Stock market manipulation has been around since shortly after stock markets were invented. Everyone is familiar with the methodology in the standard “pump and dump” scheme: False rumors are circulated, the stock is bid up by the manipulators, supply might be constrained, and, once the public’s appetite is aroused, the stock is dumped by the manipulators.
But the internet has changed all that. No need exists today for the boiler shop or its battery of phones or even carefully assembled lists of suckers. All that one needs today is to put one’s message (written under a pseudonym) on a blog that features hot news about individual stocks. Of these sites, the best known and most watched is Seeking Alpha, whose “Short Ideas” column contains numerous posts recommending that specific stocks be shorted. Reversing the old pattern, the focus is no longer on touting stocks for an immediate rise, but rather on suggesting a dark downside. Once the professional media may have played a gatekeeper role, refusing to publish wild and unsubstantiated reports. But on the blogs, it is the Wild West today.
Some sense of the scale of these contemporary efforts comes from one of the few cases that the SEC has recently prosecuted: SEC v. Lidingo Holdings.[1] There, the SEC charged a stock promotion firm with commissioning hundreds of ghostwritten articles, written under pseudonyms and posted on Seeking Alpha and other blogs. Because these payments to the ghostwriters for their columns clearly violated Section 17(b) of the Securities Act, the SEC was able to sue. Otherwise, the SEC seems to have been constrained by fear of encroaching on the First Amendment (which provides considerable protection for anonymous speech, at least in the political setting).[2]
Besides the First Amendment, the other major obstacle that restrains SEC enforcement is the need to show that a trader acted “for the purpose of inducing the purchase or sale of such security by others.”[3] Aggressive directional trading — long or short — does not demonstrate, standing alone, the necessary intent to manipulate. As the Second Circuit wrote in 2007, “To be actionable as a manipulative act, short selling must be willfully combined with something more to create a false impression of how market participants value a security.”[4]
What can constitute this “something more?” Proof that the trader made false statements will work, but increasingly those seeking to drive down prices point to comments made by others.
One of us (Professor Mitts) has shown that a distinctive, new feature of short selling by some traders is a sharp reversal in the direction of their trading.[5] That is, they first sell short or buy put options, then post on Seeking Alpha or other blogs stressing bad news about the company. The stock predictably declines, but then, a day or so later, they begin to buy the stock aggressively. We believe this is because they anticipate that the bad news that they earlier posted will be rebutted and the stock price will rebound. Thus, they are seeking to profit both by trading ahead of the decline and ahead of the rebound. Put simply, we think this “V shaped” trading pattern should constitute the “something more” that is needed to demonstrate manipulation. Our premise is that traders who reverse their direction in this manner do not truly believe that their short sales were pushing the stock price to a truer, more accurate equilibrium, but were only seeking to fool the market for a moment.
We stress that we are not seeking to chill short selling in general. We understand that the market needs short sellers and that some (such as Jim Chanos in the Enron scandal) performed a very valuable public service in exposing fraud. In this column, we offer proposals by which regulators and lawmakers can adapt and modernize the securities laws so that manipulation is not as easy and riskless as it appears to be today.
First, the SEC needs to update its guidance on manipulation. Given that the case law requires “something more” beyond substantial concentrated purchases, we would suggest that traders who anticipate a market rebound and buy ahead of it (after selling short heavily only a day or two earlier) are conceding that they did not believe their earlier purchases were truly establishing a new price equilibrium. We do not suggest that this reversal in trading supplies irrebuttable evidence of manipulation, but it could be given presumptive weight. Similarly, if the short seller conducted little or no due diligence of the issuer it was shorting, but did publicize its negative views on blogs, this could also be a factor. In our discussions with the best known short sellers, we find that they make extensive investments in due diligence before shorting a stock. The SEC could give guidance either in a rule or a release.
One way to justify our position is to look to Omnicare v. Laborers District Council Construction Industry Pension Fund,[6] which held that an expression of opinion can contain “embedded” factual assertions, both that the speaker sincerely holds the view stated and did some minimal research. The sudden reversal in position by the trader in the new “V” pattern strongly suggests it never believed in the adverse news or rumors that it cited.
