A committee of law professors, led by John Coffee and Joshua Mitts, both of Columbia Law School, have submitted a petition for rulemaking with the rhythmic title, “Short and Distort,” concerning the practice of “negative activism”: as they describe it, a negative activist “opens a large short position; disseminates sometimes aggressive negative opinion about a public company (often stopping just short of factual falsehoods)…, which induces a panic and run on the stock price; and rapidly closes that position for a profit, prior to the stock price partially or fully rebounding.” In these scenarios, the short sellers do well, but the investing public—not so much.
According to a study conducted by Mitts of pseudonymous short attacks on public companies, the pattern of aggressive negative public attacks followed by steep drops in price and subsequent reversals is likely precipitated by “manipulative stock options trading,” and facilitated by trading under pseudonyms that “allows manipulators to switch identities without accountability.” These types of trading strategies are sometimes referred to as “‘scalping’ schemes, which involve making statements that lead…investors to purchase or sell a stock, while failing to disclose a position or an intent to trade in the opposite direction of one’s recommendation.”
The petitioners believe that this pattern of activity highlights flaws in the regulatory system in connection with short selling. Under most circumstances, there is no duty to disclose short sales. But what about voluntary disclosure—should there be some duty related to that information? According to the petitioners, the “failure to update a voluntary short position disclosure which no longer reflects current holdings or trading intention is a deceptive device or contrivance” and should be prohibited under SEC rules. Specifically, the petitioners ask the SEC:
“First, precisely because there is no duty to disclose one’s short position, we ask the Commission to impose a duty to update promptly a voluntary short position disclosure which no longer reflects current holdings or trading intention.
“Second, we ask the Commission to clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5. We further propose that a safe harbor be drafted which would allow for closing a position at a price equal to or lower than a valuation stated, expressly or impliedly, by a short seller.”
Duty to Update. With regard to the first point, the petitioners contend that negative activists do more than just take large short positions or convincingly articulate their opinions advocating sale of the stock; they also assert that the activists are themselves poised “to profit if the share price declines and lose if the share price rises.” Many investors are persuaded to sell when an activist with a reliable reputation discloses a short position, often even more than by a “sell” recommendation from an analyst who has no “skin in the game.” That is why, the petitioners argue, the SEC
“should vigilantly ensure that short position disclosure, when voluntarily initiated by a short seller, remains truthful and accurate. We are not advocating that the Commission mandate the disclosure of short positions. However, when a short seller has chosen to disclose a short position, failure to disclose that the position has been closed is doubly misleading: first, because the statement that the activist has a short position is literally no longer true; and second, because, the author’s negative opinion lacks the ‘skin in the game’ element that gives market participants reason to believe the underlying claims are true.”
SEC rulemaking to impose on these negative activists a duty to update “promptly” is warranted because, according to the petitioners, the circuits are currently split as to whether short sellers are subject to a duty to update a voluntary disclosure under federal securities law. The petitioners would define “promptly” consistent with Reg FD: “as soon as reasonably practicable (but in no event after the later of 24 hours or the commencement of the next day’s trading on the New York Stock Exchange).”
In addition, the petitioners urge the SEC to make clear that a boilerplate disclosure of the possibility of future sale would be inadequate. Instead, they advocate, the SEC should require “as much detail as necessary in order to clarify that a prior position disclosure no longer reflects current holdings or trading intention,” as a result of closing the position or otherwise hedging against exposure to a decline in the stock price.
Scalping. While the courts have a long history of finding that scalpers “have a duty to disclose their financial interests in touted securities so that their promotional materials are not materially misleading,” the petitioners were not aware that the SEC had brought any scalping cases against short sellers. Accordingly, the petitioners advocated that the SEC adopt a rule making clear “that liability for fraudulent scalping applies to any individual who encourages the sale of a security and purchases shares ‘for a quick profit’ soon after an article is published, while failing to specifically disclose intent to do so.” Once again, they suggest that boilerplate be considered inadequate. The petitioners emphasized that they were not advocating any mandatory holding period for short sellers, just a disclosure requirement.
To foreclose the possibility that a rule could “chill legitimate criticism of public companies by short sellers,” who they recognize, “serve an important function in the capital markets,” the petitioners also propose that the SEC adopt a safe harbor allowing short sellers to “close a position at a price equal to or lower than a valuation stated expressly or impliedly.” The rationale is that when
“a short seller closes its position at a share price equal to or lower than a stated valuation, he or she furthers price discovery by making it more likely that the share price reflects that proffered valuation. On the other hand, when a short seller states that a company is worth a given valuation but purchases the stock at a price higher than the indicated valuation, the short seller is not furthering price discovery. Rather, the short seller is buying at the same time that he or she is encouraging other investors to sell. [The safe harbor] would give negative activists confidence that a well-researched short thesis, which advocates that the firm’s stock is overvalued by a given amount, can be freely traded upon at or below the indicated valuation. On the other hand, short sellers who use words like ‘insolvent,’ ‘bankrupt’ or ‘zero’ to characterize a public company would be unable to enjoy…the benefit of the safe harbor[, although] not necessarily…subject to liability for fraudulent scalping….”
Finally, the petitioners suggest that the SEC require speakers/writers who are compensated by a short seller to “disclose any compensation and acknowledge that he or she is subject to a potential conflict of interest.”
