Are Activist Short Sellers Misunderstood?

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Thirty minutes before the market opened on Nov. 3, Gabriel Grego, an activist short seller, unveiled a research report on Cassava Sciences, a biotech firm that had become a meme stock, rising over 700 percent by that point.

After spending months researching Cassava, which claimed to have developed a promising Alzheimer’s treatment, Mr. Grego said he had found serious problems with its clinical studies, including possible forgery of data and cherry-picking of patients. A citizenpetition to stop Cassava’s drug trials had been filed with the Food and Drug Administration, and he thought the stock would go to zero.

Mr. Grego had already placed his short — a bet that the stock would decline — and a substantial portion of his capital was on the line. But the day before, trading volume had spiked, and the stock had jumped 50 percent in intraday trading. His short was in the red.

As he made his presentation, the stock quickly fell about 10 percent, but within hours it was back up.

To take a short position, investors sell borrowed stock in hopes of buying it back at a lower price later. If the price rises instead, they would have to buy stock to “cover” what they borrowed.

Mr. Grego scrambled to cover his position, and by day’s end he was out, according to an email he sent to investors in his hedge fund, Quintessential Capital Management. A day later, Cassava, which is based in Austin, Texas, released a report in a scientific journal that seemingly exonerated the company. The stock spiked another 50 percent — but reversed shortly later after the journal indicated the report would most likely be retracted and Cassava disclosed an investigation by the Securities and Exchange Commission.

Such a stomach-churning roller coaster is not an unusual ride for activist short sellers, who typically bulk up their position just before releasing their reports but cover a chunk after making them public. Investors who use this strategy argue that covering their position is a form of risk management, since companies often immediately try to refute activist short sellers’ claims, sending stock prices back up.

“If we had not exited that position when we did, I probably would’ve had to shut down my fund now,” Mr. Grego said. “We would have had career-ending losses.”

Short sellers aren’t loved, nor well understood, by the general public. They became the target of angry retail investors during the GameStop trading frenzy early last year, blamed for driving GameStop’s stock into the ground before a short squeeze — in which the pace of buying forces short sellers to buy stock to cover their positions — catapulted it to the sky. The fracas sparked investigations into GameStop short sellers’ trading, but they have gone far beyond the wild events of January 2021. An investigation of short sellers by the S.E.C. and the Department of Justice, first reported by Bloomberg, has ensnared at least 25 individuals and firms — most of them activist short sellers — who have received subpoenas and search warrants, an individual familiar with the investigation said.

Companies targeted by the activists have been pushing regulators to go after these short sellers for years. But some in the financial industry say the far-reaching inquiry is fueled by a mistaken belief that abuse by activist short sellers is widespread and distorting stock prices.

Those beliefs have also led critics of activist short sellers to propose S.E.C. rules that they say would stem such abuses. These include forcing the activists to hold their positions for at least 10 days or, failing that, to disclose when they cover their shorts. Some have petitioned the S.E.C. to change the rules so that rapidly closing a short position can be considered a form of market manipulation.

Supporters of short sellers say that the research behind these proposals is misleading and that activists, by uncovering fraud, do more good than harm. They argue that the proposed changes would hamstring, if not destroy, a business that provides a vital service in policing the markets.

A cooling-off period

The idea that short activists need to be reined in has largely been driven by Joshua Mitts. An associate professor at Columbia Law School who also has a consultancy business, he claimed in a 2018 research paper, “Short and Distort,” that activist stock sellers who wrote under pseudonyms were deceiving the market to make a quick buck, and that the stocks they shorted bounced back a few days later.

Mr. Mitts first mentioned the idea of a “cooling off” period in a 2019 paper, and by the next year he and a former hedge-fund short seller, Marc Cohodes, had proposed a 10-day holding period for all short activists once they made their research public.

“If you’re a short activist, you scared investors into selling stock, well, you should have to ride the consequences with them,” Mr. Mitts said in an interview, noting that he has presented these ideas to the S.E.C. and on Capitol Hill. On his résumé, Mr. Mitts also says he has “extensive experience supporting the Justice Department,” but he declined to say whether he is involved in the current investigation or to name any of his clients.

In opposing the proposed holding period, Jonathan Macey, a professor of corporate law at Yale University, said it was “a rather blunt instrument” that would punish “the good short sellers in order to get rid of the bad short sellers.”

Marlon Paz, a former S.E.C. official who is a partner at Latham & Watkins and has represented companies targeted by short sellers, called the idea “dangerous.” “If you force people to hold,” he added, “you’re creating the potential for short squeezes.”

In addition to his own experience, Mr. Grego cited the famous case of Wirecard — the German fintech company, now defunct, whose stock soared for years despite fraud allegations by short sellers and in the media — as an example of why such a ban would be impractical.

Mr. Mitts’s research has laid the groundwork for additional efforts aimed at reining in activist short sellers.

