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SELLING SHORT


Short Selling Plaintiffs - Illegal or Should it be?
By Moin Yahya

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.


Selling short: response
By Larry Ribstein

Thanks to Jim Copland and the Manhattan Institute for inviting this debate between me and Moin Yahya over dumping and suing, which started over at my blog. I hope to show that this relatively narrow issue has broader implications for the debate on the litigation crisis, and on public policy generally.

First, there’s a fundamental problem with Moin’s analysis: it presupposes a division between the long-term and “principled,” on the one hand, and the “pragmatic,” on the other. In fact, there is no great divide. Policy doesn’t work pragmatically unless it’s principled.

Second, Moin’s initial point – that short-selling without disclosure that you are going to sue is, per se, a violation of 10b-5 and fraudulent – is simply inaccurate.

Focusing, as Moin does, on 10b-5, the Supreme Court held in the O’Hagan case that liability for insider trading under these circumstances requires the misappropriation of information from its owner. Merely trading on information the rest of the market does not have is not enough for liability. While I believe that even the Court’s theory is too broad (stealing shouldn’t be a federal offense), what matters for now is that even the Court wouldn’t go as far as Moin does. This rule is significant because it recognizes the fundamental principle that liability for insider trading does not extend beyond cases that involve misappropriation or other violations of property rights in information. Moin’s approach would instead base 10b-5 liability on trading because it involves the exploitation of an informational advantage. This approach has been rejected by the Court and by financial economists as detrimental to market efficiency.

Here is where principle meets pragmatism. Moin has unfortunately succumbed to the temptation to do something about the government’s and trial bar’s “attack” on corporate America (pragmatism) by discarding a vital principle -- limiting liability for insider trading -- that actually protects business against harmful lawsuits. Consider what harm Moin’s theory would do to business: without any limitation based on property rights, liability for insider trading could expand almost infinitely, as it threatened to do before the series of court opinions beginning in 1980 that recognized the property right limitation.

Sure, one might hope that Moin’s new “pragmatic” rule would be limited to dumping and suing. But can we rely on the trial bar to be principled when business seizes on pragmatism to attack it? Liability based on inequality of information would surely spread like a virus beyond this narrow situation. The only reliable pragmatic weapon against the endlessly expansionary ambitions of the trial bar is adherence to strong principle.

Moin’s policy basis for regulating dumping and suing – that plaintiffs and trial lawyers would be “doubly enriched” – is also misguided.

This argument has some pragmatic appeal to those who believe that litigation is excessive. Of course, if litigation is excessive, we don’t want to provide even more incentives to trial lawyers and plaintiffs.

The problem with this argument is not (unlike Moin’s first argument) that it is wrong, but that it is weak and incomplete. Any trial lawyer could think of a comeback in about a millisecond: lawsuits are valuable instruments of social policy, and therefore we need better and stronger incentives. Class action plaintiffs may expect recoveries that are too small to justify individual action – that’s why we have class actions. Their lawyers may seem egregiously overcompensated, and therefore have a powerful incentive to bring too many suits. But the fact is that, because they only get a piece of the action, they may have inadequate incentives to maintain high-quality litigation. The result is not necessarily that we get too many lawsuits, but that we get the wrong kind -- “strike” suits for fees, and settlements that do not adequately reflect the legal damage to the class.

Continuing the argument, class action plaintiffs and lawyers might say that what would fix this would be if we could get another piece of the actual value of the suit, as measured by the effect of the suit on the company. This compensation would be valuable in meritorious cases based, but worth little in frivolous suits.

This last point illustrates another error in Moin’s analysis. He assumes that lawyers can profit simply by announcing any suit – that any suit, no matter how “improbable,” will have stock price effects. But this ignores another principle that defenders of business would do well to keep in mind – that securities markets are fairly efficient, in the sense that they reflect public information about traded firms. This principle is important, because it suggests that markets already protect securities investors and others, and therefore that significant liability and regulation is unnecessary. Efficient markets can distinguish between silly lawsuits and good ones – and between good and bad lawyers that bring them.

So, in theory at least, if we gave lawyers or plaintiffs a piece of the stock market action, this would give them an incentive to develop the sort of reputations by selecting and diligently prosecuting cases that would increase stock price effects when suits were filed. In fact, Bruce Kobayashi and I in a recent working paper see some general theoretical merit in such an argument.

