Market Efficiency and Limits to Arbitrage: Evidence from the Volkswagen Short Squeeze

Angel Tengulov is an assistant professor of finance at the University of Kansas School of Business. This post is based on a recent paper, forthcoming in the Journal of Financial Economics, by Mr. Tengulov; Franklin Allen, professor of finance and economics at Imperial College Business School; Eric Nowak, professor of financial management and accounting at Università della Svizzera italiana (USI) and Swiss Finance Institute (SFI); and independent researcher Marlene Haas PhD.

On October 26, 2008, Porsche announced a largely unexpected takeover plan for Volkswagen (VW). The resulting short squeeze in VW’s stock briefly made it the most valuable listed company in the world. In our paper, forthcoming in the Journal of Financial Economics, we argue that this was a manipulation designed to save Porsche from insolvency and the German laws against this kind of abuse were not effectively enforced. Using hand-collected data, our paper provides the first rigorous study of the Porsche-VW squeeze and shows that it significantly impeded market efficiency. Preventing this kind of manipulation in the European Union is important because without efficient securities markets, the EU’s major project of the Capital Markets Union cannot be successful.

At the height of the financial crisis on Monday, October 27, 2008, VW’s stock price rose dramatically and surged past EUR 1,005 per share on Tuesday, October 28, 2008, from a close the previous Friday of EUR 211 per share. This briefly made VW the most valuable listed company globally in terms of market capitalization. Our paper explores the degree to which this price increase was the result of an unexpected press release that Porsche Automobil Holding SE (Porsche SE or Porsche) made on Sunday, October 26, 2008. On the evening of this Sunday, Porsche announced a domination plan for VW. The rise in VW’s stock price caused a short squeeze and turned out to be very advantageous to Porsche. Using hand-collected data and information from court proceedings in Germany, the paper estimates that the rise in VW’s stock price resulted in a profit of at least EUR 6 billion and allowed Porsche to avoid bankruptcy.

The press release proved especially problematic for investors who had shorted VW’s stock. Porsche had entered into call option contracts with Maple Bank, the German subsidiary of the Canadian firm Maple Financial Group Inc., to lock in an acquisition price for VW’s shares. Maple Bank in turn hedged its position by purchasing derivative contracts on VW shares through other banks. These other banks held VW’s shares as a hedge. This implied that the free float of VW’s shares was decreased significantly. Therefore, it became increasingly difficult for short sellers to acquire VW shares to cover their short positions when the share price started rising after Porsche’s press release. This in turn exerted increasing price pressure on VW’s stock and resulted in estimated losses of more than EUR 20 billion for investors that had entered into these short-sell trades.

Despite strict market regulations in the US, short squeezes continue to be a phenomenon of today’s financial markets. Examples of events that resemble short squeezes investigated by regulatory agencies include the announcement of Tesla’s CEO to take the company private or the coordinated trading of investors in “meme” stocks such as GameStop, Inc. and AMC, Inc. The latter events, which took place in the first half of 2021 and made use of social media platforms to facilitate coordinated trading, are studied in detail in Allen, Haas, Nowak, Pirovano, and Tengulov (2021). The Porsche-VW squeeze of October 2008 is therefore an interesting and important short squeeze to study. The consensus of analyst reports at the time suggested that the voting stock of VW was expected to decrease to EUR 140 per share or less in the foreseeable future. In other words, VW’s ordinary stock was overvalued compared to its peers and consequently sold short by arbitrageurs. The market environment at the time was characterized by questions regarding bank solvency, declines in credit availability, economies worldwide slowing down, global stock markets facing continuous heavy losses, and a crisis of the automotive industry at large. Given this environment, it was unlikely that VW’s ordinary shares would be staying at an overvalued level, with no fundamental data supporting these prices. Yet Porsche had effectively insured more than 50% of the voting stock of VW against falling stock prices by selling cash-settled put options. Liquidity and solvency analyses show that against the background of the credit crisis, Porsche lacked the funds to back up its contractual derivatives obligations that came under mounting pressure in October 2008. This provided an incentive for Porsche to manipulate VW’s stock and save itself from insolvency. In many countries such as the U.S., market regulators would have quickly punished this kind of abuse. However, this example illustrates that in Germany, there has been a lack of effective enforcement, and so this did not occur—neither by the German securities regulator BaFin nor by subsequent court proceedings.

In our paper, we provide a comparison of relevant regulations in the U.S. and Europe as well as an account of Porsche’s plan to take over Volkswagen. We also provide analyses of Porsche’s option strategies, margin requirements, and probability of default at the time, as well as detailed analyses of the short squeeze event and its impact on market quality and price discovery. These types of analyses are an important tool to understand the negative impact that a lack of disclosure requirements and effective enforcement of securities laws can have on financial markets and investors.

While stock price manipulations such as squeezes and corners have been outlawed in the U.S. since 1934, legal limitations have only been introduced and enforced in many European countries in recent years. This paper uses the German financial market system as a unique setting that represents a market with imperfect disclosure requirements, low shareholder protection, and most importantly weak enforcement of securities laws. We show that such an environment does not effectively prevent market-distorting events, such as short squeezes, from happening. In fact, history repeats itself as just demonstrated by the collapse of Wirecard AG. The collapse of Wirecard AG, which as of the time of its default was part of the German stock index DAX-30, has the potential to turn out to be Germany’s biggest corporate governance and accounting fraud scandal, which was not caught by the company’s auditor, Germany’s securities regulator BaFin, or other supervisory entities. Short sellers started to short Wirecard AG’s stock many years ago, when allegations of accounting fraud appeared for the first time—even though “US hedge funds warned […] that they would never again bet against German stocks after a market squeeze was allowed to develop that temporarily made carmaker VW the most valuable company in the world in 2008.” These types of events and the findings of our study have important public policy implications. Going forward, the European Union will only be able to develop the Capital Markets Union with well-functioning and efficient capital markets if regulations designed to prevent and outlaw market-distorting events such as stock price manipulations are effectively enforced. The fact that they have not been enforced in the EU’s most important country economically, namely Germany, suggests that it is necessary to implement significant changes. In particular, rather than remaining a national competency, enforcement of regulations needs to become the full responsibility of an EU level body, specifically, ESMA, whose primary objective should be to protect—both long and short—investors of corporate securities (not just their issuers and executives).

The complete paper is available for download here.

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