The Government Should Tread Carefully in Its Short Seller Investigation

POMERANTZ MONITOR | MARCH APRIL 2022

By Veronica V. Montenegro

In February 2022, it was revealed that the Department of Justice (“DOJ”) and the U.S. Securities and Exchange Commission (“SEC”) commenced an investigation into dozens of investment firms and researchers engaged in short selling. It is not clear yet who on the list is considered a “target” of the probe and who might just have information relevant to the investigation, but the business of short selling in general has caught the attention of regulators.

Short sellers identify a stock that they believe will suffer a decline and borrow shares of that stock from a broker in order to sell them to buyers willing to pay the current market price. If the stock drops, the short sellers make a profit when they return the shares to the broker and buy them at a cheaper price. A short squeeze occurs if the price goes up, and the investors need to rush to buy the stock to cut their losses. Many of those under investigation have made a profession from exposing corporate fraud while betting that companies’ share prices will fall. For their part, some executives, accusing short sellers of targeting their companies for profit, have put pressure on the DOJ and other financial regulators to investigate short sellers for market manipulation. During the early 2021 meme-stock mania, short sellers were especially vilified by retail investors and the Reddit “Wall Street Bets” crowd who intentionally drove up the price of stocks of companies like GameStop and AMC Entertainment, which were heavily shorted at the time. The short squeeze on GameStop saw its share price jump from $17.25 to $325 over the course of just four weeks, posing the risk of catastrophic losses for short sellers as the share price skyrocketed.

It is not entirely clear what the DOJ’s and SEC’s specific allegations of wrongdoing might be, but The Wall Street Journal has reported that federal prosecutors are investigating whether short sellers conspired to drive down stock prices by engaging in illegal trading tactics such as “spoofing” and “scalping.” Spoofing involves flooding the market with a series of fake orders in order to manipulate the stock price without the intention of actually buying the stock. Illegal scalping (as opposed to “legal scalping”) is a short seller influencing investors or otherwise manipulating prices with the intent to sell the stock secretly and profit from the manipulation. U.S. prosecutors are reportedly exploring whether they can bring related charges under the Racketeer Influenced and Corrupt Organizations Act (“RICO”).

The short sellers’ practice of publicizing negative research and profiting when the stock falls has been criticized by those who argue that the allegations can be false and that the traders are artificially deflating share prices to the detriment of shareholders. However, short sellers may be an invaluable source for uncovering corporate wrongdoing and outright fraud. Such short seller reports uncovered fraud at Enron and other corporations and warned of the impending financial crisis in 2008. While companies targeted by short sellers rejoice at the government’s investigation, others believe that the inquiry is premised on the mistaken belief that abuse is widespread and distorting stock prices. Columbia Law Professor Joshua Mitts, one of the biggest critics of short selling, has proposed SEC rules which would require short sellers to hold their position for at least 10 days after releasing their negative research, or be accused of market manipulation for rapidly closing their positions. However, if such rules were to be implemented, they would deprive short sellers—who provide a vital service in policing the markets—of profiting from their research and short positions. In a 2018 research paper titled “Short and Distort,” Professor Mitts looked at 1,720 negative short seller reports and found that the stock prices of targeted companies began to recover just one day after the negative research was published and continued to recover for three days thereafter.

Critics have argued, however, that Professor Mitts did not examine a representative sample of activist short sellers and their reports. For example, Dealbook reported that an analysis shared by Carson Block, the activist short seller who founded Muddy Waters Capital, found that 75% of the negative reports analyzed in “Short and Distort” are not in a database of activist short seller campaigns compiled by Activist Insight, a leading provider.

Additionally, only 20% of the authors of those reports stated that they were shorting the stock of the companies on which they were reporting. Professors Frank Partnoy (Law School at the University of California, Berkley) and Peter Molk (University of Florida Levin College of Law) analyzed 825 negative research reports located in the Activist Insight database between 2009 and 2016 and found that, four years after the release of the reports, the average stock price decline of 573 targeted companies was more than 20%.

The SEC has not indicated whether it will adopt Professor Mitts’ proposed rules, but the government should move carefully when designing rules that can hamstring short selling as a viable profession. Many respected professionals in the securities field believe short selling plays an important role in public markets by improving price discovery and rational capital allocation, preventing financial bubbles, and finding fraud. In the securities class action space specifically, negative research reports authored by short sellers may play a vital role in alerting the market and investors that fraud has been committed by the company. These reports are often cited in class action lawsuits as revealing the truth of the fraud to the market, thereby serving as the “corrective disclosure”—a necessary component of a securities class action. Defendant companies frequently move to dismiss short seller claims, arguing that loss causation cannot be predicated on their reports as corrective disclosures because, among other reasons, the authors had a financial incentive to convince others to sell.

Unfortunately, various federal courts have sided with defendants on this point, with or without the existence of a financial incentive. Even though the information contained in such reports is revelatory of a previously undisclosed fraud, the reports should nevertheless qualify as corrective disclosures. If government action makes short selling a nonviable profession, class action investors would no longer be able to count on their reports to help make their case against fraudulent companies. Additionally, government action that further stigmatizes the role of short sellers could cause federal courts to take an even more skeptical view of short seller reports when analyzing the loss causation element of a securities class action lawsuit. To be clear, securities fraud, in whatever form it takes, should be prosecuted and punished—short selling firms should not be the exception. If the government investigation reveals that the targeted short selling firms have in fact engaged in illegal trading tactics, prosecution is warranted. However, it cannot be denied that short sellers and their reports have aided defrauded investors in prosecuting their cases.

The government should be diligent in ensuring that its investigation targets actual potential market manipulation and is not influenced by disgruntled corporate executives who are simply upset that their companies were subjects of hard-hitting research that revealed fraudulent activity.