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US criminal authorities are gathering information on contacts between dozens of short selling
hedge funds and prominent bearish research providers right now as they investigate possible
trading abuses in the stock market relating to short selling.
According to the press, the FBI seized computers from the home of the well-known short seller
Andrew Left, the founder of Citron Research, back in early 2021.
In more recent months, the Justice Department subpoenaed other market participants seeking
information on their communications, calendars and other records.
The Department of Justice is not the only government agency investigating possible wrongdoing,
The SEC has also sent requests for information to many of these firms.
Right now, no one has been accused of any illegal activity, and it is quite common for
investigations to be opened without them leading to any charges.
The SEC, is a US regulatory agency whose purpose is to maintain a fair securities market and
protect investors from various types of fraud.
They can conduct investigations and bring civil actions, but they don’t have the authority
to send a criminal perpetrator to jail.
The SEC would need to work with a criminal authority like the Department of Justice in
order for that to happen.
The list of names who have received requests for information includes some of the best-known
firms that publish negative research and investment funds that seek to profit when individual
stock prices fall.
Among them are Muddy Waters, Melvin Capital, Hindenburg Research and Citron Research.
The Justice Department’s probe is being run by the fraud section with federal prosecutors
in Los Angeles and there’s no indication right now that the authorities have come to
any conclusions at all.
According to Bloomberg, they’ve been examining trading in dozens of stocks, as well as the
relationships between investment funds and researchers, looking for signs that markets
have been manipulated or that any other laws have been broken.
Subpoenas, requesting firms and individuals to provide information apparently went out
in the autumn of 2021 but many of the firms on the list have told the press they have
not been contacted by authorities and have no reason to believe they are the focus of
any investigation.
These investigations come at a difficult time for short sellers, and short selling research
firms.
A number of bearish funds closed down over the last few years as the market steadily
rose after the credit crunch and government stimulus pushed up stock prices.
Many short sellers lost fortunes last year during the meme-stock frenzy, when retail
investors banded together to pump up the stock prices of popular short positions.
By late January of last year, Citron research vowed to give up short-selling research and
focus on long only bets.
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Anyhow, back to our content.
Short selling is a trading strategy that really upsets some retail investors.
They hate that firms publish negative research on stocks that they invest in and they are
upset that investors are able to profit from falling stock prices.
Some of the most prominent short-selling critics historically were executives at companies
that were later found to have engaged in fraudulent activities.
It has always been seen a bit of a red flag on Wall Street when a CEO begins blaming short
sellers for poor stock performance.
Lawmakers in Congress held hearings on the topic of short selling last year amid the
frenzy over meme stocks like GameStop and AMC and began demanding more regulatory oversight
of this trading strategy.
I made a video a bit over a year ago explaining the mechanics of short selling, but I don’t
generally recommend it as an investment strategy to most investors, as I feel that it is often
easier to find stocks that are likely to rise than to fall, and the risks of the strategy
are quite different to the risks of owning a basket of stocks.
Short selling involves selling borrowed shares in the hopes of profiting from a fall in their
price.
I think that the fact that people can do this is generally good for markets, as it draws
attention to market bubbles, improves price discovery, and from time-to-time digs out
the occasional fraud.
The term "naked shorting" which we have heard a lot about over the last year has very little
to do with a short seller's lifestyle, or wardrobe decisions, but instead refers to
the illegal practice of selling shares without having properly secured the borrowed shares
first.
Now, financial history is filled with examples of governments and financial regulators banning
short selling.
In 2019, Ba Fin the German regulator announced that they were prohibiting new short positions
in Wirecard, a company that a year later collapsed due to fraud.
Short selling has been around as long as the stock market has, and allegations of wrongdoing
by short sellers have been there from the start too.
The first notorious short seller was a Dutch man named Isaac Le Maire.
The Dutch East India Company was the very first company to issue bonds and shares of
stock to the general public, and it was the first stock ever listed on a stock exchange.
So, the very first stock that existed was also the first stock to be sold short.
Isaac Le Maire started out on the inside - as a director of the Dutch East India Company,
there was a dispute over money and Isaac was not only fired, but he was also banned from
engaging in the spice trade.
