Salute Your Shorts

I. A Short Introduction

With the recent collapse of numerous financial institutions,
the practice of short-selling (“shorting”) has come under fire. Some authors have gone so far to claim that
the actions of short-sellers (“shorters”) are among the core reasons for the
current credit crisis.[1] In response to this outcry, the United States
has imposed temporary bans on the shorting of certain stocks, particularly the
stocks of firms in the banking and finance sector, citing the need to protect
investors and markets.[2] Furthermore, New York Attorney General Andrew
Cuomo has launched an investigation into shorters for allegedly spreading false
rumors in the financial market.[3] These enforcement responses prompt the question;
do shorters have a legitimate role to play in a fair and open market?

II. History, in Short

There is a
long history of animosity towards shorters. Following the collapse of tulip craze in the Netherlands in the 1630s,
England banned shorting, fearing the effects of that collapse would spread onto
their shores.[4] More recently, shorters have been blamed for
stock market crashes in Malaysia in 1997 as well as in the United States in
1929 and 1987.[5] The recent restrictions on shorting across
the world are nothing new.

On a basic
level, short-selling works as follows. The
shorter borrows shares from her broker. The
shorter turns around and sells those shares to a buyer. Eventually, the shorter buys the shares back
and returns the shares to the broker. If
the price of the shares has decreased between the seller selling and buying the
shares, the shorter makes a profit. If
the price has decreased in that time, the seller loses money.[6] A variation of this model, known as “naked
shorting,” involves the shorter never borrowing the shares from the broker, but
selling non-existent shares to the buyer in any case.[7]

Short-selling
is typically used for two purposes. The
first purpose is for speculation. Some
short-sellers are only looking to make a profit off of the decline in the
stocks’ value. This is essentially the
flip side to speculators who go long on stocks looking to make a profit off of
the stocks’ increase in value. The
second purpose is for hedging. A shorter
who acts for hedging purposes is looking to offset possible future losses
related to the stock she is shorting. Many
hedge funds utilize short-selling for exactly this purpose, using shorting to
offset potential losses from stocks on which these hedge funds have gone long.[8]

III. A Short Fuse on Rumors for Regulators

One of the primary concerns about
shorters is their alleged spread of false information regarding various
firms. Section 9(a)(4) of the Securities
Exchange Act of 1934 prohibits dealers, brokers, sellers, and buyers of
securities from knowingly making a false or misleading statement regarding any
of those securities.[9] In April, the SEC charged a Wall Street
trader with securities fraud and market manipulation for disseminating false
rumors.[10] The SEC reached a settlement agreement with
the trader; with the trader agreeing to disgorge $26,129 in profit and
interest, pay a $130,000 fine, and consent to being barred from associating
with any broker or dealer.[11]

One of the
most striking examples of these false rumor allegations came about following
the dramatic collapse of Bear Stearns earlier this year. According to a number of people within Bear
Stearns, the collapse was brought about by short-sellers who wanted to bring
them down. One variation of the tale
involved prominent hedge fund managers celebrated bringing down Bear Stearns
over breakfast the morning after Bear Stearns collapsed.[12] Other potential culprits for spreading the
false rumors were a former employee and Goldman Sachs.[13] Bear Stearns CEO Alan Schwartz was adamant in
his conviction that this was part of a complex scheme to induce an artificial
panic and bring about the downfall of Bear Stearns.[14]

In the
midst of the Bear Stearns collapse, the Federal Reserve had to step in and take
action. The Federal Reserve engineered
the rescue of Bear Stearns’ debts through assisting JPMorgan Chase’s acquisition
of Bear Stearns via a credit line, taking control over Bear Stearns’ portfolio,
and backstopping various Bear Stearns liabilities.[15] If there is truth to these allegations, the
activities of shorters must be taken as a grave threat to markets.

IV. The Short
Shrift

At first
glance, there could be some truth to these tales of intrigue involving covert
rumors, spite, and celebration over breakfast burritos. Those who were shorting Bear Stearns profited
handsomely from the firm’s demise. Shorters seem to have every incentive to spread false rumors and profit
from falling share prices, especially if those rumors could never be traced
back to them. Yet, in spite of these
Bear Stearns insiders spinning tales of rumor-mongering and coordinated attacks
against Bear, the reality of the matter is that the likelihood of such a scheme
occurring is minimal.

There are
two things which caution against blindly blaming short-sellers for the current
credit crisis. The first matter is the
potential liability arising out of knowingly spreading these false rumors. The aforementioned charges the SEC brought
against a Wall Street trader brought about a costly settlement for the trader.[16] While rumors may be difficult to trace, these
potential liabilities could serve as a strong deterrent for anyone who wishes
to knowingly spread a false rumor.

The second matter is that firms
subject to these false negative rumors can employ a powerful defense: the
truth. Through employing disclosure,
firms can combat false negative rumors in order to quickly restore any damage
done through the spread of these rumors. Moreover, because managers must answer to shareholders and typically also
have performance-based salaries and stock options, these managers have a strong
incentive to disclose the truth, lest they suffer monetary loss or lose the
confidence of their shareholders. On the
other side of the equation, if the disclosure of the truth in response to
negative false rumors serves to increase stock prices, the shorters will lose
money on their positions.

Lost in all of this discussion and
analysis of the role of shorters in the market is the issue of false positive
misinformation. Section 9(a)(4) does not
differentiate between negative misinformation and positive misinformation.[17] Knowingly spreading positive misinformation
is illegal. However, there has been very
little discussion or action regarding the spread of this misinformation. Managers and shareholders benefit from false
positive information. As long as the
share prices are high, they have little incentive to combat these rumors.

