Salute Your Shorts

by ptschuette October 2 2008, 00:29

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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