Are Activist Short Sellers Just Talking Their Own Book?
Short selling involves borrowing and then selling shares, placing a bet that they can later be bought back more cheaply to cover what the short seller had borrowed. Activist short sellers go a step further. As the name implies, they actively influence the market in stocks they have taken a position, typically by releasing reports containing information detrimental to the public companies. The activists typically add to their positions just prior to the release of their reports.
Researchers are an integral part of the short selling ecosystem. They seek to profit by selling their insights to subscribers. Often those insights contain allegations, unknown to the public, of fraud, mismanagement and other corporate problems.
It’s widely believed that short sellers are important to the functioning of an efficient market. After all, they typically trade on, and in the case of activitist short sellers publicize, damaging information which often leads to regulatory investigations, favorable outcomes for plaintiffs in litigation, corporate shakeups and other societal benefits.
But what about an activist short seller that takes a position in a stock, publishes damaging information in the form of an opinion, which results in a rapid drop in the stock’s price, and then covers the short before the company can defend itself with contrary information. If the information is untrue or the opinion misguided, by the time the company reacts and the price of the stock recovers to its pre-report level, the activist will have locked in a profit to the detriment of investors who acted on the report, but held the shares. Where the activist does not disclose that it has closed its position, the strategy has been referred to as “scalping.”[1]
Putting aside the failure to disclose, such activity by itself has never been viewed as price manipulation. The Supreme Court has held that the expression of opinions about securities in a registration statement which are sincerely held does not violate Section 11 of the Securities Act of 1933,[2] which affords a purchaser of securities a cause of action, on a strict liability basis, on account of registration statements which either contain “an untrue statement of material fact” or “omit to state a material fact … necessary to make the statement therein not misleading.”[3] Opinions can give rise to false-statement liability under Section 11 only if the opinions are not expressed in good faith or have embedded in them statements of untrue facts.
Therefore, activist short sellers have long felt themselves immunized against allegations of manipulation as long as their reports are not materially misleading, express sincerely held opinions and do not publicize insider information.
Enter a Columbia Law School professor named Joshua Mitts. In a 2020 research paper entitled “Short and Distort,” he examined 1720 short attacks where the activists had rapidly closed their positions following a negative report, but the share price recovered shortly thereafter. Professor Mitts also co-authored and filed, along with a dozen other academics, a rulemaking petition with the SEC. In both, he argued that activist short sellers were manipulating the market by failing to disclose they had covered their positions or used synonyms to mask their identities. In an interview, he reportedly said, “If you’re a short activist, you scared investors into selling a stock, well, you should have to ride the consequences with them.”4
Mitts may have a point when it comes to the more abusive actions of activists. But is that enough to warrant a reappraisal of what it means to manipulate the market? Merely because you rapidly closed a position and failed to disclose that you have bought stock to cover what you’ve borrowed is something different altogether.
The activists’ reaction to Professor Mitts has been swift and predictably pretty furious. Mitts has a consulting firm which does work for companies targeted by short sellers, who have not only attacked his methodology, but claimed that he is a shill for corporations, all the while “masquerading as an academic.”
The SEC has as yet taken no action on the rulemaking petition, but the United States Department of Justice, yet another client Professor Mitts’s firm, has launched a wide-ranging investigation aimed at proving a conspiracy among activist short sellers. According to press reports, DOJ’s targets read like a roster of the leading activist short sellers and the research firms that cater to them. It’s not yet clear exactly what the investigation is looking for, but, at a minimum, it would seem the prosecutors have a suspicion that abusive trading is going on.[4]
The DOJ may conclude there is nothing to see or, prodded by Professor Mitts and his corporate clients, decide to prosecute activists and their allies and, among other things, test the theory that the failure to disclose covering a short is an omission of material fact.
But is it really? Assume that a firm takes a long position in the stock, issuing a favorable report, which has the predictable effect of driving the share price up, and then sells to lock in a profit. Assume further that the firm does not publicize its sale on the uptick. It doesn’t seem there is a principled difference between a firm’s talking its own book—hardly an unusual occurrence--and what has been pejoratively labelled “scalping” by a short seller.
[1] Scalping is more commonly understood as a type of arbitrage which takes advantage of small gaps in price created by the bid-ask spread. No one has yet suggested that such activity constitutes fraud. [2] 15 U.S.C. §77k(a). [3] Omnicare, Inc. v. Laborers Dist. Council Constr. Ind. Pension Fund, 576 U.S. 175 (2015). 4 Michelle Celariar, Are Activist Short Sellers Misunderstood?, The New York Times (February 12, 2022). 5 Katia Porzecanski and Tom Schoenberg, Vast DOJ Probes Looks at Almost 30-selling Firms and Allies, Bloomberg Markets (February 4, 2022).
