Misleading the market: an analysis of the Citron Research case
The recent Market Misconduct Tribunal (MMT) decision in the Citron Research case confirms the usefulness of Section 277 of the Securities and Futures Ordinance (SFO) for regulators seeking to prevent a false market in the shares of Hong Kong listed companies.
Evergrande Real Estate Group Ltd is a Mainland property developer listed on the Hong Kong Stock Exchange. In 2012, it was among the Mainland’s biggest property developers. It reported a roughly 47% increase in net group profit in its 2011 financial year. Several prominent banks wrote favourable research reports about it, recommending ‘buy’. Its share price was relatively stable from April to June 2012. On 21 June 2012, Evergrande’s share price rose as high as HK$4.52, but fell as low as HK$3.60 and closed at HK$3.97, about 11% lower than the previous day’s closing price. Evergrande’s stock turnover that day was four times more than 2012’s previous high. The Hang Seng Index only fell 1.3% that day.
On 21 June 2012, Evergrande was the subject of a report issued on the internet at sometime in the morning Hong Kong time. It made a number of allegations, most seriously that ‘Evergrande is essentially an insolvent company that has consistently presented fraudulent information to the investing public’.
Citron Research issued the report. This is a business name of Andrew Left. Citron was previously unknown in Hong Kong. This was its first report on a Hong Kong listed company. On its website, Citron claimed a 10-year successful record issuing reports identifying fraud and ‘terminal business models’.
Around March 2012, Left received an anonymous package of material analysing Evergrande. It made the two key allegations Left’s report did. Left reviewed the material, deleted publicly non-verifiable information using the internet and company filings, updated the numerical information and published it as his report. He did not seek any expert advice on the accounting standards that applied to Evergrande or approach the company for comment first.
The MMT characterised the report as being ‘presented in a hard-hitting “tabloid” style’, using bold headlines such as ‘fraudulent accounting’, and accusing Evergrande of ‘intentionally and systematically hiding important financial information from investors’. An expert witness who testified before the MMT characterised the report as ‘frightening’ to general investors.
The report quickly became news internationally, being picked up by equity researchers and news services around 10.30am–11.00am on 21 June 2012. By 1.00pm, Evergrande issued a clarification announcement denying the allegations. Later, Evergrande held a telephone conference with analysts again denying the allegations. That day, a number of prominent banks issued reports disagreeing with the Citron report. On 22 June, Evergrande issued a longer announcement rejecting the allegations.
In the report, Citron said Evergrande was a good opportunity to short sell and that Citron might hold a short position. Left short sold Evergrande shares from 6 to 19 June. On 21 June, he bought shares to cover his short position. He made a profit of HK$1,596,240.
The Citron Research case
The SFC, with the assistance of the US Securities and Exchange Commission, investigated Left and, on 15 December 2014, started proceedings against him in the MMT accusing Left of breach of Section 277 of the SFO.
Section 277 is a form of civil market misconduct committed where someone:
- in Hong Kong or elsewhere disseminates information
- that information is likely to induce another person to trade the securities in Hong Kong or be likely to affect its price in Hong Kong
- that information is false or misleading as to a material fact or through the omission of the same, and
- the person who disseminated the information must know, be reckless or negligent as to whether the information is false or misleading as to that.
The SFC specifically alleged that:
- Left disseminated the report and information in it
- the information was false and/or misleading as to a material fact or through the omission of the same in that Evergrande was not insolvent and had not engaged in fraudulent accounting
- that information was likely to induce people to trade Evergrande shares or affect its share price in Hong Kong, and
- Left knew, was reckless or negligent that the two allegations were false and/or misleading as to material facts.
The MMT heard the case from 22 February to 3 March 2016.
Left argued a number of legal points.
