Short Selling: What It Is, and What It Isn’t
Short selling, the practice of betting a stock will go down, not up, has been controversial since it was invented more than 400 years ago in the Netherlands. In the early 1600s, there was only one stock in Holland, or anywhere else. It was the Dutch East India Company, or VOC (Verenigde Oostindische Compagnie). Formed on March 20, 1602, it enjoyed a 21-year monopoly on trading in Asia granted by the Dutch government. Shares in the company could be purchased by any resident of the Netherlands, and then bought and sold in outdoor secondary markets. The company was extremely powerful, possessing quasi-governmental powers, but successful trading depended on many things: well-built ships, competent captains and efficient crews, good weather, peaceful trading partners, and so on. Insurance existed at the time and offered protection, but a few real disasters could cause the VOC’s stock price to plummet.
Short selling was invented by Isaac le Maire. He’d been one of the founders of the VOC in 1602 and served as a director for three years. In 1605, he was sacked amid accusations of fraud and embezzlement. He wasn’t imprisoned but was forced to sign a non-compete agreement, pledging not to become involved with companies of any nationality that traded beyond the Cape of Good Hope or the Strait of Magellan. He was cut off from involvement in the Asia trade, the business he loved and knew best.
He tried to start a rival company in France but without success. He then took a different approach. Like a modern activist investor, he wrote a long letter to the chairman of the VOC’s board of directors, pointing out what he saw as problems that were hurting the company’s profitability. One of his biggest concerns was a lack of transparency on the part of the board. Shareholders were given only scant information about the VOC’s performance. Board members were enriching themselves at the shareholders’ expense. The directors were unmoved by Le Maire’s letter, which demanded an audit and a new charter, and formally rejected it a month later. He needed a better plan.
And he found one: in 1609, he and some associates created the Groote Compagnie (Great Company) with the intention of bringing down the VOC. Le Maire used Groote Companie, financed by himself and his partners, to commence speculation by short-selling through forward contracts. (A forward contract is a customized contract to buy or sell an asset at a specified price at a future date. It can be used for hedging or speculation.) He and his men also spread false rumors of disaster on the high seas, and, with a government bookkeeper as their collaborator, they committed fraud by altering the shareholder register.
The first bear raids were effective but did not achieve the desired results. A dividend was distributed to shareholders, but they were still unhappy because it drove the stock price down. Dutch officials banned what is today called “naked” shorting—selling stock without first obtaining a borrow—but short selling itself remained legal. Le Maire and his friends had, alas, been shorting naked, and the ban on the practice ruined them. Le Maire himself left Amsterdam and died in poverty. Activist shareholders who didn’t stoop to fraud continued to protest the VOC’s high-handed treatment of them, and in 1623, succeeded in forcing the board to consent to a new company charter.
What’s Changed in Short Selling?
A little more than 400 years have passed since Le Maire’s pioneering bear raid. During that time, short selling has almost always been legal in the major financial markets. Retail investors have sometimes objected, fearing that it harms their prospects for long-term gain, but it’s generally agreed that shorting stocks is healthy for the public markets. In a bull market, it helps burst potentially dangerous speculative bubbles; in a bear market, shorts buying to cover can stop or at least slow a strong downtrend.
In 2008, when the U.S. markets cratered frighteningly, regulators banned the short selling of financial stocks following the collapse of Lehman Brothers. Most observers thought the ban, which was always intended to be temporary, was a good idea. But by Christmas Eve 2008, Christopher Cox, then SEC Chair, had doubts. “While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again,” he told a Reuters reporter. His chief concern was the damage that had been done to liquidity. It was not Cox’s fault; he’d been subjected to a great deal of pressure from the Federal Reserve and the Treasury Department.
Once the crisis was over, the Federal Reserve Bank of New York commissioned a study called “Market Declines: What Is Accomplished by Banning Short-Selling?” Its authors noted in conclusion that “A statistical exercise conducted to determine the relationship between short-selling and stock returns finds that the two variables are minimally correlated.” In 2011, when some European markets temporarily banned shorting, the Brookings Institute weighed in on the subject:
Trying to prevent stock prices from falling, the U.S. banned short selling of financial stocks in September 2008. However, the prices of these stocks continued to fall, and the ban was lifted before it was due to end.
During its short life, the ban precluded institutional investors from engaging in legitimate hedging activities in financial stocks. For example, a long-time holder of a high-dividend stock could not short it to protect against price declines while continuing to receive its dividends.
Despite these and other accounts of lessons learned, many retail investors dislike the idea of shorting. Some even say they feel it’s “un-American,” which makes no sense. But regardless of their sentiments, shorting is here to stay. Given that, it’s best to be informed.
How Does Naked Shorting Work?
Obviously, the point of a short trade is the same as the point of any trade: to make money. Naked shorting, engaged in by Isaac de Maire so long ago, is, for the most part, forbidden by the SEC here in the United States. There is one major exception. Market makers are allowed to short naked in their role as middlemen to provide liquidity.
