Short Selling and Short Selling Disclosure in a Pandemic
GCGC/ECGI Global Webinar Series
This post first appeared on the Oxford Business Law Blog on 20 May 2020
By Joshua Mitts (Columbia Law School)
Even prior to the emergence of COVID-19, global securities regulators were questioning whether short sellers needed to be put on a tighter leash. On December 4, 2019, Japan’s GPIF, the largest pension fund in the world, announced it would not lend shares to short sellers on its multi-billion portfolio of global equities, pointing out that ‘the current stock lending scheme lacks transparency in terms of who is the ultimate borrower and for what purpose they are borrowing’. This was particularly notable because securities lending is a large source of revenue for passive investors like GPIF who embrace a buy-and-hold investment strategy.
Following the outbreak of COVID-19, regulators in several EU member states employed emergency powers to temporarily ban short selling. On April 16, with the backing and support of the European Securities and Markets Authority, those bans were renewed for another month. And in a report published on April 28, 2020, the French AMF called for broader short seller disclosure and fewer constraints on issuer responses to short seller attacks. Yet it has long been shown that short selling serves a critical function in the capital markets by encouraging price discovery and preventing the formation of asset bubbles. In the midst of a global pandemic, what principles should guide the regulation of short selling and short selling disclosure?
The starting point is to recognize that recent years have seen a rise in ‘negative activism’, a novel phenomenon which has flourished in the era of social media and algorithmic trading. The typical negative activist opens a large short position; disseminates sometimes aggressive negative opinion about a public company (often stopping just short of factual falsehoods) on Twitter and elsewhere, which induces a panic and run on the stock price; and rapidly closes that position for a profit, prior to the stock price partially or fully rebounding.
My colleague Professor Coffee has previously written about the largely discredited attack on GE by Harry Markopolos. Research shows that the GE-Markopolos episode is not a one-off phenomenon. And my prior work studying pseudonymous short attacks on public companies has found that these attacks are followed by price declines and sharp reversals. These data suggest that these patterns are likely driven by manipulative stock options trading. Among 1,720 pseudonymous attacks on mid- and large-cap firms from 2010-2017 there is over $20.1 billion of mispricing. These reversals seem to persist because pseudonymity allows manipulators to switch identities without accountability.
This evidence highlights shortcomings of the current regulatory framework as applied to manipulative short selling. Professor Coffee and I, along with ten securities law faculty in the United States, [1] have recently petitioned the SEC to employ its rulemaking power as follows.
First, precisely because there is no duty to disclose one’s short position, we ask the SEC to impose a duty to update promptly a voluntary short position disclosure which no longer reflects current holdings or trading intention. Second, we ask the SEC to clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5. We further propose that a safe harbor be drafted which would allow for closing a position at a price equal to or lower than a valuation stated, expressly or impliedly, by a short seller.
I.We ask the SEC to impose a duty to update promptly a voluntary short position disclosure which no longer reflects current holdings or trading intention.
The case law is clear that merely taking a large short position is insufficient to establish market manipulation. [2] Moreover, one can disagree with a short seller’s analysis, but strongly stated opinions are not fraudulent on their own. However, a negative activist typically goes further, claiming not just that investors should sell the stock, but that the activist itself is posed to profit if the share price declines and lose if the share price rises.
The truthful disclosure of an activist’s short position can enhance price discovery. The fact that a short seller with a credible track record in identifying fraudulent companies has opened a short position in a new stock may very well ‘alter the total mix of information made available’ [3] by aligning the activist’s reputation and economic incentives with its analysis. This is likely why many investors sell shares following a report by a negative activist but may be less quick to do so upon encountering a ‘sell’ rating by an ordinary analyst who lacks such ‘skin in the game.’
It is precisely for this reason that the SEC should vigilantly ensure that short position disclosure, when voluntarily initiated by a short seller, remains truthful and accurate. We are not advocating that the SEC mandate the disclosure of short positions. However, when a short seller has chosen to disclose a short position, failure to disclose that the position has been closed is doubly misleading: first, because the statement that the activist has a short position is literally no longer true; and second, because, the author’s negative opinion lacks the ‘skin in the game’ element that gives market participants reason to believe the underlying claims are true.
