Betting on stocks to go down prompts federal investigations and free speech discussion

The Department of Justice and Securities and Exchange Commission are looking into the practice of “activist short selling.”

By Sean SaldanaFebruary 20, 2023 1:45 pm,

As many Texans struggle with rising prices and just paying bills, the news about Wall Street’s ups and downs can often seem a world removed.

But right now there’s a high level investigation underway involving the Department of Justice and the Securities and Exchange Commission that touches on something that potentially affects us all: Free speech and the limits of it. 

Evan Hughes is an author and reporter whose new article in The Atlantic explores the world of short selling, corporate espionage and potential market manipulation and he joined the Standard to discuss. Listen to the story above or read the transcript below.

This transcript has been edited lightly for clarity:

Let’s begin with a basic idea here. I mean, most people invest in the stock market in hopes that the stock they buy will go up, but there are others involved in the markets who want to see certain stocks go down so they can profit. And it’s these folks in the crosshairs of investigators. Do I have that right? 

That’s right. Short sellers are the ones under scrutiny, so-called. The easiest way to explain short selling: it’s a way of taking a bet that a stock will go down. You know, if you own a stock and you think it’s going down, well, that’s simple: You sell it. If you don’t own a stock and you think it’s going down, you have to sort of make a more complicated maneuver. But that’s basically what you’re doing. 

What’s the more complicated maneuver here? 

So basically because you don’t own the stock, you have to borrow it. So you borrow some shares. You sell them immediately. And your hope is the price of those shares will fall and then you’ll buy back the shares and return them to the lender and you’ll pocket the difference.

Now, there’s nothing new about doing this. I’ve heard of short selling all my life. So, what exactly is it that the Department of Justice and the Securities and Exchange Commission are looking into? 

Well, what is more new is a practice called “activist short selling.” So one way to short sell would be to take a bet against the stock and then quietly wait for the share price to fall. These guys don’t do that. They are vocal. They say, “we think this stock is way overvalued and here’s why. And maybe even we think there’s some corporate misconduct here. We think there’s some fraud here. We think we can prove it.” And they publish a long memo like that online, a so-called “short report,” in an attempt to move the price down. 

Well, I guess you do have this thing called free speech, the First Amendment. There isn’t anything that prohibits them from doing that. Or is there? 

Right, no, there’s nothing in particular that does restrict that other than, you know, if you make a false statement about a company that can constitute defamation or it can constitute securities fraud. These things have to be extremely carefully vetted. And it is a risky business on that front. And then you have the question of “how are they profiting on this?” And that seems to be the focus of investigators, is how they are making trades timed around these reports.

Well, what do you see at stake here with this investigation? Is it all about the people trying to manipulate the markets or is there a broader issue when it comes to what’s allowed to be said about a company? I mean, a lot of whistleblowers, right? I mean, that’s part of their function, too.

Exactly. And some short sellers have received whistleblowing awards from the Securities Exchange Commission. It is a complicated issue, because short selling is often an early warning system for corporate fraud. You know, there’s a lot of money at stake if you can prove that there was malfeasance and take an early bet against the company. It was a short seller who played a pivotal role in uncovering the Enron scandal, for instance. So you wouldn’t really want to chill that behavior, would you? What you’d have then is perhaps a flowering of corporate fraud. Scholars make the case that this could constitute market manipulation.

One stock that a lot of people think has been shorted is Tesla. Could you say more about that? 

That is true that short sellers really, since Tesla went public a decade ago, have felt that it was overvalued and kind of shook their heads in disbelief over its meteoric rise until recently. And they’ve made the case. I mean, it was never really expected a decade ago that Tesla would sell millions of electric cars. You know, maybe there’d be some fancy car that you saw once in a blue moon on the road, and it would be like a toy for the super rich. But that’s not the case. Tesla succeeded in ways that weren’t anticipated. So sure, it’s lost a lot of money, but they’re still out there making the case that they shouldn’t be valued more than like several other leading automakers combined.

Can I ask you about something? Because I’m thinking that someone who’s been very much against short selling as an activity is Elon Musk. He sees this as really harming the companies that are often the targets of short sellers. And yet he infamously purchased Twitter and has a big footprint now in Texas and often touts himself as an advocate of free speech.

Yeah, that’s an interesting point. I mean, you know, Musk isn’t alone. Short sellers don’t have a great reputation. You know, it looks bad that they’re sort of rooting for failure of companies. You know, if the company fails, people lose their jobs, the economy suffers. And the short sellers are quietly celebrating because they just made a profit on the trade. So, you know, that’s part of what Elon Musk carries on about. But he’s also displeased because short sellers have zeroed in particularly on Tesla and have long believed that it’s an overvalued stock and that that alienated him. And as we know, Elon likes to fight back.

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