Traditional investors buy low and sell high, holding the position in the meantime with the hope that the share price will increase. Short-selling inverts this strategy and involves borrowing a stock that is believed to be overvalued, selling at the high point, and then returning the shares once the price drops. Basically, borrow high, replace low and pocket the difference. Typically, the shares are loaned out by large institutional investors such as pension funds, who collect a small fee per share. It is a risky investment approach because if the stock price doesn’t decrease – or worse, if the stock price increases – the short seller will have to pay the difference out-of-pocket to return the shares.
Short sellers have been vilified in recent years. Elon Musk, the volatile genius at the helm of Tesla, described short sellers as “value destroyers” and mocked the Securities Exchange Commission as the “Shortseller Enrichment Commission” for failing to ban short selling.
Abusive short-selling has been a popular target. This is the practice of investors who intentionally spread so-called baseless rumours designed to bring down a stock price. Recall that the greater the stock drop, the more money a short seller makes. Such tactics use the power of social media to spawn and spread lies that spread quickly and lead to panicked selling.
Of particular concern are pseudonymous short sellers, according to a paper by Professor Joshua Mitts of Columbia Law School. While some pseudonymous short sellers uncover corporate misconduct, Mitts warns of the danger of “short-and-distort” attacks by anonymous authors. He says that they are particularly dangerous because mechanisms that discredit systematic manipulators cannot function, and that there are no reputational penalties for lying. Mitts examined 2,900 attacks published on a popular investing blogging platform, Seeking Alpha, and found that “pseudonymous [attacks] are accompanied by a decline in the target’s stock price followed by a sharp reversal”. The steep declines are sometimes accompanied by suspiciously well-timed options trading, suggesting the initial pseudonymous reports were designed to manipulate markets.
In Canada, the power of short sellers was on full display with the Alberta soil excavation firm Badger Daylighting Ltd., which saw its share price drop after allegations of corporate misconduct. American short seller Marc Cohodes made negative public statements about Badger and ran a website attacking financial disclosures from Badger, stating “Badger numbers can’t be relied upon” and asking “Is Badger the next Poseidon?”. Badger counterattacked with a request that the Alberta Securities Commission issue an interim cease trade order against Cohodes, though that request was ultimately denied.
Short sellers have their defenders. Some argue that short sellers target companies engaged in fraud and other mischief, and help expose the wrongdoing to the market, which reacts to correct the price. Another touted virtue of short sellers is that they create liquidity for stocks with small capitalization and no listed options.
The recent spate of attention given to short sellers has put them on the regulatory map worldwide. Suggestions for regulating short selling include the bare minimum of disclosure for short positions above a certain threshold. This is the approach taken in Europe, where the European Securities and Markets Authority imposes disclosure requirements for “significant net short positions in shares”, generally requiring public disclosure for positions of at least 0.5% of company issued shares.
Other suggestions are to target solely abusive short-selling. Lies and distortions are actionable as market manipulation by securities regulators and/or private litigants such as the affected companies. For example, Section 126.1 of the Ontario Securities Act prohibits activities that result in or contribute to “a misleading appearance of trading activity in, or an artificial price for, a security, derivative or underlying interest of a derivative” and also prohibits perpetuating “a fraud on any person or company”. Under Section 127, the Ontario Securities Commission has a general public interest jurisdiction to issue certain types of orders regulating trading “if in its opinion it is in the public interest to make the order or orders”.
One challenge with such statutory rights of action is that it is difficult to assess falsity. An abusive short seller might defend his or her statements as honest beliefs about the value of a stock. We run into murky waters deciding what is an assertion of pure fact (actionable) versus a statement of true opinion (not actionable). Another challenge is materiality, or whether a reasonable prospective investor would have actually considered the short seller’s statements to be important. In the Badger Daylighting matter, the Alberta Securities Commission refused to issue a cease trading order due to the fact that materiality was not satisfied, noting that Badger’s stock price closed down less than 1% immediately following one of the offending tweets from the short seller.
For pseudonymous attacks, there is the additional hurdle of identifying a mystery manipulator. Unless the abusive short sellers are unmasked, they will be just out of regulatory reach, though one approach could be to hold the online intermediaries – blogging platforms like Seeking Alpha – accountable, as suggested in Professor Joshua Mitts’ paper.
At the Anti-Short Selling extreme are critics like Mr. Musk, who recommend a total ban. This isn’t a new idea, and was actually tried by the SEC and other regulators at the height of the financial crisis in 2008. The SEC’s emergency order banned short-selling in shares of financial institutions for three weeks, and was intended to combat the “crisis of confidence and panic selling” in the financial markets. The ban was a bust. Christopher Cox, the chairman of the SEC at the time, said it led to a short-term correction, but it was “just like a glass of orange juice, and then we had the sugar crash a couple hours later”.
Here in Canada, the securities regulators’ challenge will be to draw as clean a line as possible between corrective short selling and abusive short selling. Investors holding large long positions are generally closely monitored by Canadian securities regulators, but so far, there has been little oversight and enforcement related to short selling. The tide may slowly be turning. Two years ago, the Ontario Securities Commission reported that it was keeping an eye on abusive short selling, though it has not had many high-profile enforcement actions in that area. More recently, the Canadian Securities Administrators announced that it was reviewing “the nature and extent of abusive short-selling” in Canada, though any reforms would likely be far-off in the future.