The Nikola electric truck © Handout

Whenever big money starts flowing into a hot new sector, it seems inevitable that companies that list on the stock market fall short of hype and hope around them.

One of the market’s current hottest areas is environmental, social and governance investing. And, like the cryptocurrency boom and cannabis stock surge, the flood of money has been followed closely by allegations of fraud.

These claims are often made by activist investors and short-sellers, who bet on the fall in value of stock or bond. As interest in ESG has surged, they have been on the prowl, looking for companies where investors have overlooked flaws and fraud in the rush to gain exposure to a technology or sector.

While often assailed by companies under attack, these short-sellers play a key role in identifying these issues.

Shorts are important in the ESG space because it is so “white hot” right now, says Rob Furdak, chief investment officer for ESG of Man Group, a hedge fund. “People are looking for any kind of sustainable angle and want to jump on the bandwagon when they see the potential for these new technologies to really be game changers,” he says.

Two high-profile cases so far have involved the short-seller Hindenburg Research. It has accused Nikola, an electric truck company, and Loop Industries, a Canadian plastics recycler, of exaggerating their technological capabilities. Both companies operate in areas in an ESG sweet spot — technology that brings environmental benefits.

Nathan Anderson, founder of Hindenburg, says the ESG sector is particularly fertile ground for companies that overstate what they do. “When people feel good about giving away their money or investing their money, they’re less likely to scrutinise where it’s going,” he said.

Nikola, which had won the backing of activist Jeff Ubben and General Motors, was accused by Hinderberg of an “intricate fraud” that had exaggerated its technology and faked product launches.

The company called the report “false and misleading” and issued a detailed rebuttal of the claims. However, it did admit one of the firm’s allegations — that it rolled one of its trucks down a hill in a video that made the vehicle look like it was capable of moving under its own power.

Hinderberg also targeted Loop, which claims to have revolutionary technology that can extract usable plastic polymers from garbage. Hindenburg alleged the company never actually found a way to make its process work at scale, saying Loop’s claims were “technically and industrially impossible.”

Loop said Hindenburg’s claims were “unfounded, incorrect or based on the first iteration of Loop’s technology”.

Both Loop and Nikola saw their share prices plummet after Hindenburg published its research and are now subject to US government inquiries.

In an ideal world, errant companies would be caught by the regulators or exposed by investors doing their due diligence before they ever gained any scale. But in reality, it doesn’t always work that way. Academic research has shown that short sellers play a “significant role in identifying, uncovering, and mitigating the effects of financial misconduct.”

However, there are some who see short sellers doing more harm than good. Hiro Mizuno, the former head of the world’s largest pension fund, stopped lending out securities from the Japanese scheme last year because he believed shorting was antithetical to his mission of long-term value creation.

“I never met a short seller who has a long-term perspective,” he said at the time. He has since been hired as a board director at Tesla, where chief executive Elon Musk has been an outspoken critic of short selling.

And while short-sellers can fill the gaps when corporate governance, due diligence and regulators fail, it is not clear they are a net plus, argues Neil Foster, partner and head of impact investing at law firm Brown Rudnick.

Even legitimate companies can become short targets if they go public at the wrong time, and that can stymie innovation, he says. Mr Foster adds early stage, lossmaking technology and life sciences companies need to ask whether they should put themselves in a position where they can be shorted.

Short-sellers though believe their actions can promote better ESG outcomes and push the laggards to improve.

“We want companies that bring real technology that can bring meaningful change to the environment in the world,” said Mr Anderson. “Part of that needs to be minimising the flow of investment to companies that are frauds.”

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