On October 8, 2020, in In re BofI Securities Litigation, the United States Court of Appeals for the Ninth Circuit reversed the district court’s finding that the plaintiffs had not adequately alleged loss causation when claiming that BofI Holding portrayed its banking company as a safer investment than it actually was. These claims originated in two places: a whistleblower lawsuit and blog posts published by a pseudonymous short seller. The court reversed the district court on the first, holding that a whistleblower lawsuit could serve as a corrective disclosure even though it merely alleged that fraud had occurred.
More interesting was the court’s conclusion that short seller blog posts cannot serve as a corrective disclosure. The Ninth Circuit held that “it is not plausible that the market reasonably perceived these posts as revealing the falsity of BofI’s prior misstatements” because “[t]he posts were authored by anonymous short-sellers who had a financial incentive to convince others to sell.” The court also pointed to disclaimers in the posts which, along with these financial incentives, meant that “[a] reasonable investor reading these posts would likely have taken their contents with a healthy grain of salt.”
It is helpful to view BofI through the lens of two recent trends in this area. One is the rise of “event-driven” securities litigation, in which an event (like a blog post) serves as a putative corrective disclosure, inducing a rapid decline in the share price by allegedly revealing that a prior corporate statement was false or misleading. The second trend is “negative activism,” where traders open a large short position; disseminate a negative report about a public company on social media, which induces a panic and run on the stock price; and rapidly close that position for a profit, prior to the stock price partially or fully rebounding.
The intersection of these two trends has led to cases like BofI, in which short sellers and plaintiffs’ firms enjoy a kind of de facto symbiosis. A share price crash accompanied by an allegation of fraud is mutually profitable for both: the former, because they have a short position in the stock; and the latter, because they can bring a class action claiming that the report revealed the truth to the market. Indeed, short seller reports are often followed by plaintiffs’ firms rushing to file a complaint which quotes the short report at great length as revealing of the truth.
The prospect of costly and protracted class action litigation gives investors an additional reason to sell the stock, especially for small firms for which a fight with a short seller can be a dangerous distraction. This can give rise to a self-reinforcing death spiral in which investors’ incentive to sell is heightened by the litigation itself, which in turn drives down the share price and drives up the profits enjoyed by short sellers and plaintiffs’ firms.
The BofI court concluded, as a matter of law, that traders cannot rely on pseudonymous blog posts. But as Professor Ann Lipton puts it, “That’s a helluva thing to conclude on the pleadings . . . the plaintiffs alleged that the stock price dropped in reaction to the blog posts, which – for pleading purposes – suggests that traders did take them seriously, regardless of the Ninth Circuit’s post hoc assessments of what a reasonable investor would do.” It is difficult to quarrel with Prof. Lipton’s point that the court should make conclusions based on evidence rather than gut feelings, and I’m grateful for her shout out to my research showing that investors make judgments about the reliability of blog postings based on the reputation of pseudonymous authors.
However, it is not always the case that a stock price decline means traders took the blog post seriously. My research finds that pseudonymous short reports are often preceded by a high volume of put option purchases, which can induce delta-hedging by market makers that mechanically drives down a share price. And while in theory closing the puts should apply an equally powerful upward force on the price, the reality is that stop-loss orders by retail investors – alongside trading rules like “always sell a stock if it falls below 7%-8% what you paid for it” – can trigger an avalanche of additional selling that would not have occurred but for the downward price manipulation. This can allow a short seller to crash a stock and profitably close the position regardless of whether investors found the information convincing to begin with.
Prof. Lipton fairly points out that “the blog posts of the bad actor manipulative short-sellers – the ones who manufacture accusations in order to force a stock price drop – are also immaterial, have no effect on stock prices, have caused no harm, and therefore the posters are immune from punishment.” But an alternative view is that the correct basis for liability for bad actor short selling is market manipulation under Sections 9(a) and Rule 10b-5(a)/(c) of the Securities Exchange Act of 1934, rather than a misstatement theory under Rule 10b-5(b). It is not clear how much weight investors place on the substantive claims made by anonymous internet personas (which are often non-actionable opinions anyway), as opposed to the identity of an author, which my research suggests does influence investor behavior (but is usually not a misstatement).
Another reason to focus on trading rather than speech is the importance of encouraging short selling to deter fraud and corporate misbehavior. Short selling is already a highly risky endeavor: Short sellers are exposed to substantial undiversified risk, often pay substantial fees to borrow stock, and face the prospect of costly retaliation by targeted companies. The strong First Amendment interest in promoting the free flow of speech has led some courts to deny discovery requests to unmask pseudonymous short sellers, out of a concern that doing so would chill legitimate criticism of powerful corporations.
