. Concerns around how such a prominent firm managed to dodge scrutiny of its allegedly-cooked books have understandably taken centre stage so far. But, accusations of accounting fraud may ultimately prove rather humdrum compared to the more pernicious conspiracy to protect the darling of Germany’s tech sector from activist short sellers.
The ban
Wirecard was founded in 1999 in Munich with a run-of-the-mill credit card payment processing service. After a rocky start, the ship was steadied by former-KPMG consultant, Markus Braun, who took over in 2002. Braun was among the first of Wirecard’s senior management to resign last month shortly before being arrested by the Munich authorities.
Under his stewardship, Wirecard found its niche processing payments for companies in the pornography and online gambling sectors, made some acquisitions and then entered the Frankfurt Stock Exchange in 2005.
It continued to grow and first came to the attention of short sellers in 2008, who were alerted by accusations of accounting irregularities by German shareholders. EY, one of the Big Four accounting firms, was brought in to quash the claims. It now has its own questions to answer. Wirecard escaped the incident largely unscathed and continued to grow and buy-up other payments service providers around the world; mostly in Asia.
In 2015, the UK’s Financial Times newspaper began to take an interest in Wirecard’s activities and published a series of articles which brought down the wrath of Wirecard’s legal team.
A year later, short interest was renewed after new evidence surfaced of Wirecard exaggerating its earnings, international scope and bank balance. Known short sellers and journalists covering the matter became the target of cyber-attacks by unknown actors while Wirecard continued to threaten legal action.
Then, in February 2019, following another round of shorting and yet more allegations of Wirecard’s financial mismanagement, BaFin did something it had never done before. It applied to the European Â鶹´«Ă˝ and Markets Authority (ESMA) for a two-month short selling ban on Wirecard shares. At the time, BaFin argued that the intense short interest and significant share price drop the firm was battling “constituted a threat to the orderly markets and to market confidence”.
Until now BaFin had stood firmly behind Wirecard during each of the prior incidents of accusations followed by short interest and negative headlines. But, this latest action was different. No EU regulator has ever applied for a short selling ban for a single issuer outside of a major financial crisis. Even during periods of volatility such as that seen during the recent COVID-19 turmoil in Europe in February and March, national regulators only ever sought to protect floundering banks, not fintech firms, and only for single trading days at a time, not two months. Confusingly, when some European regulators imposed blanket bans on short selling in embattled equities markets under their respective remits, BaFin was one of the most outspoken critics of the restrictions.
The blame game
When it came to Wirecard, BaFin saw the growing black smoke-cloud of accusations filling the sky and prayed for wind, rather than checking on the barn.
In its request for ESMA’s endorsement of a ban, BaFin’s argument was two-fold. Firstly, it emphasised that Wirecard’s size and international prominence meant that its rapid decrease in value was a threat to Germany’s economic stability. Moreover, it argued that such concerted “attacks” on a member of the prestigious DAX 30 index (which it joined in 2018 by supplanting Commerzbank) represented “a risk of contagion to other shares of the DAX”.
Secondly, BaFin supplied evidence to ESMA that indicated that members of the media were working with short sellers for mutual gain and the downfall of Wirecard. BaFin highlighted repeated instances where short positions were increased mere minutes after new negative stories were published by the press.
This, it claimed, indicates that hedge funds were not simply reading the reports and reacting but were acting in coordination with journalists. It is worth noting at this point that, bar closely-alignment in press coverage and further short activity, BaFin has failed to produce any evidence to corroborate its claims, despite calls to do so. Around the same time, the regulator took another radical step by filing a criminal complaint against two Financial Times reporters and certain short sellers that were most prolific is asking awkward questions about Wirecard. Again, however, the regulator did not go so far as to make evidence for its concerns public. The day after BaFin filed its application for a ban on shorting Wirecard, the FT issued a statement on its legal snafu with the regulator.
“We have not been contacted by the German financial regulator or the Munich prosecutor,” the newspaper’s statement read. “Any investigation would, therefore, appear to be at the very earliest stage, with investigators not yet having spoken to those they say they are investigating.” No further action has been taken.
When asked by this magazine if the ban could still be justified in light of recent events, a BaFin spokesperson explains: “At the time of our short selling ban, we observed a) big (and growing) net short positionings, b) significant losses in share price, c) high volatility and d) specific hints on manipulation of share prices (via coordinated short selling attacks).
“This set of factors forced us to take action. Our target was neither evaluating the outstanding accusations nor shielding a single issuer, our focus was on protecting market confidence.”
For ESMA’s part, it agreed with BaFin’s analysis and issued a positive opinion on the ban.