There is also an information asymmetry
problem with positive misinformation. Oftentimes, managers are in the best position to combat misinformation
since they are in a terrific position to access and publicly information about
the firm. Outsiders lack access to this
information and therefore cannot verify the substance of these false positive
rumors. Because of their incentive to
have share prices fall, shorters are enormously important for dispelling this
misinformation.

Shorters are hawkish in their monitoring
of firms’ financial statements and accounting.[18] Shorters are
excellent monitors for
accounting fraud and can provide effective early warning signals to the
market
regarding the fundamental soundness of firms.[19] James Chanos, a
well-known shorter, had his
firm short Enron a year before Enron’s scandal unraveled in 2001.[20]
In 2002, Chanos testified before Congress. In his testimony, Chanos
mentioned that his
firm noticed discrepancies in Enron’s financial statements and insider
selling
tendencies, despite the fact that Enron was a seemingly healthy and
successful
company at the time.[21]

Shorters are strongly incentivized
to keep markets honest. They provide
information and transparency in the market. Shorters provide additional monitoring in markets, which is enormously
important in deterring firms from engaging in fraud and spreading positive
misinformation. Furthermore, the
likelihood of shorters successfully spreading false negative rumors about a
firm to the point of bankrupting a firm seems almost remote, given the
likelihood of liability and the ability of firms to disclose the truth. When acting lawfully, shorters serve an
enormously important role in markets.

V. In Short…

Shorters
serve an important function in markets. They curtail irrational
exuberance. They are strongly incentivized to detect and disclose other
firms’ bad
behavior. While shorters should be
subject to the same laws as any other market actor, their pessimism
should not
be punished. An outright ban on shorting
removes important actors from the market who contribute valuable
information
and transparency. Removing shorters from
markets altogether only serves to remove an important monitoring
component of
that market.


[1] See, e.g., AC Grayling, Beware
the City’s Robber-Barons
, Guardian, Sept. 24, 2008, http://www.guardian.co.uk/commentisfree/2008/sep/24/economics.marketturmoil.

[2] Press Release, Securities
and Exchange Commission, SEC Halts Short Selling of Financial Stocks to Protect
Investors and Markets (Sept. 19, 2008), http://www.sec.gov/news/press/2008/2008-211.htm.

[3] Aaron Lucchetti, Amir
Efrati, and Kara Scannell, Cuomo Plans
Short-Selling Probe
, Wall St. J. (Sept. 2008), http://online.wsj.com/article/SB122176389889653245.html?mod=googlenews_wsj.

[4] James Chanos, Op-Ed, Short Sellers Keep the Market Honest,
Wall St. J., Sept. 22, 2008, http://online.wsj.com/article/SB122204250955761325.html?mod=todays_us_opinion.

[5] Daniel Trotta, Short Sellers Have Been the Villain for 400
Years
, Associated Press, Sept. 26, 2008, http://www.reuters.com/article/reutersEdge/idUSTRE48P7CS20080926?PageNumber=2&virtualBrandChannel=0&sp=true.

[6] Further information about
short selling can be found on the Securities and Exchange Commission’s website
at http://www.sec.gov/answers/shortsale.htm.

[7] The practice of naked
shorting introduces peculiar issues that are not covered in this article. The SEC has moved to clamp down on the
practice in the midst of the credit crisis. Marcy Gordon, New SEC Rules Target
‘Naked’ Short Selling
, Associated Press via Wash. Post, Sept. 18, 2008,
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091703631.html.

[8] Hedge Funds Wrestle with Short Sale Ban, Wall St. J., Sept. 25,
2008, http://online.wsj.com/article/SB122229997080673311.html?mod=googlenews_wsj.

[9] Securities Exchange Act of
1934 (“’34 Act”) § 9(a)(4), 15 U.S.C. § 78i (2007).

[10] Press Release, Securities
and Exchange Commission, SEC Charges Wall Street Short-Seller with Spreading
False Rumors (Apr. 24, 2008), http://www.sec.gov/news/press/2008/2008-64.htm [hereinafter Apr. 24 SEC Press Release].

[11] Id.

[12] Bryan Burrough, Bringing Down Bear Stearns, Vanity Fair,
Aug. 2008, http://www.vanityfair.com/politics/features/2008/08/bear_stearns200808?currentPage=8.

[13] Id.

[14] Id.

[15] Edmund Andrews, Fed Acts to Rescue Financial Markets, N.Y. Times, Mar. 17, 2008, http://www.nytimes.com/2008/03/17/business/17fed.html.

[16] See Apr. 24 SEC Press Release, supra
note 10.

[17] 1934 Act § 9(a)(4).

[18] Len Boselovic, Short Selling Shouldering Disproportionate
Amount of Blame for Crisis
, Pittsburgh Post-Gazette, Sept. 28, 2008, http://www.post-gazette.com/pg/08272/915455-435.stm.

[19] Id.

[20] James Chanos, Op-Ed, Short Sellers Keep the Market Honest, Wall St. J., Sept. 22, 2008, http://online.wsj.com/article/SB122204250955761325.html?mod=todays_us_opinion.

[21] Developments Relating to Enron Corp.: Hearing Before the H. Comm. on
Energy and Com.
, 107th Cong. 71 (2002) (statement of James
Chanos, Kynikos Associates, Ltd.), excerpts
available at
http://www.pbs.org/wsw/opinion/chanostestimony.html.

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