Nothing in this analysis forecloses an alternative route to liability for short sellers, namely, that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping. As the Ninth Circuit explained in the case of Zweig v. Hearst Corp.: “the defendant . . . encouraged purchases of the securities in the market” and thus “should have told his readers . . . of his intent to sell shares that he had bought at a discount for a quick profit.”
Scalping liability would be unaffected by the BofI rule. For one, liability in a scalping case is predicated on an omission theory. Statements encouraging selling may be entirely true, but they give rise to a duty to disclose intent to trade against one’s readers. Moreover, the material omission in a scalping scheme arises from voluntary disclosure about trading intent (“we are short the company”) – not the short seller’s substantive claims about the company. While there is no duty to reveal one’s position, the case law is clear: Having voluntarily chosen to disclose a trading strategy, the ongoing truth of said strategy is material to investors – especially when it mechanically triggered stop-loss orders and a panicked run on the stock.
By following the Ninth Circuit and finding that the substantive claims in a financially motivated short seller’s report are immaterial to investors, courts would encourage a focus on trading behavior that has artificially skewed share prices. That would have the doubly beneficial effect of foreclosing securities class actions premised on short seller reports while shielding short sellers from retaliatory lawsuits in response to healthy criticism. It would put the focus where it belongs: manipulative trading.
 2020 WL 5951150 (9th Cir., Oct. 8, 2020).
 See, e.g., John C. Coffee, Jr., Event-Driven Securities Litigation: Its Rise and Partial Fall, N.Y.L.J., Mar. 20, 2019, https://www.law.com/newyorklawjournal/2019/03/20/event-driven-securities-litigation-its-rise-and-partial-fall/.
 On February 12, 2020, a group of securities law professors submitted a rulemaking petition to the SEC on “short and distort” campaigns. See Petition for Rulemaking on Short and Distort, Feb. 12, 2020, https://www.sec.gov/rules/petitions/2020/petn4-758.pdf; see also Joshua Mitts, A Legal Perspective on Technology and the Capital Markets: Social Media, Short Activism and the Algorithmic Revolution, Colum. L. & Econ. Working Paper No. 615, Oct. 28, 2019, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3447235.
 See, e.g., Gary Zagami, et al. v. Cellceutix Corporation, et al., Case 1:15-cv-07194-KPF (S.D.N.Y. June 8, 2016) (dismissing class action lawsuit against Cellceutix and noting that “[a] few hours after the Mako Research posting, the original plaintiff in this case authorized the filing of a securities class action complaint. . . . In large measure, the lawsuit tracked the Mako Research posting.“); Gamboa et al v. Citizens, Inc., Case No. 1:17-cv-00241-RP (N.D. Tx. Mar. 16, 2017), http://securities.stanford.edu/filings-documents/1060/CI00_06/2017316_f01c_17CV00241.pdf (claiming that “The Truth Emerges” by copying and pasting Seeking Alpha post).
 From an economic standpoint, this “double incentive” raises the question of whether there might be too much negative activism, a question I leave for another day.
 Daniel R. Fischel & David J. Ross, Should the Law Prohibit “Manipulation” in Financial Markets?, 105 Harv. L. Rev. 503, 513 (1991) (“[T]he basic dilemma of the prospective manipulator is to seem informed enough to cause prices to rise by purchasing, but not so informed as to cause the price to rise simultaneously with purchase. Also, he must not appear informed at the time of sale, lest his sales cause the price to fall.”)
 Investor’s Business Daily, Limit Your Losses (last visited Oct. 12, 2020), https://www.investors.com/ibd-university/how-to-sell/limit-losses/#:~:text=Live%20to%20invest%20another%20day,loss%20become%20a%20BIG%20one.
 My colleague Professor Coffee and I have examined elsewhere whether trading patterns inconsistent with one’s opinion renders the opinion misleading under the Supreme Court’s Omnicare standard. John C. Coffee, Jr. & Joshua Mitts, Short Selling and the New Market Manipulation, Colum. Law Sch. Blue Sky Blog, Mar. 18, 2019, https://clsbluesky.law.columbia.edu/2019/03/18/short-selling-and-the-new-market-manipulation/.
 See, e.g., 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.”).
 94 F.2d 1261, 1268 (9th Cir. 1979).
This post comes to us from Joshua Mitts, who is an associate professor at Columbia Law School and consults on litigation and regulatory matters involving short sellers and market manipulation.