Short sellers are like Dr. Jekyll and Mr. Hyde: Some exist ethically to uncover business fraud, while many are the fraud, targeting publicly traded companies to tank their stocks for personal gain. In either case, short-selling schemes demand greater scrutiny that chief compliance officers and in-house counsel can no longer afford to ignore.

In the United States, short selling—the practice of investors betting on a company’s stock price falling—is not, per se, illegal. A legal short sale works like this: An investor borrows shares—from a financial institution, for example—at the current market share price to then immediately sell. If the stock price falls, the investor buys back shares on the open market to return the borrowed shares to the lender and profits the difference.

In theory, done legally, short selling can be beneficial to the markets by holding companies accountable when they do not properly represent their financial statements or when they fail to disclose certain other matters that could affect stock price.

“The problem is that isn’t what I have seen in the last 20 years in the litigation space of stock manipulation,” said Wes Christian, a partner at law firm Christian Smith & Jewell. “What I see is prime brokers, hedge funds, and market makers rigging the system to basically guarantee they’re going to be able to make money off their shorts.”

Naked short selling is among the most fraudulent of schemes. It is the illegal practice of selling shares a short seller has neither borrowed, owns, nor intends to buy, resulting in a “failure to deliver” (FTD) amounting to trillions of dollars in FTDs, as some research indicates.

“I believe [illegal short selling] is the largest commercial fraud in U.S. history. It makes the Bernie Madoff scheme look like a gnat on an elephant’s behind.”

Wes Christian, Partner, Christian Smith & Jewell

By selling so-called “phantom” shares, naked short selling gives criminal-minded investors the power to manipulate share prices at will.

“It’s like xeroxing your car title 100 times and selling that car to 100 people, but you only have one car,” Christian said. “That’s what Wall Street is doing.”

With lax enforcement on the part of regulatory agencies, big banks are incentivized to turn a blind eye to these illegal tactics and be a willing participant by funding shorts because of the large trading fees they collect. Big banks make most their money in two ways: doing proprietary trading (trading on their own behalf) and lending stock to short sellers, Christian said.

The Depository Trust & Clearing Corporation (DTCC), a self-regulatory organization, also is not an uninterested party. A classic example of the fox guarding the henhouse, the DTCC self-describes itself as providing “settlement services” for the financial markets, but the number of FTDs is so systemic the DTCC has created what it calls its “obligation warehouse,” where FTDs essentially go to die.

Simply put, naked short selling is one massive embezzlement scheme that for years has mostly gone ignored.

Criminal investigation underway

The U.S. Department of Justice’s Fraud Section has recently begun a widespread criminal investigation into the shadowy underworld of short selling. The Justice Department has issued several subpoenas in a probe that seeks to examine the interplay between hedge funds and investment research firms that publish studies on companies, including negative reports, according to a report from Bloomberg last month.

“It is long overdue that the Department of Justice is now looking into this,” Christian said. “I believe this is the largest commercial fraud in U.S. history. It makes the Bernie Madoff scheme look like a gnat on an elephant’s behind.”

The investigation is reportedly focused on the type of manipulative short-selling tactics that have garnered suspicions from critics for years. An example of a manipulative short sale involves publishing research under the guise of “independent” reports that are, in truth, intentionally misleading or inaccurate and heavily funded.

These so-called “short-and-distort” campaigns manipulate stock prices to induce shareholders into panic selling, enabling criminal-minded short sellers to cash out their trades and pocket the gains before shares rebound. The Justice Department’s investigation is also said to be looking into potential insider trading, whereby an infiltrator obtains sensitive information on the company and leaks it intentionally.

At its core, short selling raises questions that demand answers: Which shorts are engaging in deceptive and illegal tactics versus those who are not? And what clear evidence exists to prove the difference?

Among the firms under investigation include Anson Funds and anonymous researcher Marcus Aurelius Value, Bloomberg reported. Other short-selling firms that have targeted companies in recent months include Muddy Waters and Citron Research.

Requests for comment from Anson Funds, Muddy Waters, and Citron Research were not returned.

Fighting back

The best proactive defense against abusive short selling practices is for public companies to monitor trading and daily volume in their securities for signs of manipulative trading patterns, said Barry Goldsmith, a partner at law firm Gibson Dunn.

Some firms offer trade monitoring services. ShareIntel, for example, as stated on its website, proactively tracks equity flows and can help companies identify “suspicious, aberrant, and/or unusual trading activity.” ShareIntel also offers companies “the capability to historically aggregate repository data from reporting entities, broker-dealers, and shareholders.”

Keep an eye out for false market rumors and the dissemination of materially false information about the company, Goldsmith added. Monitor social media channels, chat rooms, and message boards, he said.

Once a company suspects it has been targeted by shorts illegally, consider taking legal action. That is exactly what more publicly traded companies are choosing to do: revolt.

Cassava Sciences is one such example. In a regulatory filing in November, the clinical-stage biopharmaceutical company disclosed “certain government agencies” asked it to provide them with “corporate information and documents” following allegations made against it by Labaton Sucharow—a law firm found to be representing anonymous clients who have a short position in Cassava stock.

Cassava Chief Executive Officer Remi Barbier fired back in a 20-minute video message. “There is an enormous profit motive at work,” he said. “After the allegations were made public—which is to say after the damage was done—the law firm issued a press release admitting its anonymous clients ‘hold short positions in Cassava stock.’”

Barbier added, “We intend to vigorously defend ourselves and our stakeholders against false and misleading allegations.”

Coming out on the winning end of a settlement following a short seller attack is possible. One high-profile example is Farmland Partners (FPI), an internally managed real estate company which last year won its lawsuit against Quinton Mathews. Mathews—who went under the pseudonym “Rota Fortunae”—was the author of an attack published on the financial website Seeking Alpha in July 2018 as part of a short-and-distort scheme targeting FPI.

Mathews was conducting research on FPI on behalf of hedge fund Sabrepoint Capital, which had a position in FPI stock. Mathews admitted Sabrepoint paid him more than $100,000 in 2018 alone for his work on FPI and other companies. He later acknowledged publicly the article contained false statements that drove down FPI’s stock price 39 percent on the day of publication. Under a settlement, Mathews agreed to pay FPI “a multiple of the profits” he made from the short positions.

“While the company waits for the relevant government agencies to take the necessary steps to meaningfully protect companies like FPI from these kinds of attacks,” FPI said it will continue to recover ill-gotten gains from Sabrepoint “and any others who may have wrongfully profited from the artificial decline in FPI’s share price caused by the false and misleading attack on the company.”

Christian said while targeted companies can go to relevant government agencies, “Honestly, they’re overwhelmed. They don’t have the manpower for this.” If going to a regulatory agency is the avenue you choose, “Give regulators a very short window, and if they don’t perform, then file suit and try to be made whole,” he said.