In other words, Moin’s “double recovery” argument is subject to dead-easy rebuttal. All we have to do is to say Moin’s assumptions about litigation and stock markets are wrong. Since Moin doesn’t defend these assumptions, he’s left with no principle to fall back on.

The better attack on dumping and suing is based, not on false assumptions or on incorrect statements of the law, but on the specific harms that we can show it causes. For example, one way to enhance the effect of the filing of a suit is to accompany it with false statements about the stock. This is already actionable under the federal securities laws. Also, a plaintiff who sells short the stock held by other class members is probably not an adequate class representative – his interests in prosecuting the suit are not aligned with the interests of the other class members.

Concentrating on the real causes of harm in such cases will avoid the error inherent in Moin’s approach of using the blunt instrument of the securities laws to attack lawsuits regardless of their merit.

This relates to Moin’s policy prescriptions.

1. Yes, the SEC can investigate. But let’s make sure the investigation doesn’t lead to an expansion of the already overbroad securities laws. Limit the investigation to violations of current law, including misrepresentations and market manipulation.

2. Let’s make clear that lawyers and plaintiffs who merely dump and sue are not thereby violating the securities laws, and establish that principle as a bulwark against further expansions of the securities laws.

3. If plaintiffs and their lawyers are doing something wrong, a fortiori, insiders should not be allowed to do the same thing. Again, principle rules. Let’s not go back to the pre-1980 days when the courts failed to make this crucial distinction between insiders and outsiders, with the result that the insider trading laws threatened to impose costs on business people far in excess of anything we could fear from dumping and suing.


My Response
By Moin Yahya

Basic Objections

Larry’s basic objections to my proposal to deem plaintiff’s temporary insiders prohibited from short-selling until they disclose their intent to sue can be summarized as follow:

  1. A rule forcing plaintiffs to disclose their intent to sue could eventually capture all outsiders who possess some information.
  2. Double recovery is needed to create the right incentives for lawyers to find meritorious suits.
  3. There is no danger from frivolous litigation negatively affecting the stock price, because the market is efficient, and it can tell good suits from bad ones.

I will deal with these objections in sequence.

1. The Slippery Slope

Larry’s argument amounts to a slippery slope argument.  If we stop the “bad” guys, “good” guys might be harmed.  This is because my rule, according to Larry, could be converted to hold any possessor of non-public material information liable for trading on the information without disclosure.  My response is twofold.  First, my proposal was to have the SEC promulgate a narrowly tailored rule that specifically covers plaintiffs.  Such a rule would be ideal in that it would avoid any common law expansion of a judicially created rule that Larry fears.  But even a judicially created rule can be contained, for as Larry pointed our the courts have curtailed the expansion of insider trading liability since the early 80s.

Additionally, there is a substantial difference between short-selling plaintiffs and other outsiders who possess non-public material information:  plaintiffs do not just possess information; they also intend to act in a way that will undoubtedly destroy the value of the shares.  When someone normally short-sells the stock, both sides (the short-seller and the purchaser) are taking a risk that the price will not perform according to expectations.  But here, not only is the bet one-sided (in that one side will surely profit while the other will not), the one side (the short-seller) is the very cause of the stock price’s demise.  Imagine if someone sold you a car that had a bomb activated by the seller once the deal was completed.  This is precisely what is happening here.  Suppose, the 9/11 terrorists had sold short airline stock, would Larry say that (aside from the obvious terrorism charges) there was nothing wrong with their short-selling?  There are numerous cases that state that selling a good or service with knowledge that a third-party is about to destroy its value is actionable under tort or contract law.  I see no reason why that analogy should not extend here, when there is more than mere knowledge of a third party’s actions; in fact, the very seller is about to be the cause of the decline in price.

In the real life examples of the short-sellers teaming up with lawyers, the short-sellers initially sold-short and then spread bad news about their targets, most of the time, to no avail.  Finally, they either sued or convinced a government entity to announce an investigation, which then led to the drop in price.  Again, to reiterate, outside trading on non-public information is fine; doing so and being the cause of the fall in price is not.

Because short-selling plaintiffs take that extra step of acting to lower the value (as opposed to merely trading on the information), I do not see how any possessor of information can be caught under a slippery slope argument.  Larry’s fears may be correct, but they are akin to a farmer being afraid of shooting the wolf attacking the sheep, because one day the farmer may start shooting his sheep, because they will start appearing similar.

