The U.S. Justice Department has launched an expansive criminal investigation into short selling by hedge funds and research firms -- thrilling legions of small investors and other skeptics of the tactics that investigative firms use to bet on stock declines.
The probe, run by the department’s fraud section with federal prosecutors in Los Angeles, is digging into the symbiotic relationships between funds and researchers, hunting for signs that they improperly coordinated trades or broke other laws to profit, according to people familiar with the matter.
The government is examining how the investors handle information and set up their bets, especially in the run-up to publication of reports that move stocks. Authorities are looking for signs that money managers sought to engineer startling stock drops or engaged in other abuses, such as insider trading, said two of the people, asking not to be named because the inquiries are confidential.
News of the broad investigation on Friday set off
With that charged backdrop, the Justice Department will have to be careful to zero in on blatant wrongdoing, said
“They do not want to look as if they are criminalizing conduct that was formerly only actionable civilly,” he said. “It would be the traditional pattern of prosecutors, particularly in the first case they bring, to search for a case that has ‘badges of fraud’ -- for example, bribes or clear insider trading.”
Underscoring the inquiry’s sweep, federal investigators are examining trading in at least several dozen stocks, including well-known short targets such as
The U.S. probe opens yet another front in an already treacherous era for those who try to profit on stock drops. Some bearish funds
Meanwhile, companies criticized by short sellers have become increasingly bold in firing back, sometimes launching legal battles even as they face government probes that ultimately support short sellers’ theses. A number of corporate executives have been hoping U.S. authorities might help to further shift the focus to investors’ tactics.
Still, successfully bringing charges against short sellers could be challenging, given that betting against companies and publishing research believed to be accurate is lawful and even beneficial for markets. So far, nobody has been accused of wrongdoing, and authorities may ultimately decide not to pursue charges.
Government attorneys are trying to determine whether short sellers engaged in some form of deception -- say, by misleading the public about their financing of what appears to be independent research, violating confidentiality agreements with authors, or orchestrating stock plunges to panic shareholders and exacerbate selling.
Spokespeople for the Justice Department and Muddy Waters declined to comment, and there was no response to messages sent to Anson Funds and Aurelius.
An attorney for Citron said he’s aware of an industry probe but that it’s routine for U.S. investigators to open and close cases. He expressed doubt that their theories would be borne out.
Authorities are prying into financial relationships between hedge funds and researchers, according to the people. Such firms are known wide variety of deals, with funds sometimes paying researchers handsome subscription fees for fresh insights into possible corporate trouble, or even becoming an author’s primary source of funding. In one example, prominent financial investigator
Some hedge funds have been known to suggest targets to researchers, who then deliver scathing reports.
One cautionary tale emerged in court after Dallas-based
Mathews later said in a statement that he subsequently learned his article “contained inaccuracies and false allegations” and retracted it. He and Farmland reached a settlement. Sabrepoint has said it didn’t know about the Seeking Alpha article.
Farmland is also on the list of stocks that the Justice Department is examining as it looks at short sellers. Lawyers for Sabrepoint and Mathews declined to comment.
The Justice Department unit handling the inquiry already has a formidable reputation on Wall Street. It recently brought several cases against global banks and traders for illegal spoofing of precious metals and Treasury futures. As part of that probe,
While prosecutors in the short-selling investigation issued subpoenas as recently as October, the effort has been underway much longer, the people said.
The inquiry gained momentum after U.S. lawmakers called for more scrutiny of short sellers following the meme-stock trading frenzy that erupted in January. In a single week that month, retail investors sent the price of
Lawmakers have since held multiple hearings on the fracas, at times discussing whether to force short sellers to boost disclosures.
Concerns about how short sellers carry out attacks have arisen repeatedly over the years.
The Securities and Exchange Commission and Justice Department have gone after hedge funds for running “short and distort” campaigns. The practice typically involves setting up bearish bets, then releasing misleading or inaccurate information about a company to drive down the price before closing out the position for a profit.
But there are also concerns about the impact that earnest research can have when it’s sprung by surprise on the market.
Studies by Columbia University law professor Joshua Mitts have found that short sellers’ reports can briefly induce bouts of panic selling before shares rebound. In those jittery moments -- sometimes mere minutes or hours -- well-positioned short sellers can cash out of trades and pocket significant gains.
Mitts examined more than 1,700 reports made by pseudonymous short sellers from 2010 to 2017, concluding that they contributed to more than $20 billion in dislocated values or temporarily mispriced stocks.
Academics have been encouraging U.S. authorities to address the possibility that short sellers are laying out their cases against stocks, then using the impact of that news to quickly reap gains and quietly move on.
Early last year, Mitts, Coffee and about a dozen other prominent securities-law professors urged the SEC to write rules requiring that short sellers who voluntarily reveal bets against a stock be required to disclose when they’ve exited the position. The professors also asked the regulator to write a new rule that would make closing a short position immediately after disseminating a negative report -- with an intent to do so upon publication -- constitute market manipulation.
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