In a recent post on the Harvard Law School Forum on Corporate Governance, three partners at Skadden, Arps, Slate, Meagher & Flom LLP give practical advice to companies in preparing for and responding to a short attack. With respect to litigation, they argue that “suing short sellers is not an effective response strategy, even though there will often be an understandable desire to bring claims for defamation, stock manipulation or other unlawful practices.”
I disagree. A board of director’s fiduciary duty to the company and its shareholders in the face of a fraudulent or manipulative short attack compels a careful cost-benefit evaluation of potential litigation. Besides the strength of the evidence underlying a potential claim, boards should consider the extent to which the issuer raises ongoing capital by selling stock in secondary offerings, issuing convertible debt, or engaging in other forms of financing that depend on the share price. Merely responding to a short seller’s substantive claims may not be enough in the face of persistent market manipulation that not only drives down the share price but handicaps the firm’s ability to survive as a going concern.
Short Attacks: Negative Opinion, Securities Fraud, or Market Manipulation?
It is well-established that short sellers play an important role in the capital markets. Activist short sellers can identify corporate fraud and mismanagement, leading to share-price declines that benefit their own short positions but may also benefit investors more broadly by enhancing share-price accuracy. However, like fraudsters everywhere, bad actors may try to free ride on the important work that activist short sellers perform, spreading materially false information with the goal of harming a company and its shareholders.
I agree with the authors of the Skadden memorandum that it can be difficult to establish defamation liability against short sellers, a point I noted years ago in my article Short and Distort. While short sellers have occasionally reached settlements with companies pursuing defamation claims, many short reports consist of constitutionally protected opinion, and it is difficult to establish actual malice against a public company (which may be a public figure under defamation law). The SEC has, however, successfully pursued an enforcement action against activist short sellers for securities fraud under Rule 10b-5 of the Securities Exchange Act of 1934, obtaining a victory at trial that recently was upheld on appeal by the First Circuit. That decision, SEC v. Lemelson, provides a roadmap for imposing liability under the securities laws for deceptive short reports. Media reports also suggest prosecutors are examining whether certain short reports constitute a form of illegal “scalping” by deceiving investors as to a short seller’s trading intent.
As an alternative to bringing a claim based on an activist short seller’s statements, issuers might consider whether there is evidence of other forms of market manipulation in a firm’s shares. In two recent cases, Harrington v. CIBC, 585 F.Supp.3d 405 (S.D.N.Y. 2022) and Kessev Tov v. Doe(s), No. 20-CV-04947, 2023 WL 4825110 (N.D. Ill. July 27, 2023), courts upheld claims by private plaintiffs under Rule 10b-5 against third parties for spoofing the securities of publicly traded companies. To the extent that an issuer can identify and establish that other forms of market manipulation (like spoofing) are taking place, discovery obtained during that matter may shed light on the totality of misconduct occurring alongside a short campaign.
When Is Litigation in the Company’s Best Interest?
Of course, boards should not rush to litigation, which is not without cost and risk for the company. But the flip side is this: Fraudulent and manipulative short attacks can have a devastating, long-term impact on the price of a company’s shares – even if the short report’s allegations are unfounded – and it can take years for the market to rebuild confidence in the target firm, if ever. For this reason, boards cannot sit by idly while fraudulent short sellers (or other manipulators) persistently destroy firm value.
The primary consideration for the board when evaluating possible litigation is the strength of the evidence of misstatement fraud or other forms of market manipulation (like spoofing). But when evaluating whether litigation is likely to be a net plus for shareholders, boards should also weigh whether the issuer raises ongoing capital in secondary stock offerings, convertible debt issuances, or other forms of financing that depend on the share price. In cash-intensive industries like biotech, a depressed share price may be more than a source of frustration for shareholders; it can directly undermine the ability of the company to stay afloat and invest in research & development. Sometimes, fraudulent short selling can destroy a company.
To be sure, litigation is unlikely to be a quick fix for a company plagued with a depressed share price. Litigation is slow-moving – it can take years for a resolution of a company’s claim on the merits. A victory on a motion to dismiss or revelations in discovery may, however, provide a powerful deterrent for future misconduct, and damages (or settlement) could put money back in shareholders’ pockets. Of course, a key consideration is whether it is worth obtaining a symbolic victory or injunctive relief even if the defendant can’t pay. And if the share price has already recovered most of the way, the case for litigation may be less compelling – though a careful damages analysis might show that the price “but for” the manipulation would have been even higher.
Plaintiffs’ Firms and Issuers as Investor Advocates
The typical securities class action involves shareholder-plaintiffs suing issuer-defendants. A market manipulation claim under Rule 10b-5 turns that paradigm on its head. When suing third-party manipulators, the incentives of issuers and shareholders are aligned. That presents an entrepreneurial opportunity for plaintiffs’ firms to work with issuers and reduce the cost of pursuing a market manipulation claim by taking a contingent or hybrid fee.
The identity and composition of plaintiffs can also shape the likelihood of success on the merits. Depending on the type of claim and underlying evidence, class certification in manipulation claims is not always straightforward. But issuers or large investors may have sold enough shares to establish a compelling damages model to bring an individual (non-class) action. The question then becomes how to compensate other shareholders for the damages suffered by a manipulative scheme, and the answer is likely to vary from case to case.
Boards should also consider offensive litigation in the context of other likely litigation against the issuer. The decision not to sue doesn’t mean there won’t be a lawsuit. Securities class actions and derivative litigation will likely follow a large price decline, no matter what. The choice to sue should be considered as part of an overall litigation strategy. Depending on the type of claim, discovery might be more available or at least available earlier on. And an offensive claim allows the issuer to establish an alternative theory of causation for shareholder losses and affirmatively put forward evidence consistent with that theory, which could enhance confidence in the issuer and management.
The bottom line is simple. A board’s fiduciary duty to maximize shareholder value may compel litigation to deter fraudulent and manipulative short selling, especially when it threatens to capsize the firm. In that case, issuers have a role in protecting their shareholders and making them whole.
This post comes to us from Joshua Mitts, the David J. Greenwald Professor of Law at Columbia Law School. He advises on the analysis of trading data in connection with high-frequency market manipulation and securities violations. He has extensive experience supporting the U.S. Department of Justice.