A more controversial area is the possibility of liability for intermediaries, such as Seeking Alpha. We appreciate that a blog can claim that it is in the same position as the New York Times in New York Times v. Sullivan,[7] where a unanimous Court found that a public figure could not recover damages for defamation “unless he proves that the statement was made with ‘actual malice’ — that is, with knowledge that it was false or with reckless disregard of whether it was false or not.”[8]
But even if the applicability of Times v. Sullivan is assumed, the “reckless disregard” standard could still leave vulnerable a blog that repeatedly publishes unfounded stories where the market quickly reverses directions and recovers the initial discounts. We do not suggest that courts should encourage such suits, and because private plaintiffs cannot sue for aiding and abetting, we doubt that any such private suits under the securities laws could succeed.
The SEC, however, is in a different position. It can sue aiders and abettors of securities law violation under Section 20(e) of the Securities Exchange Act if such person “recklessly provides substantial assistance to another person in violation of a provision of this chapter.”[9] This standard seems consistent with Times v. Sullivan, and courts in any event should expressly require proof meeting such a standard. Even the most obtuse blog will eventually realize that some pseudonymous traders were publishing rubbish, particularly if issuers put the blog on notice.
We also recognize that Section 230 of the Communications Decency Act provides sweeping immunity for intermediaries against defamation liability. But this provision did not, we suggest, intend to prevent the SEC from suing an intermediary who actively assists a securities law violation. In any event, our key suggestion is that the SEC establish a safe harbor for blogs and other informational intermediaries that would require some limited monitoring by the blog of the behavior of recurrent posters on the blog. This safe harbor might require at least a minimal level of due diligence, not in every case, but in cases where there were recurrent complaints. As a first step, the SEC could push the industry to establish a “code of best practices.”
Finally, we recognize that manipulation is a fast-moving target, and new patterns are likely to evolve. Thus, we would suggest that the SEC be given the same authority that it has under Section 14(e) of the Securities Exchange Act of 1934, which authorizes the SEC to “prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative.”[10] This provision reaches beyond fraud and manipulation to allow the SEC to adopt prophylactic rules that are “reasonably designed” to prevent manipulation. The SEC’s long history of only modest (at best) success in combating manipulation suggests that this addition is needed.
ENDNOTES
[1] SEC v. Lidingo Holdings, LLC, No. 17-cv-01600 (W.D. Wa. April 10, 2017). The other recent case in which the SEC has pursued a manipulation charge against pseudonymous short sellers is SEC v. Lemelson, Case No. 1: 18-cv-11926 (D. Mass. 2018), https://www.sec.gov/litigation/complaints/2018/compr2018-190.pdf (Sept. 12, 2018). For a close review of this case, see Perrie Weiner, Edward Totino, and Aaron Goodman, “SEC Fires Warning Shot Against ‘Short and Distort’ Schemes,” Law360, September 26, 2018.
[2] In the words of Justice Stevens, “Anonymity is a shield from the tyranny of the majority.” McIntyre v. Ohio Elections Com’n, 514 U.S. 334, 357 (1995) (citing J. S. Mill, On Liberty, in On Liberty and Considerations on Representative Government 1, 3-4 (R. McCallum ed. 1947)); Nanoviricides, Inc. v. Seeking Alpha, Inc., 2014 WL 2930753 (N.Y. Sup. Ct., Jun. 26, 2014) (rejecting a discovery motion brought against Seeking Alpha to reveal the identity of a pseudonymous author, “The Pump Terminator,” concluding that “the alleged defamatory statements identified in the petition constitute protected opinion and are not actionable as a matter of law.”).
[3] See Section 9(a)(2) of the Securities Exchange Act of 1934.
[4] ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, at 101 (2d Cir. 2007).
[5] See Joshua Mitts, Short and Distort (working paper 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3198384.
[6] 135 S. Ct. 1318 (2015).
[7] 376 U.S. 254 (1964).
[8] Id. at 279-80.
[9] 15 U.S.C. § 78t(e).
[10] 15 U.S.C. § 78n(e).
This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and director of its Center on Corporate Governance, and Joshua Mitts, an associate professor of law at Columbia University Law School. Professor Mitts consults on litigation and regulatory investigations involving short sellers and market manipulation.