He wanted revenge and hatched a plan to take down the Dutch East India Company while profiting
from the collapse.
The bet itself - the short trade - was fairly easy to do.
Back in those days, you could bet that, say, the price of grain would drop.
Le Maire did the same sort of thing, putting on a bet that shares of the Dutch East India
Company would fall in value.
Le Maire’s next would be illegal today, he lied and spread false rumors to drive the
price of the stock down.
After the rumors, the stock price did begin to drop, so the Dutch East India Company did
what a company today might do - it launched a counterattack.
It called for a ban on short selling; saying short selling was hurting society's most vulnerable.
The Dutch government issued a partial ban on short selling and Isaac Le Maire was barred
from accessing any of his shares.
He ended up losing what today would be 10 or $20 million dollars, basically his entire
net worth.
He left Amsterdam and went into exile.
The writing on his tombstone states, “Here lies Isaac Le Maire, a merchant for more than
30 years, blessed by the Lord, he gained a lot of money then lost all but his honor.”
Had he not been shaken out; his short bet would have eventually paid off.
The Dutch East India Company did eventually collapse, but that happened 200 years later.
Timing in markets is everything…
Now, not all short selling works that way, there’s a long history of short sellers
uncovering fraud and improper accounting at firms.
We have already discussed the wirecard example, and another recent example is Trevor Milton,
the CEO of the gravity powered truckmaker Nikola, who is awaiting trial on allegations
first raised by short sellers.
He has plead not guilty to making false claims about the company’s vehicles.
Enron is another example of what short seller Jim Chanos describes as “legal fraud”
— where companies adhere to the accounting rules and regulations but there’s still
an “intent to deceive”.
Chanos identified that Enron was using aggressive accounting to front-load profits and hide
debt in its subsidiaries.
According to Chanos, short sellers are the real time financial detectives, whereas regulators
are often financial archaeologists, who turn up after the fraud is long over and work out
what happened.
The main reason people are often uncomfortable with the idea of short selling is that it
just seems wrong to be profiting from someone else’s failures.
But short selling provides several benefits both to the capital markets and to the real
economy.
Theoretical and empirical studies have shown over time that short selling improves overall
market quality by contributing to price efficiency, liquidity, and corporate governance.
Short selling firstly contributes to the accuracy and efficiency of prices in securities markets,
by ensuring that both positive and negative public information about firms is quickly
reflected in market prices.
Without a facility for short selling, security prices would have an upward bias and not accurately
reflect a security’s underlying fundamentals.
Short selling secondly has a positive impact on overall market quality as it improves market
liquidity.
If you reduce the number of people trading a stock - liquidity is reduced.
Additionally if people are prevented from trading on negative fundamental data, stock
prices become less efficient and liquidity providers – like market makers - need to
take the higher pricing errors into account.
They do this through charging a higher bid-ask spread.
A paper by Beber and Pagano in 2013 examined the liquidity impacts of short selling bans
across 30 countries and found a decline in liquidity when shorting constraints were more
severe.
The study found that a complete ban on all short sales led to an increase of almost 2%
in the bid-ask spread.
Another study by Massa, Zhang and Zhang in 2015 showed that short selling contributes
positively to good corporate governance by serving as an external disciplining mechanism
on company management.
In theory, since short sellers are motivated to uncover wrongdoing by management (and then
trade on that information through short sales), the probability and speed with which corporate
misconduct is discovered increases.
As a result, in a world with short selling, it is riskier for management to engage in
misconduct, thus, improving overall corporate governance.
The study found that the mere possibility of short sale activity disciplines firm managers.
The higher the “short-selling potential” of a given stock – measured by the total
supply of shares that are available to be lent for short sales, the less likely it was
that firm management were manipulating corporate earnings.
This clearly illustrates the disciplining effect of short sales on corporate executives.
It will be interesting to see how these investigations go and if any wrongdoing is found in the investigations
by the Department of Justice and the SEC.
Those who feel the regulators have been asleep at the wheel will be happy to see an investigation,
and law abiding short-sellers will equally be happy to show that they have not been breaking
any laws.
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If you liked this video, you should watch the one on the top ten short selling disasters
next.
Have a great day and talk to you again soon.
Bye.