Before the main hearing, Left argued that, because the SFC alleged that the report was false and/or misleading in claiming that Evergrande was insolvent and had not presented true accounts, Left was entitled to discovery of Evergrande’s corporate documents relevant to its solvency and true financial position. This was far wider than the scope of documents the SFC had disclosed or that the SFC had investigated into as the SFC had concluded early in its investigation that Left’s two key allegations were poorly reasoned and its conclusions unjustified. The SFC argued and the MMT accepted that Left’s report was based on publicly available material and the question was whether Left’s report was false or misleading on the basis of material on which it was prepared and publicly available information. The MMT therefore refused Left’s application. At the hearing, Left reargued the point saying that he had been denied a reasonable opportunity of being heard as a result. The MMT again rejected this argument for the same reason. Left then argued that the SFC should only be allowed to admit evidence that post-dated Left’s report. The MMT rejected this, ruling that material would be admitted if it was relevant to whether Left’s report was false or misleading based on publicly available information at the time Left issued his report.
Left also argued that negligence should be judged differently for those who did not have a special relationship to the market by being company insiders or analysts, as people outside these categories assumed no duty of care to the market. He suggested this would better protect freedom of speech. The MMT rejected this argument saying that Section 277 on its own words applied to everyone who disseminated information that might affect the market and did not restrict liability for negligence to those with a special relationship to the market. It noted that freedom of speech was not unqualified and the restrictions Section 277 imposed on that freedom proportionately protected legitimate public interests.
Left further argued that it was enough to avoid negligence for an outsider like a short-selling stock commentator who relies on public information and has no special relationship like a company insider or licensed analyst to make clear they rely on public information and set out that public information. The MMT rejected this, ruling it would not protect financial markets sufficiently from false or misleading information. It ruled that whether Left was negligent would be judged by whether Left took the care that a reasonably prudent market commentator or analyst would take.
There was no argument that Left had disseminated information by issuing his report. Left, however, argued that his report was not likely to affect trading decisions or Evergrande’s share price as he was unknown in Hong Kong. The MMT decided that, owing to Left’s reputation as a fraud analyst, the sensational nature of the allegations in the report and that they appeared backed by substantial reasoning, it was likely to come to the Hong Kong market’s attention. The MMT also ruled that the report was likely to affect trading decisions and Evergrande’s share price for the same reasons.
Considering the evidence of Evergrande’s auditor audit partner, its chief financial officer, an analyst at a prominent bank and an experienced independent accounting expert, the MMT ruled that there was no evidence that Evergrande was insolvent or had engaged in accounting fraud.
The report alleged that Evergrande had used off-balance sheet joint ventures to dishonestly substantially under-report its debt. The MMT considered that Left’s report failed to understand the nature of trust financing which was becoming a common form of Mainland financing and misunderstood its Hong Kong accounting treatment. It ruled that Evergrande had not used trust financing as a means of concealing off-balance sheet debt, rather as a means of financing the buying of land. Further, these financial obligations were openly disclosed as liabilities in Evergrande’s accounts. The MMT considered Left’s allegations ‘not only displayed an ignorance of, or disregard for… Hong Kong accountancy standards, they were fundamentally misguided… [and] false and/or misleading as to material facts’. The MMT considered that, as someone who held himself out as an expert in detecting corporate fraud, Left should either have sought expert accounting advice or sought comment from Evergrande, as regulated analysts often do.
The MMT found that Left’s allegation that Evergrande overstated the value of its investments by at least RMB10 billion was also false and/or misleading as valuing them at fair value was in accordance with Hong Kong accounting standards which in fact required that treatment. The allegation displayed a ‘significant ignorance’ of those standards.
The MMT found that Left disregarded the real risk he was aware of, that the report was false and/or misleading as to material facts, and he was reckless. In the alternative, it found that he failed to exercise that level of care to avoid the inclusion of false and/or misleading information that is realistically required of a reasonably prudent person who has chosen to carry out the function of a market commentator and/or analyst. In deciding this, the MMT considered the anonymous source of the material the report was based on; its sensationalist basis; Left’s experience as an analyst of corporate fraud; and that the allegations of fraud and insolvency required an understanding of accounting standards but Left did not get any expert accounting advice or approach Evergrande for comment.