Double Recovery Provides Incentives

This is one of those points where we will have to agree to disagree.  Clearly I believe what Walter Olson and other tort-reformers believe, which is that the civil justice system is out of control and rigged in favor of the plaintiff’s bar.  The idea that we need to provide more incentives to them to find meritorious lawsuits boggles my mind.  One just has to peruse the websites of most major plaintiffs’ law firms’ websites to be nauseated by the claims of the billions and hundreds of millions that they have recovered.  Awards of attorneys’ fees to plaintiffs but not to defendants is another asymmetry in the incentive to sue.  States whose judges receive campaign donations from the plaintiffs’ bar (and yes there are some states where the opposite is true) and where fraudulent joinder prevents removal to federal court; state courts that entertain the most absurd theories of liability; and the list goes on of how much the deck is stacked against defendants.  The idea that we need to give them one more set of incentives, therefore, defies logic. 

Larry’s suggestion that sanctions and disqualifying lead plaintiffs who short-sell would only work if we actually knew that the plaintiff was short-selling.  In many of the real life examples, the short-selling plaintiffs sometimes have been detected and disqualified but always escaped sanction.  And many times, they were not even detected or at least not until after the suit was over.

The quality of lawsuits will not come from making it more profitable to sue; rather it will come from reforming the underlying substantive legal principles that have been perverted by many courts.  I will address this issue later in the next section.  [As an aside, the idea that reputation effects will allow the screening of good from bad lawsuits should then apply to firms – in other words, reputational effects can also sort out the honest and dishonest firms, and there would be no need for the plaintiffs’ bar.]

Efficient Markets will Sort the Good from the Bad

Larry’s reliance on the efficient market hypothesis (EMH) is misplaced for a variety of reasons.  The idea of efficient markets does not mean perfect markets or instantaneous markets.  All that it means is that the market absorbs all publicly available information (in the semi-strong form of the EMH) so that no one is able to consistently profit (i.e. outperform the market) by devising trading strategies using publicly available information.  EMH says that the market absorbs the collective beliefs of investors, and that the stock prices will ultimately reflect this.  While EMH says that the current price may be the best predictor of what the objective value of the stock is, EMH says nothing about the market being able to be the correct predictor.  The market sometimes will not be able to assess the quality of a lawsuit if there insufficient publicly available information.  If the market could truly discern the merits of each lawsuit, there would be no need for a trial – simply look at the market reaction, and we could judge the winner of the case. 

Larry seems to take a view that there are either meritorious suits that will be won with 100% certainty or frivolous ones that will lose with 100% certainty – and hence the market can discern which one is which.  Were this the case, then my concerns would be truly misplaced.  Litigation, however, is quite random, so that even a frivolous lawsuit has a small chance of winning, and a meritorious suit has some chance of losing.  The problem, therefore, becomes one of signal to noise.  Suppose a suit is launched against a company that has a 90% chance of losing and a 10% of winning and yielding the amount claimed of $100 million.  The efficient market will still devalue the stock by the expected loss to the firm, which will be $10 million.  If the short-selling plaintiff sold-short some share of the firm’s stock (or potentially all of it if he executed a naked short sale), then the plaintiff stands to gain a portion of the $10 million.  Even though the suit is frivolous, the plaintiff can still profit.  Would a suit that only had a 10% chance of success warrant sanctions?  In some jurisdictions, where the “pure heart – empty mind” standard prevails, the answer is probably no.  It is these suits that even efficient markets will not prevent.  Furthermore, the market will also discount the legal fees that the defendant target company will have to incur.  In my example, in addition to discounting the value of the shares by $10 million, an additional $10 million in legal fees could be added to the lost stock value.  This means, that even the threat of litigation, no matter how frivolous, presents a real threat to the stock’s price.

The classic example to illustrate this is the case where Pennzoil sued Texaco for tortuous interference with contractual relations.  Texaco’s stock fell, but one would have expected Pennzoil to gain all of that loss in stock value, since any loss by Texaco would be a gain for Pennzoil.  Yet in a study by Cutler & Summers,[1] they found that during the litigation, only 1/6 of the loss by Texaco was gained by Pennzoil.  This reflected the market’s huge estimate of legal fees that Texaco would incur.  It is precisely this chasm between the losses and gains, that also make the bringing of low-quality suits even more profitable.  Low-quality suits can be brought by short-selling plaintiffs who make most of their gains not from the loss in stock value due to the claims, but legal fees.  Combing the legal fees with the expected losses from a high payout low probability suit means that even in an efficient market, short-selling plaintiffs can prosper.  Worse they prosper on low-quality suits, thereby belying Larry’s arguments against my concerns about double recovery.

