Wall Street’s Short Kings

There has been a recent trend toward activist short selling. Rather than shorting stocks simply because they are overvalued, activist short sellers focus on corporate fraud.

The activist short sellers are a mixture of well-known activist investors and firms, such as Muddy Waters Research, Citron Research, and Hindenburg Research, led by investors Carson Block, Andrew Left, and Nathan Anderson.  These firms profit by identifying companies engaging in fraud, taking short positions in those companies, publishing their investigations, and then closing their short positions after those companies’ stock prices decline in response to their investigations. This is entirely legal, as long as what they publish is not fraudulent. 

These passionate fraud busters stand on the shoulders of James Chanos, the legendary short seller known for his bearish bets against Enron and Tesla. This group of activist shorts is united by a deep conviction that just about everyone else is either corrupt or clueless. Block, for example, decorated an office bathroom of his Muddy Waters headquarters with a poster bearing the letterhead of the consulting giant McKinsey & Company.[1]  Chanos refers to himself as a “real-time financial detective who is incentivized to root out fraud.” Or, more prosaically, a “forensic financial statement junkie.”[2]  His pitch is that he can identify corporate disasters-in-the-making.  Anderson prefers to think of himself as a private detective, identifying corporate fraud that might otherwise go undetected by snoozing regulators. “The scale of fraud is quite massive. I don’t think any system can sustain itself with that scale of grifts happening,” Anderson says.[3]

It is worth reiterating how often short sellers have performed a public service in drawing attention to companies involved in fraudulent activity. In the case of Enron or Tyco, shorts were vilified but proved to be wholly right, while most Wall Street analysts kept buy ratings on the stocks until the very moment of bankruptcy. Shorts warned investors about the 2008 crisis and ended up being immortalized in the book and the movie The Big Short. 

Activist short sellers play a quasi-journalistic function and add significant value to the securities markets. Financial economists are generally of the view that short selling is highly beneficial. Short selling helps make stock prices more accurate. Bans on short selling are associated with higher bid-ask spreads, increased stock price volatility, and slower price discovery, leading to skewed market efficiency. Securities litigation jurisprudence has recognized that short seller activity is indicative of market efficiency; in particular, courts rely on short seller activity to assess whether a stock trades in an efficient market when assessing motions for class certification.[4]  Moreover, short selling prevents stock price “bubbles” and other overvaluations in securities prices. Owen A. Lamont, a finance professor at the Yale School of Management, studied a group of companies that battled with short sellers and found that those companies’ share prices fell 42 percent on average over the next three years, suggesting their share prices were inflated, just as the shorts had claimed.[5]

Today, Chanos says, “we are in the golden age of fraud.” Chanos describes the current environment as “a really fertile field for people to play false and loose with the truth, and for corporate wrongdoers to get away with it for a long time.” He explains why: a level of retail participation in the markets reminiscent of the end of the dotcom boom; Trumpian “post-truth in politics”; and Silicon Valley’s “fake it until you make it” culture, which is compounded by Fomo — the fear of missing out. All of this is exacerbated by lax oversight. Financial regulators and law enforcement, he says, “are the financial archaeologists — they will tell you after the company has collapsed what the problem was.” Thus, Chanos believes that “this market is setting up to be one of the great short opportunities of all time.”[6]