The MMT findings and sanctions
On 26 August 2016, the MMT issued its report finding that Left had engaged in market misconduct within Section 277 in that:
in June 2012, Left had disseminated the report, which contained what was advertised as being research and analysis compiled over several months which concluded that Evergrande was essentially an insolvent company that had consistently presented fraudulent information about its accounts to investors
information in that report, that Evergrande had been culpable of fraudulent accounting and was insolvent, was likely to affect the Hong Kong market in one or more of the ways set out in Section 277(1)
the information was false and/or misleading as to material facts or through their omission
Left had been reckless as to whether that information was false and/or misleading as to material facts or through their omission, and
in finding that Left had been reckless, that, when he came to publish his report; first, Left was aware of the risk that the information in it that Evergrande had engaged in fraudulent accounting and was essentially insolvent were false and/or misleading; second, he was further aware that, in the circumstances, the risk was of such substance that it was unreasonable to ignore it; third, nevertheless, he went ahead and published.
On 10 November 2016, the MMT issued its report imposing sanctions on Left. The MMT imposed on Left orders that:
- without the leave of the Court of First Instance, he cannot directly or indirectly trade in SFC-regulated financial products for five years
- he cannot disclose false or misleading information inducing transactions again within the meaning of Section 277 or face criminal prosecution
- he must disgorge the profit of his short selling before the report of HK$1,596,240 subject to compound interest from 21 June 2012, and
- he must pay to the government its costs for the conduct of the MMT proceedings and the SFC for costs in bringing those proceedings and its investigation.
In making the first two orders, the MMT considered relevant that:
- Left’s aggressive allegations that Evergrande had engaged in fraudulent accounting and was insolvent would have unnerved general investors and likely caused them to sell their shares
- he had intended to profit from that by short selling and he was reckless as to whether these allegations were false and/or misleading
- Left was cynical that ‘the ends justifies the means no matter what the collateral damage to general investors’ and that the fault with Left’s conduct was not his expressions of opinion but assertions of fact
- Left’s assertions could only be made with an understanding of the applicable accounting standards but he had made no efforts to ensure his assertions were made with knowledge of those standards
- his recklessness was of a ‘gross nature’ and ‘the allegations… displayed such an ignorance of relevant accountancy regulations and standards that, in the opinion of one expert, a number of them constituted nonsense’
- Left claimed himself to be an expert in identifying company fraud and ‘terminal business models’, and
- Left’s actions were likely not a one off but a ‘well-established procedure… that… was more likely to be undertaken in the future if… a further opportunity presented itself’.
Left appealed the MMT’s decision on both questions of fact and law. He may only appeal questions of fact with the Court of Appeal’s leave. On 13 January 2017, the Court refused leave saying that Left’s appeal was out of time. It also rejected Left’s argument that there was no evidential basis for the MMT to find that Left knew of the risk that his allegations were false and/or misleading as to material facts and that it was unreasonable to ignore that risk. It also rejected that the MMT erred in finding that Left must have known that his allegations required accounting expertise.
Freedom of speech vs investor protection
Left has since criticised the MMT decision as an attack on freedom of speech and free flow of information in financial markets. But, a review of the decision suggests that it is a cautious consideration of the risk that false or misleading statements about listed companies pose for investors who can be panicked into trading decisions based on the resulting false or misleading information. The MMT decision was carefully made with an awareness of the need to balance freedom of speech and investor protection. It found that Section 277 is a proportionate restriction on freedom of speech, a right which is not unqualified, in pursuit of the legitimate aim of protecting financial markets from materially false or misleading factual information that would likely induce trading decisions or affect a company’s share price. What is perhaps surprising is that Left considered it appropriate to make serious allegations of accounting fraud and insolvency in alarmist terms based on an anonymous unsolicited package of material when he had no knowledge of Hong Kong accounting standards and sought no expert accounting advice.
Left’s appeal on questions of law, which mainly restate his legal arguments during the MMT hearing, is yet to be decided.
Strategic Operations Coordinator & Senior Director, Enforcement, Securities and Futures Commission