The Great Short Debate

By Drew Bernstein on April 22, 2019
The Great Short Debate
Drew Bernstein
Drew Bernstein

Joshua Mitts and Carson Block Square Off at Fraud Conference

After months of sparring on twitter, the two opponents were to face off at a recent conference on Fraud in the Bull Market organized by the Berkeley Center for Law and Business. Is activist short selling the best hope for cleansing the stock market of bad actors? Or is a plague of shadowy short-report gunslingers destroying worthy companies and fleecing retail investors?

Columbia Law Professor Joshua Mitts established a name for himself and made friends in corporate suites by publishing dense research indicating that “short and distort” campaigns by pseudonymous authors on Seeking Alpha may be using market manipulation to amplify the returns from publishing damning articles about public companies. His recent working paper has been seized on by critics as evidence that short sellers need to be more tightly regulated and subject to greater disclosure, and he is currently an expert witness in a case by Farmland Partners Inc against the pseudonymous author Rota Fortunae.

Carson Block of Muddy Waters is among the brashest of the activist short sellers and has expressed skepticism about Mitts’ conclusions. Having cut his teeth writing novella-length short reports on small cap Chinese issuers, Block has recently moved on to tangle with larger companies including Manulife Financial and Tesla and advance the concept of “morality shorting” as a mechanism for social good. He has never been shy about using the f-word (fraud) and is known for blistering and effective use of the media to prosecute his case against alleged management wrongdoing.

With these two debating in front of a room full of fund managers, lawyers, and investigative reporters, sparks were expected to fly. Instead, a surprisingly balanced and well-reasoned discussion ensued.

Professor Mitts cleared the air by declaring that he did not think short selling should be illegal, doesn’t believe short sellers are “un-American,” and didn’t personally advocate “putting short sellers in jail tomorrow on the basis of options trading.” Which undoubtedly reassured many of the hedge funds managers in the room.

Instead, Mitts zeroed on a particular type of trading he calls “short and distort,” in which a pseudonymous short report using inflammatory language and damning conclusions is combined with excessive use of options and high frequency trading techniques to trigger a “flash crash” in the targeted stock.

By buying short-term, at-the-market puts the day before their reports are published, and then buying calls once the stock has cratered, Mitts theorizes that pseudonymous shorts make money on both sides of a V-shaped stock panic and recovery. He claims that many of these short artists build the credibility of their pseudonym over time with legitimate reports before launching a manipulative scheme. Once it becomes apparent that the short attack was ill-founded, the authors abandon the fictional identity and begin afresh with a new pseudonym. Mitts estimates that the sharp declines and reversals due to these attacks have led to over $20 billion in stock mispricing between 2010 and 2017.

Do Shorts Distort the Market?

Carson Block lamented the use of the phrase “short and distort,” saying that he hated how easily it rolled off the tongue and that is was “great branding.” He took exception to the notion that short sellers engage in sophisticated trading techniques to artificially depress stock prices. Buying large volumes of puts and then trading out on the day of the report is likely to backfire, he said, because it inevitably leads to a strong upward reversal in the share price as the hedges are coming off, which erases any profits.

Mitts has also gathered evidence of a surge in deceptive trading practices on the day reports are released usually associated with High Frequency Trading (HFT) firms. This includes “spoofing,” in which orders are entered outside the spread and then immediately canceled, and “layering,” in which multiple orders at different price points are entered and cancelled before being filled in an effort to distort prices and induce others to trade. Both of these techniques are illegal, and Mitts points to the spike in cancelled orders as proof that they are used to amplify the impact of pseudonymous short reports.

Carson Block retorted that he was familiar with the largest and most sophisticated activist short funds and that there is “no f---ing way that we know how to do the stuff that Josh is talking about.” If algorithms used by HFT firms happen to be triggered by a short report and distort the market, that is outside of the short seller’s control and she or he can’t be held responsible. As for the notion that shorts are conspiring with HFTs, he commented that “the whole point of being an HFT is that you don’t need to be tipped off.”

Taming the Shorts 

The two also debated various ideas for holding short sellers more accountable for publishing faulty research or engaging in manipulative trading practices. Requiring authors of short reports to use their real names would provide greater transparency and avoid the practice of swapping out pseudonyms. But Block pointed out that it would have a chilling effect on those who don’t have the resources to defend themselves against corporate defamation lawsuits and in some cases might place the authors at risk of physical harm and retribution.

Professor Mitts advocated companies that fall victim to inaccurate short reports to consider suing on the basis of manipulative trading practices where there is evidence that options trading, spoofing and layering were employed to drive the price down. In order for a defamation suit to be successful, companies must typically prove that a short seller knowingly and maliciously made a false statement of material facts. Block said that expanding the “cause of action” in the lawsuits that companies file against short sellers to trading practices would make unfounded “nuisance lawsuits” much more expensive to defend and intimidate smaller funds from publishing short ideas.

Another idea to increase transparency would be to require funds to report their short positions, analogous to how funds with over $100 million in assets now need to report their long positions, call options and put options in quarterly 13-F filings. Neither of the speakers felt this would be effective, although Mitts suggested that those who publish short reports should be required to provide greater detail about their positions, including shares shorted and options holdings, rather than a generic disclaimer that they may be short the stock.

Block advised companies who believe they are being unjustly targeted by shorts to “keep your head down, focus on your business, print numbers that are good, that are real.” If the business performs and the allegations are wrong, the stock will recover. Mitts pointed out that the shareholder class-action lawsuits that often follow a short attack can be an enormous drain on corporate resources and that if the company misses the window for a critical financing, that can have devastating consequences for its growth and for employees’ jobs.

Hating on the Flash Boys

So, what did the debaters agree on?

Both speakers believe algorithmic and high frequency trading are leading to market distortions that hurt both fundamentals-oriented money managers and retail investors. Mitts said that both “flash crashes” and “flash pumps” deserved greater focus from regulators since smaller investors were usually on the wrong side of the trade in both directions. Block felt that investors were drawing false comfort from the one-day stock reversals when a report was published and failing to dig into the substance of the issues in his reports. 

Next time maybe the conference organizers will invite an AI-powered HFT algorithm to come along to the debate and defend itself.

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