In 2020, a dozen business law professors signed an S.E.C. rule-making petition co-written by Mr. Mitts. Among other measures, it asked the S.E.C. to create a requirement to disclose closing a position that “no longer reflects current holdings or trading intention.”

Activist short sellers say that could send the wrong signal — which is that they have changed their view of the company.

Distorting the shorts?

In his “Short and Distort” research, which the rule-making petition quoted, Mr. Mitts looked at 1,720 short attacks published on a popular finance website, Seeking Alpha, by authors using pseudonyms. The targeted stocks initially slid, he found, but began to recover on the day after a negative report and for three more days.

“The paper is making a very specific point that, by using anonymity, one can effectively manipulate the market,” Mr. Mitts said.

His critics have said that the research didn’t look at a representative sample of activist short sellers and that Mr. Mitts’s consulting business is a conflict of interest.

Carson Block, an activist short seller who founded Muddy Waters Capital, an investor research and hedge fund firm, has been among the most vocal of these critics. He calls the professor “a corporate lobbyist masquerading as an academic.” Mr. Mitts has done consulting work for companies targeted by short sellers, including Farmland Partners and Burford Capital, the latter of which Muddy Waters shorted. (Mr. Mitts said Mr. Block’s characterization was false because he worked with a variety of clients.)

In an analysis shared with DealBook, Mr. Block found that 75 percent of the Seeking Alpha cases that the “Short and Distort” research examined are not in the database of activist short seller campaigns compiled by Activist Insight, a leading provider. He said Mr. Mitts’s data also showed that only about 20 percent of the study’s Seeking Alpha authors said they were short the stocks they were writing about. (Seeking Alpha requires authors to disclose if they have a position.) Others have noted that some of the authors in Mr. Mitts’s database were simply suggesting shorting companies ahead of earnings announcements.

Mr. Mitts did not take issue with either of these numbers but said some authors “could be lying” about not being short.

The Columbia professor’s results have also been challenged by newer research, which has found that stocks targeted by activist short sellers, on average, fare worse than the short-term recoveries that Mr. Mitts documented in his sample.

One analysis by Frank Partnoy, a professor in the School of Law at the University of California, Berkeley, and Peter Molk, a professor at the University of Florida Levin College of Law, shows that stocks targeted by activist short sellers decline in price significantly over time.It also found that the reports often result in regulatory investigations, settlements for plaintiffs in class-action cases, and changes in leadership and operations. Activists provide substantial benefits to society, the professors argue.

They studied the Activist Insight database of 825 short reports between 2009 and 2016 and found that four years after the release of the reports, the average stock price decline of the 573 targeted companies was more than 20 percent.A study published last year byWuyang Zhao, an assistant professor of accounting at the University of Texas, also found that stocks targeted by activist short sellers fell over time.

Mr. Partnoy said Mr. Mitts’s research focused on the short term, which can be “an absolute blood bath for short sellers.” He added, “If your view is that short sellers are helping the market and are helping to bring information about overpriced companies to the market, the last thing you want to do is regulate them more.”

Mr. Molk, who signed onto the rule-making petition co-written by Mr. Mitts, said that after doing his own research, he had “second thoughts” about its proposals.

What is manipulation?

For activist short sellers, perhaps the most ominous part of the rule-making petition is a request that the S.E.C. make the rapid covering of a short a possible form of market manipulation known as scalping.

Historically, scalping involved investment advisers who recommended stocks to clients and then quickly sold them.

Short sellers have long been told by their lawyers that as long as their reports contain no material inaccuracies and are not based on inside information, they have done nothing illegal. In the disclosure accompanying their reports, activist short sellers typically say they are short the stock but may cover at any time. And they add that they are not offering investment advice.

John Courtade, a former senior S.E.C. enforcement litigator who now represents short sellers, has designed some of these disclosures. “Scalping has to involve deception of some sort,” he said. “Just the fact that you’re going to close your position has never been held to be deception. If you look at the cases, they involve situations like not disclosing that you have a position at all.”

But Mr. Mitts argues that whether the boilerplate disclosure is sufficient “has not been tested by the courts.”

For now, the S.E.C. appears unlikely to move on Mr. Mitts’s rule-making petition, though it may add some broad disclosure requirements of short sales as mandated by the Dodd-Frank Act, which overhauled financial regulation after the 2008 financial crisis. But it’s an open question as to whether the Justice Department will try to set a precedent by prosecuting short sellers for market manipulation under the scalping theory — or any other one not yet tested.

The debate has led Mr. Grego to wonder whether society wants activist short selling. If it does, he said, any proposed rule should be vetted for “unintended consequences that maybe reduce or even make this activity impossible.”

As for Cassava, after the company announced that the S.E.C. was investigating it, Mr. Grego reopened his short position, and the stock has fallen 20 percent. He said he had never doubted that his thesis was correct.

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