Empirically, the results suggest that the market may not be able to discern which suits are meritorious, which suggests that there is a lot of randomness in determining the outcome of the lawsuits.  In a study by Pritchard and Ferris of securities fraud class actions,[2] they found that the revelation of fraud caused a large and statistically negative reaction in the market, a smaller but significant negative reaction upon the announcement of the suit, BUT no significant reaction to the judicial resolution of the motion to dismiss.  They concluded that “the outcome of litigation is not generally anticipated by stock market participants and that market returns are not influenced by the outcome of litigation.”

The reason for such findings, perhaps, is that not only is the outcome of litigation so complex and random, but all the information needed to resolve these issues may be beyond what is publicly available.  This again dents Larry’s idea that reputational effects alone will allow the bringing of high-quality suits if plaintiffs are allowed to short-sell (which they currently seem to be allowed to do).

Information is also costly to acquire, and hence not all investors can be fully informed.[3]  If information were costlessly available, there would be no need for research departments, and all information would be assessed immediately and accurately.  In fact, all the stock market manipulation schemes such as “pump and dump” and “cyber-smear” would have had absolutely no impact on the market.  So when smearers released false negative information about a company, the market should not have reacted at all.  This is the contrary of what we observe.  In fact, Larry shouldn’t worry about the slippery slope of my proposals, because any outsider who traded on non-public information would not be able to profit, since the information would have been absorbed anyway (and hence would escape sanction since there would be no unjust enrichment). 

Precisely because information is hard to gather, I am asking for the SEC to at least ascertain the magnitude of this practice.  This would add some information to the mix of what is publicly available to investors.  My proposal for disclosure by plaintiffs would also save the market the investment in ascertaining the bona-fides of every suit that the short-selling plaintiff might bring, which the empirical evidence suggests they are not currently able to do.

The existence of uninformed investors means that even a frivolous suit can be brought if coordinated with a large and wealthy short-seller.  The reason is that in the short-run (and this is all that matters for one to profit from short-sales), a large investor can move the market through aggressive short-sales, especially if the short-sales (as some recent evidence suggests) is naked.  Uninformed investors may not be able to determine whether the bad news driving the low stock price is genuine, at least not in the short-term, and the short-seller may be able to profit.[4]  This means that plaintiffs who they team up with short-sellers can actually bring more frivolous suits; for if they can induce an “artificial” drop in the stock-price, they can also induce quick settlements.  A drop in the stock price causes numerous woes for company managers.  It raises the cost of capital, which means that it is hard to raise cash and conduct day to day operations.  If this pressure can be applied on the firm to induce a settlement, the incentive to bring more meritless suits is amplified.

All of my discussion so far has been taking EMH seriously even in its weaker forms.  But if we were to relax the assumption of EMH, which the empirical evidence suggests is more likely the case,[5] than the need for my proposal becomes stronger, and at the very least, Larry’s claim that my “assumptions about litigation and the stock market are wrong” is incorrect theoretically and empirically.

Conclusions

Short-selling plaintiffs do not just possess information; they also intend to act in a way that will destroy value.  This is why my proposal is not a slippery slope, as Larry fears, for other investors that may be caught by an expansion of my rule could easily distinguish themselves on this point (information only – no action).  Additionally, because of the noisy signals litigation sends the market, the market will not make meritless suits unprofitable; rather they will encourage them.  This is true regardless of whether EMH holds or not.  Rather than resisting my call for investigation and some action to curb the plaintiffs’ bar, Larry should join me in fashioning a narrowly tailored proposal that would allay his fears of a slippery slope and that can adequately address the short-selling plaintiffs.


[1] David M. Cutler & Lawrence H. Summers, The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation, 19 Rand J. Econ. 157 (1988).

[2] Adam C. Pritchard & Stephen Ferris, Stock Price Reactions to Securities Fraud Class Actions Under the Private Securities Litigation Reform Act, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=288216.

[3] Sanford J. Grossman & Joseph E. Stiglitz, On the Impossibility of Informationally Efficient Markets, 70 Am. Econ. Rev. 393 (1980).

