Last week’s conviction of Andrew Left on securities fraud charges has sent a shudder through the short-selling community. After a three-week trial in Los Angeles, Left, the founder of Citron Research, was found guilty of 13 of 17 counts and faces a potential sentence of more than two decades in prison.[1] He says he plans to appeal.[2]
In the trial’s wake, some in the media have been swift to declare a new era of regulatory aggression toward short sellers.[3] As the Wall Street Journal recently noted, “Traders who bet on stock-price declines worry prosecutors are equating their tactics with market manipulation.”[4] Others, including Left himself, via a post made to Citron Research’s X profile, alleged the case was an attack on free speech.[5] While the threat of a decades long prison sentence would have a chilling effect on anyone, including a short seller, perhaps a more measured look at the role of short sellers is required before jumping to any conclusions.
While not popular, short sellers serve a function that is difficult for other parties to replicate – they are among the few market participants with a financial incentive to find fraud or expose overvaluation. That they publish their findings can be beneficial to the market. Take, for example, Jim Chanos, who detected red flags in Enron’s regulatory filings before the company’s 2001 bankruptcy.[6] Though not required to do so, a reputable short seller will disclose its position, publish its thesis, and trade or hold as dictated by the thesis. Their actions show consistency between public statements and private convictions.
Of course, there are numerous examples of companies damaged by short seller allegations that proved to be wrong. The same financial incentive that spurs a reputable short seller to expose fraud provides a less scrupulous investor the incentive to allege fraud, even in the absence of evidence, and regulation designed to protect companies from false allegations is needed. But Left’s case was not an indictment of short selling as a whole. Instead, the Securities and Exchange Commission alleged that Left used his Citron Research platform to publicly recommend positions while he secretly took opposite positions. Left “bought back stock immediately after telling his readers to sell, and he sold stock immediately after telling his readers to buy,” according to the regulator.[7] After his recommendations moved stock prices, on average, more than 12%, he would pocket the spread. In correspondence with a confidante, Left described the ease with which he made money by manipulating retail investors: “It’s like taking candy from a baby.”[8] For the scheme to work, investors had to believe his stated positions were sincere. They weren’t. Left was not exposing fraud; he was exploiting his followers’ trust to manipulate share prices for his own benefit.
Not all large companies are like Enron, and not all short sellers are like Left. And while Left’s prosecution appears to be an example of aggressive enforcement of a securities fraud case rather than a sea change in the regulation of short selling practices, if this somehow leads to short sellers taking a more measured approach before the dissemination of unproven damaging allegations against companies, maybe some of the less reputable players will think twice before taking any actions.