II. We ask the SEC to clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5.
Courts have long held that newspaper columnists are subject to a duty to disclose their intent to close a position after advocating the purchase or sale of a stock. In Zweig v. Hearst Corp., the Ninth Circuit found that a newspaper columnist violated Rule 10b-5 by failing to disclose his ownership of the underlying security and ‘his intent to sell when the market price rose:’ [4] The Zweig anti-scalping rule has been applied repeatedly over the ensuing decades, with the U.S. District Court for the Southern District of New York recently holding in a 2017 decision that ‘scalpers have a duty to disclose their financial interests in touted securities so that their promotional materials are not materially misleading.’ [5]
Nonetheless, we are unaware of any scalping cases which have been brought by the SEC against short sellers to date. We recognize this may reflect a certain reticence by the Division of Enforcement to apply a scalping theory beyond the traditional setting of stock promotion (‘touting’). We therefore urge the SEC to clarify by rule that liability for fraudulent scalping applies to any individual who encourages the sale of a security and purchases shares ‘for a quick profit’ soon after an article is published, while failing to specifically disclose intent to do so.
Finally, we recognize that the possibility of liability for fraudulent scalping may chill legitimate criticism of public companies by short sellers, who serve an important function in the capital markets. We thus propose that the SEC adopt a safe harbor which allows for short sellers to close a position at a price equal to or lower than a valuation stated expressly or impliedly.
To be sure, short sellers may have legitimate, non-fraudulent reasons for closing a position before the company’s share price reaches an express or implied stated valuation, such as risk management or liquidity needs. However, in general, price discovery would be furthered by encouraging short sellers to communicate valuations which are consistent with their internal trading plans. Consistency between what a negative activist says and does reduces the likelihood of overreaction by public-company shareholders and makes it more likely that the share price reflects the true, fundamental value of the information produced by a short seller.
Joshua Mitts is an Associate Professor of Law at Columbia University. Professor Mitts serves as an expert witness in connection with regulatory and litigation matters involving short sellers and market manipulation.
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[1] The signatories are as follows: John C. Coffee, Jr., Adolf A. Berle Professor of Law, Director, Center on Corporate Governance, Columbia Law School; James D. Cox, Brainerd Currie Professor of Law, Duke University School of Law; Edward F. Greene, General Counsel, Securities & Exchange Commission (1981-82); Director, Division of Corporation Finance (1979-81); Senior Counsel, Cleary Gottlieb Steen & Hamilton, Co-Director, Program on Law, Economics & Capital Markets, Columbia Law School; Meyer Eisenberg, Deputy General Counsel and Acting Director, Division of Investment Management Securities & Exchange Commission (1998-2006) Lecturer in Law; Senior Research Scholar, Columbia Law School; Colleen Honigsberg, Associate Professor of Law, Stanford Law School; Donald Langevoort, Thomas Aquinas Reynolds Professor of Law, Georgetown University Law Center; Joshua Mitts, Associate Professor of Law, Columbia Law School; Peter Molk, Associate Professor of Law, University of Florida Levin College of Law; Randall Thomas, John S. Beasley II Chair in Law and Business, Vanderbilt Law School, Professor of Management. Owen Graduate School of Management; Robert B. Thompson, Peter P. Weidenbruch, Jr. Professor of Business Law, Georgetown University Law Center; Andrew Verstein, Professor of Law, Wake Forest University School of Law; and Charles K. Whitehead, Myron C. Taylor Alumni Professor of Business Law, Cornell Law School.
[2] ATSI Communications v. Sha’ar Fund, Ltd., 493 F.3d 87, at 101 (2d Cir. 2007).
[3] Basic, Inc. v. Levinson, 485 U.S. 224 (1988).
[4] 94 F.2d 1261, 1268 (9th Cir. 1979).
[5] SEC v. Thompson, 238 F.Supp. 575, 590 (S.D.N.Y. 2017) (aggregating case law on position disclosure).