Let me be clear on my policy prescriptions: “dump & sue” is a violation of 10b-5, but if not or if there is a fear of that interpretation being too expansive, in the alternative, the SEC could enact regulations to capture “suing and dumping”.  In my claim that short-selling and suing violates 10b-5, I am not relying on the insider trading jurisprudence as Larry seems to keep assuming (hence his emphasizing on the abuse of property rights principle).  What I am relying are the general market manipulation jurisprudence that has flowed from 10b-5.  Section 10 of the Securities and Exchange Act (titled “Manipulative and Deceptive Devices”) states that

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange:

(a)(1) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

….

(b) To use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. (emphasis added)

This is a broad license to the SEC to promulgate rules to protect investors with respect to short-sales specifically and any transactions generally.  The SEC has then seen fit to promulgate Rule 10b-5, which states:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a)To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit 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

(c) To engage 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. (bold added)

Under 10b-5, the SEC has generally pursued two lines of cases: insider trading (which requires the property rights element as Larry points out) and the market manipulation cases (such as the “pump and dump” and “cyber-smear” schemes).

It is the second line of cases that I have argued the short-selling plaintiffs are analogous to.  When a short-seller spreads bad news to negatively affect the stock price, this is market manipulation as this falls under the first part of Rule 10b-5(b) (“make an untrue statement”).  The short-selling plaintiff is omitting to state a material fact, and therefore, this practice falls under the second part of 10b-5(b).  The material fact that I am referring to is the fact that the plaintiff is about to sue the company, i.e. the short-selling plaintiff is about to become the source of the demise of the stock price’s value.  This is not a case of an outsider who properly happened upon some non-public information; rather this is a person whose non-public information is that he is about to act in a way contrary to the company’s interest.

The “pump and dump” and “cyber-smear” prosecutions have never required any property rights theory –just market manipulation.  In the short-selling scenario, the fraud is by silence.  While there may be no Supreme Court jurisprudence saying the plaintiffs need to disclose, that is, because this seems to be a recent phenomena (and hence our discussion); there nothing preventing a court in the future from viewing this practice as falling under Rule 10b-5.  It boils down to whether a court will agree with me that failure to mention the news of an imminent lawsuit is an omission to state a material fact.  If it is, then it falls squarely under the plain reading of 10b-5.  In the alternative, the SEC has a broad license under Section 10(b) to promulgate a rule that captures this practice; as such a rule is needed to protect investors.  Larry’s claims that this is beyond the SEC’s jurisdiction is wrong as a plain reading of Section 10(b) (and Rule 10b-5) will reveal. 

The reason that it is fraud is because the announcement of a suit has an adverse impact on the stock price’s value.  I have pointed out how, even in an efficient market, a lot of noise can exist initially.  The market, even a perfectly efficient one, will discount the stock price by the expected cost of the suit.  Even if the suit is a low probability suit, as long as the potential payoff is high, there will be an adverse effect on the stock price.  This means that upon the initial announcement of the suit (especially if unexpected, which is the most likely scenario for these dump and sue cases), there will be a drop in price.  This will allow the plaintiff to profitably short-sell, no matter how frivolous the suit is.  I have not ignored financial economics, as Larry claims. I even cited a study (which he did not respond to) that shows that the market initially has a hard time figuring out the merits of the suits.  This is a function of our litigation system being so complex.  Perhaps the solution is to fix our litigation system, but until that happens, investors will be at the mercy of short-selling plaintiffs.  It is a question of what we believe the best way to combat the harm to America’s investors and corporations.  Were I convinced that meaningful litigation reform was around the corner, perhaps I would not be so upset by this practice. 

As to the argument that allowing this practice will create an incentive for better quality suits, this argument only works if high-quality plaintiffs can credibly distinguish themselves from low-quality plaintiffs in the extreme short-run.  Short-selling plaintiffs profit in the extreme short-term, however, because there is much noise in the market upon the announcement of the suit, which will allow even low quality suits to be brought.  It may eventually emerge which quality suit is being brought, but it is the initial announcement that will trigger the drop in price.  Were the markets able to initially discern the quality of any news released, there would be no need to prosecute those “pump and dump” and “cyber-smear” culprits, for when they announced their false news, the market should have never reacted.  The reality is that the market did initially react in all of those cases, thereby allowing the fraudsters to profit.  If our focus were on the long-run, then I would agree with Larry that there would be no issue.  The truth is that in the short-term, the markets are not as efficient as Larry seems to believe.  Even the most fervent defender of efficient markets Burton Malkiel states:[1]

As long as stock markets exist, the collective judgment of investors will sometimes make mistakes. Undoubtedly, some market participants are demonstrably less than rational. As a result, pricing irregularities and even predictable patterns in stock returns can appear over time and even persist for short periods. Moreover, the market cannot be perfectly efficient, or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices …. ...

… Moreover, whatever patterns or irrationalities in the pricing of individual stocks that have been discovered in a search of historical experience are unlikely to persist and will not provide investors with a method to obtain extraordinary returns.

I am not quibbling with the notion of efficient markets, which Larry misunderstands to mean perfect ascertaining of the quality of the information as opposed to the idea that no investor can consistently profit from exploiting historical information.  What I am saying is that given that short-run anomalies can exist in an efficient market where there is no noise (such as the January effect, holiday effect, or even the sunshine effect), why it so hard to accept that in a noisy environment (litigation), even an efficient market will have a hard time initially getting it right? 

Because of the potential for short-term profiting, investors are always at risk when the short-selling plaintiff dumps the stock and then sues.  Furthermore, this gives the extra incentive to bring any quality lawsuit, since it is a profitable strategy in the short-term.  The double recovery concern follows from these conclusions.

Conclusions

Short-selling plaintiffs manipulate the market by failing to mention their impending suit.  This is actionable under Rule 10b-5, just as the spreaders of false news are liable for market manipulation.  If Larry is concerned about an expansive interpretation of my view of this practice, the answer is twofold.  Those who possess outside information are not at risk from my view, since they are not acting to the detriment of the target firm and hence not manipulating the market, whereas short-selling plaintiffs are taking an active step aimed at destroying value (otherwise why would they short-sell).  Secondly, if this response does not assuage Larry, the SEC is well within its statutory mandate to enact a narrowly tailored rule that can just capture the short-selling plaintiffs.

Let me say at the end, that my arguments have all been in the shadow of our existing securities regulations framework.  The reason this practice causes me concern is, because I see no difference between an insider going long on his firm’s shares when there is good news to be announced (I understand he is an insider – but they are functionally equivalent).  Given that the laws have hamstrung those who produce the wealth, I fail to see why we are being squeamish at taking on those who destroy it. 

If we are to give free reign to the plaintiff’s bar, then let us do right thing and repeal all insider trading and market manipulation laws (i.e. the SEA, Sarbanes Oxley and all regulations).  Let the market truly decide and let caveat emptor rule the day for all.  For that matter, let us abolish all federal regulations that do not affect national security, immigration, and navigable waters.  Let the Supreme Court overturn United States v. Northern Securities, Wickard v. Filburn, NLRB v. Jones, Erie R.R. v. Tompkins, Roe v. Wade.  My list goes on.  Until that fantastic day arrives (and I do anxiously await it), we are stuck in this second-best world.  It is at the margins of this world that we operate and decide on what steps to take for incremental positive change.  I see my proposals as that – Larry disagrees.  At the end, I believe we both agree that it ultimately the citizenry’s welfare that we are after.  I would again like thank the Manhattan Institute (Jim Copland and Walter Olson specifically) for setting this up and Larry for debating a most unworthy opponent.