The Department of Justice is investigating short-selling firms for evidence of trading abuses. According to a Bloomberg report, the goal is to uncover possible connections and alliances between parties involved in a short sale.
The inquiry's scope is broad and includes analysis of recent crashes in the prices of well-known stocks—a list that includes Chinese coffee chain Luckin Coffee Inc. (LKNCY), Banc of California, Inc. (BANC), and GSX Techedu. Thirty short sellers and research firms are being probed in connection with their trades. The Justice Department is asking 'smaller' market participants about the activities and details of prominent short sellers involved in large trades recently.
The latter list includes several well-known names. For example, Andrew Left's Citron Research, which famously shorted pandemic winner GameStop Corp. (GME), has received a subpoena. Muddy Waters, which tweeted a report critical of Luckin setting off a short squeeze on in its stock, Melvin Capital Management, Orso Partners, and Sophos Capital Management are also mentioned in the list of firms about whom information is being sought by the DoJ from other market participants.
- The Department of Justice is investigating short sellers and research firms for evidence of trading abuses.
- The investigation's goal is to uncover alliances and relationships between various parties involved in a short sale.
- Short sellers were famously squeezed by retail investors last year and the latest investigation might have implications for the way that such trades are conducted.
The investigation is meant to probe relationships between hedge funds and money managers, who profit from short sales, and research firms, whose reports trigger the downward price movement in a stock. In a December report on the same topic, Bloomberg stated that the Justice Department was hunting for clues in trading that money managers sought to engineer "startling" price drops or engaged in insider trading. The investigation began last year and is being led by federal prosecutors in the Justice Department's Los Angeles office.
The news comes after a particularly bruising period for short sellers. They suffered heavy losses at the hands of retail investors in a meme stock frenzy that took hold of the markets in March 2020. Flush with stimulus money and spurred by online discussion groups, mom-and-pop investors pushed up prices of heavily shorted stocks on Wall Street, dealing an expensive blow to bets made by short sellers.
Why Are Short Sellers Being Investigated?
Short sellers are polarizing figures on Wall Street. In a fashion, they are meant to be truth tellers who profit by exposing company frauds and malpractice. But their tactics can cause market imbalances and magnify the effect of crashes. For example, short sellers are widely blamed for exacerbating the effects of the 2008 stock market crash.
Their methods came under fresh scrutiny during the pandemic. Institutional Investor published a piece last year detailing the "balance sheet" relationship between hedge funds and short-selling firms that publish research reports. As part of this relationship, the former pays the latter to publish a report (authored by the fund itself) that is critical of the company's business. The report's publication is timed to coincide with a significant company-related market event, such as an options expiry or earnings report, to induce further volatility and maximize profits. Many short sellers act in concert and pile onto the short trade, magnifying its effect and crashing the company's stock price. The research firm that published the original report gets a cut of the overall profits or a fee.
Such arrangements have been part of Wall Street's fabric for several years, and some research firms have openly disclosed their relationships with hedge funds. But the pandemic changed the dynamics of such trades. Retail investors inverted the bets made by short sellers, sending meme stocks higher and inflicting massive losses on short sellers. GameStop, a gaming company that has been struggling for years to make the shift from physical stores to online gaming, was the most prominent example.
Buoyed by retail traders, GameStop's stock price skyrocketed by 1,625% in January 2021. Short sellers, often responsible for short squeezes in the market, became the ones being squeezed. Hedge fund Melvin Capital lost a stunning 53% of its value in the same month due to its bet against GameStop. Tesla Inc. (TSLA), which became the world’s most valuable car maker during the pandemic, is also among the most-shorted stocks on Wall Street, and its CEO has often railed against the practice in his tweets. Some short-selling firms, like Citron Research, have stopped publishing research reports after the pandemic squeeze.
Is It Illegal?
There is no clear rule in law books that prohibits balance sheet relationships. But collusion tactics, if proved, might toe the line between insider trading and market manipulation, according to experts.
The Justice Department has not clarified the intent behind its investigation or brought formal charges against any of the parties being investigated. "No one has been accused of wrongdoing and, in many cases, the opening of a probe doesn't lead to anyone facing charges," the Bloomberg report states. "It's very tough to defend yourself when you haven't been accused of anything," Andrew Left, founder of Citron Research, told the publication. Computers were seized from his residence in early 2021. A short seller called the investigation "a fishing expedition," meaning it might net some firms.