[4] The first to show this possibility theoretically was Stepen Figlewski, Market “Efficiency” in a Market with Heterogeneous Information, 86 J. Pol. Econ. 581 (1978).

[5] This is no venue to discuss all the empirical studies on this matter, but see e.g.  Rozeff & Kinney, Capital market seasonality: The case of stock returns, 3 J. Fin. Econ. 379 (1976) (documenting the January effect); Cadsby & Ratner, Turn-of-month and pre-holiday effects on stock returns: Some international evidence, 16 J. Banking & Fin. 497 (1992) (documenting the holiday effect where stock returns are higher at the end of the month and before major holidays); Hirshleifer & Shumway, Good day sunshine: Stock returns and the weather, 58 J. Fin. 1009 (2003) (suggesting that sunny weather yields higher stock returns but snow and rain do not).


Selling short: second response
By Larry Ribstein

Moin argues, essentially, that allowing trades by lawyers and plaintiffs in advance of suing (1) violates 10b-5, and (2) allows “double recovery” of fees.

On (1), I pointed out in my previous post that these trades do not violate 10b-5 and regulating them would abandon an important principle limiting liability for trading on nonpublic information to abuse of property rights.

On (2), the double recovery argument assumes that incentives to class action lawyers are optimal in the absence of trading profits, a proposition Bruce Kobayashi and I have questioned in theory. Again, I emphasize that the issue here is not simply the number of lawsuits, but incentives relating to the quality of lawsuits.

Trading may provide such incentives because it operates through the mechanism of the efficient securities markets, which are the best available (even if imperfect) way of valuing information, including information about lawsuits. I argued in my earlier post that the problems inherent in dumping and suing, such as incentives for market manipulation, should be addressed by targeting those problems under existing laws regulating fraud and manipulation.

In his response to the “insider trading” point, Moin shifts ground. Now he wants a special SEC rule targeting dumping and suing, rather than liability under 10b-5. He still doesn’t get it. As I said the last time around, the Supreme Court interprets the securities laws as not extending to this conduct. The SEC can't change the law. Congress could if it wanted to. But then we would have abandoned a fundamental principle limiting insider trading liability, with potentially disastrous consequences for business.

Moin bolsters his argument about insider trading by claiming that by allowing these suits we’re encouraging all kinds of bad acts, akin to allowing the 9/11 terrorists to short the stock market. Here, again, he misses the point. We do not try to curb crimes – even terrorism – by restricting short selling. That’s what the criminal laws are for. Why start down this misguided road with dumping and suing?

As for the “double recovery” argument, Moin simply ignores my incentive argument, preferring to focus on the evils of the trial bar. I share his concerns about excessive litigation, which is why I think we need real and politically feasible solutions. Again, my argument about incentives was about the quality of litigation, not the quantity. Moreover, if there's too much litigation, more securities regulation is not the answer.

Moin spends a lot of time debunking the idea that efficient markets can distinguish good and bad lawsuits, which is what underlies the incentive effect of trading on lawsuits. But Moin misunderstands how efficient markets operate.

First, Moin says that if the market could discern the merits of a lawsuit, there would be no need for a trial. But the market discounts the likely result at trial or pre-trial settlement in the same way that pre-trial settlement discounts the likely outcome of the trial. Both processes operate in the shadow of the likely judgment, and neither process creates a magic remedy out of thin air.

Second, Moin says that the market can distinguish only between fully meritorious or frivolous lawsuits, nothing in-between. He doesn't explain why securities markets would be so much more helpless in the face of litigation than they are in evaluating the countless other events and characteristics that have been shown, in thousands of studies, to affect stock prices. Moin doesn’t help his case by demanding that we disregard so much financial economics.

Third, Moin points out that the market will produce a profit even for a claim in which there’s only a small chance of recovery, painting such a case as “frivolous.” So, it seems, the market can accurately value cases after all. The problem, apparently, is that the market is applying a positive value to a case that has a positive value. So what? No matter what litigation rules we have, there will be a continuous distribution of outcomes. What's the problem?

Fourth, Moin points to a study showing that a big part of the market value of litigation is costs and fees. But that’s a condemnation of our costly and wasteful litigation system, not of the market. We need to fix litigation. We are not going to fix it by eliminating dumping and suing. Instead, as I've said, we may make it worse by reducing the incentive to bring valuable lawsuits and increasing the incentive to bring “strike” suits.

