Short selling is arguably one of the most misunderstood aspects of the financial market, and when the complex ethical questions surrounding whistleblowing and activism are added to the conversation, things only get more obscure. That obscurity may be allowing traders to manipulate the market- according to the companies these activists have been blowing the whistle on, that is.
To understand activist short-sellers, you'll first need a firm grasp of how short-selling works: when a trader shorts a stock, they're functionally betting that the price of that stock will decrease. In practice, this means that short-sellers borrow stock from a broker which they then sell, in the hopes that they will later be able to buy it back at a reduced price.
However, if the price of the stock increases instead, short-sellers have to make up the difference in value when they purchase and return the stock. This makes short-sellers vulnerable to "short squeezes": when traders buy up a bunch of stock to increase its price independent of the company's value, forcing short-sellers to buy back their stock to cover their positions. This can drive the stock price up even higher.
The recent GameStop (NYSE: GME) short-squeeze brought the attention of regulators down on activist short-sellers. According to reports from Bloomberg, investigators with the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ) have issued subpoenas and search warrants against 25 people, mostly activist short-sellers.
The companies targeted by these activists have been pressuring regulators to go after activist short-sellers for years, as well. While a "non-activist" short-seller might short a stock for any number of reasons, activist short-sellers selectively short companies that they're planning on outing for some wrongdoing or financial weakness.
First, the trader shorts the selected stock, betting against the company. Then, they reveal some aspect of the company that will, ideally, make the stock drop. At this point, the short-seller needs to cash-out on their position, before the stock has a chance to potentially recover.
This is where business consultant and associate professor at Columbia Law School Joshua Mitts sees a problem. Mitts wrote a research paper in 2018 claiming that unscrupulous short-sellers may be revealing information that they know won't have a lasting impact in order to make a quick buck off of the chaos they cause.
According to Mitts, after activists post negative reports about a company, they rapidly close their short position, something he calls a form of market manipulation. He is proposing that the SEC introduce regulations forcing short-sellers to hold their positions for at least ten days, known as a "cooling-off period".
"If you're a short activist, you scared investors into selling stock, well, you should have to ride the consequences with them," Mitts said in an interview. "The paper is making a very specific point that, by using anonymity, one can effectively manipulate the market," Mitts later added.
However, those on the side of the activists claim both that this sort of manipulation is not widespread or representative of activist short-sellers and that activists provide a necessary regulatory force against company maleficence.
Other researchers have shown that the data used in Mitts paper has several flaws. Mitts analyzed posts made to an activist short-seller platform, a platform that requires users to disclose if they plan on actually shorting the company they mention in their posts. One major issue with Mitts' premise is that only 20% of the posts he studied were from users planning to short stocks, meaning they shouldn't reflect on the behavior of actual short-sellers.
Activists have also pointed to Mitts long-time association with businesses that have been targeted by short-sellers as a clear sign of his bias against the practice.
Financial experts, including former SEC official Marlon Paz, say that forcing short-sellers to hold their positions for ten days would be "dangerous".
"If you force people to hold," he said, "you're creating the potential for short squeezes."
Short-sellers have also pointed to examples like German fintech Wirecard, a now-defunct business that faced short-seller allegations of fraud for years with no effect. In that case, short-sellers could have been effectively driven out of business by the proposed cooling-off period.