Securities fraud and short sellers are strange bedfellows. The stereotypical story involving both happens when short sellers bring to light false statements of issuers, prompting corrective disclosures and giving shareholders a cause of action. At times, issuers accuse these short sellers, usually unsuccessfully, of market manipulation or deception to drive prices down toward the level of their own positions. Courts and regulators have not given much attention, however, to whether the private securities litigation framework works when atypical investors such as derivatives traders and short sellers want to be plaintiffs themselves.
Even for those who believe that private securities fraud litigation is a useful deterrent that provides compensation in the U.S. capital markets, the class action system works better if one does not stare at it too closely. As the appellants in Halliburton II (unsuccessfully) argued, the assumptions courts must make to allow class actions to proceed in a Rule 10b-5 lawsuit cannot withstand serious investigation. In particular, the critical presumption of class-wide reliance, which follows from the assumption that the capital markets are efficient and that investors trade based on the integrity of price signals from the market, stands on shaky ground in a typical case. Attempting to apply the Basic presumption of reliance, not to mention other elements such as loss causation, to short-seller plaintiffs only further undermines those assumptions.
A short seller believes that the market price of Issuer A’s stock is too high, based on her own analysis. The short seller thus borrows Issuer A shares from a broker-dealer and sells them at market price X, believing that when the time comes to return Issuer A shares to the broker-dealer, she will be able to purchase them at a lower price Y, pocketing X-Y as profit. If Issuer A makes false statements of a material fact after the sale, artificially raising the price to Price Z, our short seller will have to pay more to return the shares than hoped. Under current law, our short seller has standing to sue; however, this plaintiff will have a hard time proving both that the trades were made in reliance on the false statement and that the losses were caused by the disclosure of the falsity, two important elements of the Rule 10b-5 cause of action.
By definition, short sellers do not believe that the market is sending accurate signals about stock prices when they make their initial trades. However, some courts have assumed that all investors believe that the market will eventually return to a true price and have thus found a general belief in market integrity sufficient to allow all types of traders the benefit of Basic reliance as class action plaintiffs. Sometimes, however, short sellers do not take positions in anticipation of a return to an efficient share price, but rather sometimes trade based on a prediction of continued herd momentum.
In addition, our seller’s loss occurred because the price did not fall below market price X before the contractually obligated time to return the borrowed shares. The trader did not purchase in reliance on the integrity of market price because she was contractually obligated to buy the “covering” shares regardless of price. The immediate transfer of purchased shares to the lender during the inflated period yields no loss; loss is recognized only by matching the purchase to the earlier sale, before the inflated period. This timing does not match loss causation’s requirement that the loss be caused by corrective disclosure.
Reliance and loss causation are even trickier to prove for options traders. If traders purchase “out of the money” options and the option loses even more money during the class period, is the loss caused by the fraud? The riskier the option, the greater the trader’s loss, and those losses cannot all be caused by the false statement. In the case of the seller of a call option, the losses are unlimited.
If private securities-fraud cases were brought individually, courts would have to sort out these prickly issues and determine whether atypical traders are appropriate plaintiffs, given their disparate reasons for trading (hedging, speculation, contractual obligation), the nature of their trades (out of the money, in the money), and timing. These cases are not brought individually, however, but as class actions. A court does not know the individual positions of all class members; the only investors the court can identify are the lead plaintiff applicants. From our survey of Rule 10b-5 cases brought in 2017, short sellers do appear as lead plaintiff candidates in 15.7 percent of the cases. Unfortunately, not all courts address whether short sellers or options traders should be lead plaintiffs, and not all opposing lead plaintiff candidates oppose atypical traders on those grounds.
One ongoing case does explore these issues: In re Tesla Securities Litigation. In Tesla, arising out of CEO Elon Musk’s “Funding secured” tweet that launched a thousand lawsuits, multiple individuals and groups clamored to be lead plaintiff. Each candidate had a variety of holdings: common stock, call options, put options, and purchases to cover short sales. Judge Edward Chen chose Glen Littleton because he “held interests that cover most of the persons/entities likely to be in the class—i.e., long positions in common stock, long positions in options, and short positions in options—and thus can most adequately represent the class.” This statement inspired two unsuccessful candidates to object, pointedly accusing Judge Chen of holding that an investor without short positions could not adequately represent a modern class action. Judge Chen did not reverse his decision after reconsideration, but he did specify that the best alternate plaintiff stated losses only from call options that were out of the money when purchased. The trader had purchased options with a strike price above $420 after Musk tweeted “Am considering taking Tesla private at $420.” Judge Chen held that such a lead plaintiff would require the court to consider substantive issues of reliance and loss causation at an early stage, presumably class certification. Conceivably, some, but not all, of Littleton’s claimed losses would have been subject to similar scrutiny, but the defendants stipulated to certifying the class, and the case seems quickly on its way to settlement.
Whether atypical traders such as short sellers should serve as lead plaintiffs is a narrow question; the broader question is whether they should be securities-fraud class members at all. Unfortunately, this question is rarely addressed, and never consistently, because virtually all these cases settle before trial. If the questions arise at all, they arise during the claims process, which is as opaque as the composition of the class itself. As modern investing moves away from the stereotypical “buy and hold” common stock position, regulators and legislators must tackle the real but largely ignored issue of whether atypical traders should benefit from 10b-5 lawsuits. The most jaded observers of these causes of action characterize them as mere wealth transfers or, worse, a form of market insurance. Yet the statute does not exclude the riskiest traders from this insurance, even as the courts narrow the class of defendants.
If the only goal of private securities fraud litigation is deterrence, then the identities and characteristics of the plaintiffs may not be relevant. However, if class-action securities lawsuits are also about compensation, then the identity and characteristics of the almost hypothetical class are imperative. Instead of clinging to the dogma that these lawsuits are workable because of presumptions that cannot withstand scrutiny, Rule 10b-5 lawsuits should be reformed to account for modern trading practices. Among other things, the Exchange Act could be amended to eliminate the need to prove reliance, as is the case for other fraud lawsuits under Section 11 and 12 of the Securities Act of 1933. On the other hand, the Exchange Act could be amended to eliminate certain types of securities holders from Rule 10b-5 lawsuits, just as Section 11 excludes holders who cannot trace their shares to a registration statement. Finally, Congress could take on the more difficult task of creating a rational regime that allows for small claims compensation without the in terrorem threat of unlimited damages, removing the incentive for risky traders to participate.
 Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014).
 Basic Inc. v. Levinson, 485 U.S. 224, 247 (1988) (holding that if an issuer’s shares traded in an efficient market, then plaintiff shareholders do not have to prove individual reliance on misstatements or omissions but may plead classwide reliance on a public statement that was incorporated into the market share price).
 Docket No. 3:18-CV-04865-EMC (N.D. Cal. Aug. 10, 2018).
 District Court’s Response Re: Petition for Writ of Mandamus, Bridgestone Inv. Corp. Ltd. v. U. S. Dist. Ct. N.D. Cal., at 4, 3:18-cv-04865-EMC (N.D. Cal. April 12, 2019) (“missing from Bridgestone’s submission to this Court was any direct evidence that, in making the purchase of the $450 option, Bridgestone relied on Mr. Musk’s tweet”).
This post comes to us from professors Christine Hurt and Paul Stancil at Brigham Young University’s J. Reuben Clark Law School. It is based on their recent paper, “Short Sellers, Short Squeezes, and Securities Fraud,” available here.