After misunderstanding how efficient markets react to litigation, Moin points to how plaintiffs and lawyers can manipulate markets through short-sales apart from suing. That only emphasizes that dumping and suing is not the problem here. The problem may be market fraud and manipulation, which can and should be addressed under current law.

In short, to the extent lawyers and plaintiffs are manipulating the markets we should punish that conduct. To the extent that efficient markets reveal defects in current litigation rules, we should change those rules. We should not waste time on an ill-considered attack on the capital markets.


My Final Response
By Moin Yahya

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.


[1] Burton G. Malkiel, The Efficient Market Hypothesis and its Critics, 17 J. Econ. Perspectives 59, 80 (2003).


Selling short: final comment
By Larry Ribstein

Thanks again to the Manhattan Institute for setting up this debate, which I've found interesting.

I don’t want to add much to this already lengthy discussion, and Moin’s last post provides little occasion to do so. He is still flatly wrong that the securities laws prohibit trading on non-misappropriated information. Moin cites the open-ended language of the applicable statute and rule but, incredibly, continues to ignore the Supreme Court’s interpretation of the statute.

(By the way, had Moin paid attention to the Court’s rulings, he might have fashioned an argument that a class action lawyer who is trading on litigation information is misappropriating information from his “client,” the class, which would provide a basis for regulation under current law. I have not analyzed that argument because Moin explicitly says in his initial post that in his view “who does the short selling is immaterial.”)

Moin also continues to assert that the market does not accurately value the litigation on which the plaintiff or his lawyer is trading. (This is relevant to my argument that dumping and suing can provide efficient incentives to plaintiffs and their lawyers.) But the well-known fact that markets reflect noise does not mean that they do not also reflect information, including information about litigation. For an analysis of the relationship between behavioral finance and market efficiency see my article, Fraud on a Noisy Market,

In the end, as I’ve said repeatedly, this debate has not been about whether there is a litigation problem, but about how to solve it. Dumping and suing alone is not the problem. At best it may provide incentives that produce higher-quality lawsuits. At worst, it reflects underlying problems with class actions. To the extent that it is accompanied by fraud and manipulation, we already have the necessary tools. It would be perverse and not a little ironic to try to deal with the problem of excessive litigation by adding a whole new area of securities regulation.


Market efficiency, incentives and regulation
By Larry Ribstein

The NYT's Joe Nocera writes about "the anguish of being an analyst." The problem is that it's hard for analysts to get paid in an efficient market, where the value of information is dissipated as soon as it's used. This means, among other things, that analysts are more likely to get paid for buy recommendations than for sells. So what to do?

As discussed here, we should avoid regulation that reduces the few incentives that exist to produce valuable securities market information. Don't restrict use of nonpublic information in an elusive quest for "fairness." Get rid of Regulation FD. And if we're concerned that there's too little incentive to produce negative information, then we shouldn't attack the shorts.



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THIS MONTH'S DISCUSSION'S ENTRIES
SELLING SHORT

Short Selling Plaintiffs - Illegal or Should it be?, Moin Yahya, February 27, 2006, 11:38 AM

Selling short: response, Larry Ribstein, February 27, 2006, 12:47 PM

My Response, Moin Yahya, March 01, 2006, 09:34 AM

Selling short: second response, Larry Ribstein, March 02, 2006, 07:28 AM

My Final Response, Moin Yahya, March 03, 2006, 08:52 AM

Selling short: final comment, Larry Ribstein, March 03, 2006, 10:24 AM

Market efficiency, incentives and regulation, Larry Ribstein, March 04, 2006, 09:48 AM


FEATURED DISCUSSION ARCHIVE:


Obamacare Decision: Reactions, July 2012
Law School Faculty Diversity, May-June 2012
Class Actions, May 2012
Constitutionality of Individual Mandate, March 2012
Human Rights and International Law, February-March 2012
The constitutionality of President Obama's recess appointments, January 2012
Do caps on medical malpractice damages hurt consumers?, December 2011
Trial Lawyers Inc.: State Attorneys General, October 2011
Wal-Mart v. Dukes, April 2011
Kagan Supreme Court nomination, May-June 2010
Election roundtable, November-December 2006
Who's the boss, September 2006
Medical judgement, July 2006
Lawyer Licensing, May 2006
Contingent claims, April 2006
Smoking guns, July 2004

 

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.