Introduction and Background

I would like thank Jim Copland for inviting me to this discussion. I would also like to thank Larry Ribstein for agreeing to discuss this subject with an old student from his former place of employment – GMU Law School.

For those new to this discussion, I have written on the subject of short-sellers teaming up with the plaintiffs’ bar. Larry has been critical of my recommendations, perhaps, because he foresees an overburdening of capital markets if my proposals are implemented. At the outset, let me state that I do not believe that Larry and myself actually disagree on the fundamentals, as I believe we share the same goals, but disagree about how to achieve them. What, perhaps, differentiates us is that my approach is pragmatic (and perhaps short-sighted), while his approach is more long-term focused and principled.

My concern is that corporate America is under attack, and that unless something (even in the short-run) is done we are doomed to mediocrity and a decline in the quality of our life. The two sources of attack are the government’s excessive regulations and the plaintiffs’ bar. My policy recommendations, therefore, are meant to address some of the harm the plaintiffs’ bar has been causing.

In this posting, I will discuss a stylized scenario: a plaintiff decides to sue a firm, but before the suit is announced, the plaintiff short-sells the firm’s stock. It may be that the lawyer is the one who does the short selling, or a hedge fund tipped off by the plaintiff. Who does the short selling is immaterial, for as long as it is wrong for the plaintiff to do the short selling, it is also wrong for anyone who receives this information to also short sell.

Short Selling Plaintiffs – Why it is Fraud?

The starting point of my analysis is the Securities & Exchange Commission’s (SEC) Rule 10b-5, which prohibits the employment of “any device, scheme, or artifice to defraud,” or the making of “any untrue statement of a material fact or … omit[ing] to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or [engaging] in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” 17 C.F.R. § 240.10b-5. (emphasis added)

Given that short-sellers do sell borrowed stock in the hopes that the price falls when they sell their stock, their failure to mention to the public the fact that they imminently intend to sue is an omission to state a material fact, which operates as a fraud or deceit upon the public (including the purchaser).

The announcement of a lawsuit undoubtedly lowers a defendant’s stock price. This is because the market discounts the value of the company by the expected cost of the lawsuit, which includes the potential payout and legal fees. No matter how improbable the suit, given the high cost of defending lawsuits, the announcement of a suit will certainly negatively impact the stock’s price. This has been empirically validated in numerous studies. Given this definite and substantial impact on the price, no investor would ever purchase a company’s stock from someone who was about to sue it.

Normally in a securities transaction, each side takes a risk that the stock may not perform according to expectations, but when one side is about to be the cause of the stock’s demise, the transaction becomes purely one-sided. This is the source of the fraud. Modern tort and contract law recognize that in some instances silence can be fraudulent, and the short selling plaintiff definitely fits into this doctrine.

Other Policy Reasons for Prohibiting Dumping & Suing.

A plaintiff who short-sells and then sues is doubly enriched. When the short sale is followed by the announcement of the suit, the plaintiff profits due to the drop in stock price. Then, when the plaintiff settles with the defendant or collects a judgment following victory in court, the plaintiff is enriched again. The plaintiff should only be entitled to the proceeds of the lawsuit; the proceeds of the short sale are a form of unjust enrichment.

Plaintiffs are now given a double incentive to bring lawsuits – and God knows this is the last thing we need to be giving them. If this practice is legal, then plaintiffs and their lawyers can now profit by simply announcing a lawsuit. In the extreme, a lawyer can simply announce a suit, profit from the drop in price, and then withdraw the suit. Despite recent federal legislation aimed at managing class actions, many lawsuits can still be brought in state court, and in many states, the standards for what constitutes a frivolous suit are fairly low.

Policy Prescriptions

1. At the very least, the SEC should investigate the extent to which this is taking place. This is not a tough task, given that firms already have to report major lawsuits facing them and they probably could account for major short-attacks.

2. Plaintiffs and their lawyers should be deemed constructive insiders until they announce their intent to sue. By extension, all who receive any tips from them will also be prohibited from short-selling the target company’s stock. This rule can be either promulgated by the SEC or developed by the courts through counter-suits by firms against hedge funds and the plaintiffs who may have tipped them.

3. If nothing is done, then we need to re-examine the entire insider trading rules. For example, insiders should be allowed to, at the very least, go long in their company’s stock, as this is just the mirror image of what is being done by the short-selling plaintiff.