At the time, ESMA said it believed “that the price drop, the sharp increase in the net short positions and the high volatility observed in the prices of Wirecard shares constituted a threat to the orderly markets and to market confidence if those circumstances have not been caused by the release of fundamental information related to Wirecard”.
The authority further noted that “the possibility that the large short positions and the severe declines in price observed over the last weeks might correspond to manipulative practices constitutes in ESMA´s view a clearly adverse scenario for market confidence, as it risks undermining investors’ trust in the price formation mechanism”.
ESMA also reinforced BaFin’s actions prior to the ban stating that “the coincidence in time of the building up of significant net short positions, the publication of the news reports and the abrupt price declines described by BaFin deserve further investigations, in particular since similar situations took place in 2008 and 2016, that were subject to scrutiny by BaFin and German public prosecutors”.
SFT also offered ESMA the opportunity to review the validity of BaFin’s evidence of a conspiracy or the fact its endorsement of the ban now appears to have helped block legitimate investors from expressing a negative sentiment towards a fraudulent company.
An ESMA spokesperson replied by noting that “ESMA took its decision based on the material provided by BaFin in support of their proposed short selling restriction”.
“ESMA’s role in assessing requests under the Short Selling Regulation (SSR) is limited to assessing whether there is a risk to financial stability or market confidence and on the basis of the information available at that time provided by BaFin we concluded that this was the case.”
The spokesperson also noted that the SSR only allows ESMA a 24-hour window to respond and “does not require, or provide any powers to ESMA to conduct supervisory investigations into the underlying evidence supporting a short selling measure proposed by a national authority”.
Hindsight is 20/20 and the 40 percent share price drop that Wirecard suffered in the two weeks leading up to the ban no doubt raised alarms in Bonn and Paris, but regulators should now be equally concerned that they appear to have been manipulated into shielding a firm that deserved every short position it had against it. Another feature of the SSR is that BaFin would have been able to unilaterally impose a ban even if ESMA issued a negative opinion but this would have undoubtedly have caused a headache for the German regulator in justifying the unprecedented move.
Many within the securities lending and short selling communities were loudly critical of the ban at the time and are repeating their grievances now.
Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), argued vehemently at the time that imposing the ban was unjustifiable and that if market abuse is suspected then the authorities have all the tools they need in the Market Abuse Directive.
In a note to members last week, he further stated that “what is very clear is that short selling hedge funds did not cause the demise of Wirecard. Far from it.”
He went on to state: “It takes bravery and belief to commit to short positions but at last those hedge funds who have stuck with it have been vindicated. Sure, there will be some who say it is wrong for hedge funds to benefit from corporate misery, but there would have been a lot less misery for those investors who continued to buy the shares (up to a peak of €191 in the summer of 2018) had they paid heed to the public signals being put out by the short sellers.”
Missed opportunity?
As the complex web of Wirecard’s deception unravels and those involved are able to assess the part they played, regulators initially seemed keen to learn lessons from the affair that led up to the first insolvency filing of a DAX 30 member. BaFin has found the tables turned as it goes from inquisitor to defendant. In the wake of last month’s revelations and the belated collapse of Wirecard, the European Commission has instructed ESMA to conduct a “fact-finding mission” to figure out what went wrong, including a review of the supervisory responses to the events.
However, regulators risk ignoring what could arguably be a fundamental undermining precedent of EU rules meant to protect market participants during emergency situations. ESMA has subsequently confirmed to SLT that the request “focuses on financial reporting requirements under the Transparency Directive”. This suggests that the short selling ban will not feature prominently in their investigation but it has not been ruled out entirely. Watch this space.
Short selling bans are not meant to protect fraudulent firms from facing the consequences of their actions. Wirecard, at least in its current form, is no more and yet the sky has not fallen in Germany, as BaFin feared it would. In fact, the European Commission is now arguing that BaFin’s suspected mishandling of the affair is a much larger threat to market confidence than the collapse of Wirecard ever could be.
“While we are not in a position to comment on a national investigation, we would recall that the effectiveness of EU rules depend on supervisors having a strong oversight of the activities of market players and listed companies,” a commission spokesperson tells SLT.
“Strong regulation and supervision are key to preserving trust in finance, whether for traditional or new players,” they add. “This is key in order to ensure transparency, investor and consumer protection, and financial stability in the EU.”
The European Commission’s executive vice-president Valdis Dombrovskis noted succinctly: “We need to clarify what went wrong.” Indeed we do.
Hopefully, the right lessons will be learned so that regulators can properly discern between legitimate investment strategies and predatory activities when the inevitable next Wirecard comes along.
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