As an example, if Party A wants to buy 1,000 shares of Stock ABCD, he will submit an order to his broker. The broker will fill the order immediately. If he doesn’t have the stock in inventory—and most market makers don’t keep much inventory on hand—he’ll short naked to fill the order. So he’ll be short 1,000 shares of ABCD. Normally, that’s all in a day’s work; usually, within seconds or minutes, another client will appear, wanting to sell some ABCD. The market maker will buy his stock and will no longer be short. He’ll execute similar transactions throughout the day. While most of them will settle quickly, some may not. Under current market regulations, settlement is fixed at “T(rade)+2 (days). Trades that still haven’t settled by then will be considered “failures to deliver” or “fails.” Market makers and brokers have differing deadlines for delivery depending on the circumstances of the failure. Most do not normally encounter delivery problems, even if they’ve shorted naked a great many times during the trading session.
How Does Shorting Stock for Retail Players Work?
How, then, does shorting work for retail players? Let’s say Party A is feeling more adventurous and decides to short XYZZ, a stock he believes will take a beating when its annual report appears in a few days. He submits an order to sell 1,000 shares short. His broker fills it, obtaining a borrow from the account of a client of the brokerage who is long XYZZ. (The stock of any client who has a margin account can be borrowed. The broker does not have to ask permission. Clients who don’t want that to happen should have cash accounts, from which no stock can be borrowed.) Party A must have adequate collateral in his account to allow for the possibility that the stock may go up. The SEC’s Regulation T requires the client to have at least 150 percent of the value of the position at the time the short is created in his account. If the stock rises enough to exceed that amount, and the client doesn’t have that much in his account, he’ll have to add cash, sell other positions, or buy to cover his short. If that does not happen, Party A is free to keep his position for as long as he likes, but he’ll find himself paying a daily stock borrow fee for the privilege. He will, of course, have sold his position as soon as it was delivered to him, but will not have use of the funds realized from the sale until the position is closed.
Shorting is extremely risky, and not as profitable as hitting that elusive 10-bagger with a long position. The greatest profit a short can enjoy from a single position is 100 percent, minus fees. But should the stock he’s chosen skyrocket rather than tank, he’ll have to absorb the entire cost. He would then be caught in a classic short squeeze, praying to find a way out before he’s driven to bankruptcy. Theoretically, at least. In real life, his broker or clearing firm will probably buy him in before that happens.
Shorts, like longs, have price targets. When XYZZ has dropped enough to reach Party A’s target, he’ll order his broker to buy to cover. That accomplished, he can use his profit as he sees fit. Retail shareholders cannot short naked because no one will allow them to do so. Occasionally, a case of genuine intentional naked shorting appears among the SEC’s enforcement actions. A recent one that’s received a good deal of attention involves Hal D. Mintz and his firm, Sabby Management LLC, which managed two private funds. Sabby mismarked tickets for short sales, saying they were long sales. By selling without borrowing stock, the firm was unable to make delivery. In addition:
The SEC’s complaint further alleges that Sabby Management and Mintz tried to conceal their fraudulent trading, including by using securities acquired after the trades to make it appear to brokers executing the trades that they had complied with the requirement to have borrowed or located the shares prior to their trades. As the complaint alleges, when questioned by at least one broker regarding their trading, Sabby Management and Mintz repeatedly lied about the trading.
In the end, Hal D. Mintz profited to the tune of about $2 million, but he’ll be giving up more than that in penalties and disgorgement.
Brokerages keep an “easy to borrow” list and a “hard to borrow” list. Both are updated daily. Not much explanation is necessary, though we’ll add that hard-to-borrow stocks are likely also to be more expensive to borrow. The most important thing anyone thinking of shorting stocks, or even anyone watching what he believes are shorts dragging down the price of “his” stock, must bear in mind is that in the markets, no one accepts risk for anyone else. You’re on your own. No one will cut you a break on your daily fees, or hold back on a buy-in just because you’re a nice person. Contrary to the beliefs of some, trading is not a team sport.
The Department of Justice Investigates Short Selling
A couple of years ago, rumors began circulating about an investigation of professional short sellers. The backstory is unusual. It seems to have begun with a young lawyer with a Ph.D. in finance called Joshua Mitts, who teaches at Columbia University. Reuters explained a bit mysteriously that “[t]he 36-year-old securities law specialist has become an increasingly influential figure in the hot debate over activist short selling since publishing a 2018 analysis of trading data that suggested some players were manipulating the market.”
According to commentary about him, Joshua Mitts spent years compiling an impressive study. It’s suggested that his focus is activist shorts, including the well-respected Carson Block of Muddy Waters and Andrew Left of Citron Research. Left has said he’s being investigated—his home has been raided—but he doesn’t know why. Supposedly, it all has to do with Mitts, his work for the DOJ, and his report, which law enforcement and the regulators supposedly liked because it makes use of such a large sample of data. In 2018, he published his analysis of 1,720 pseudonymous posts attacking publicly listed stocks on the financial website Seeking Alpha between 2010 and 2017. His study found such posts were preceded by unusual and suspicious trading through stock options, a process he called “short and distort”.
What? Seeking Alpha? Pseudonymous posts by individuals no one’s ever heard of, even as a pseudonym, who are apparently playing options? What has any of that got to do with well-known figures like Block and Left? We might as well be talking about the meme stock APES who make daily videos about things of which they know nothing and, seeking immortality, post them to YouTube. Does Joshua Mitts have any idea that there’s a big difference between responsible professionals who do meticulous and time-consuming research and risk large amounts of their own money and the owners of a handful of options contracts pumping their picks anonymously at Seeking Alpha?
The short sale study itself is quite long and contains a good deal of math. Equations representing… something statistical. But what is the point? Pages and pages are dedicated to the question of why the authors of what are probably no better than reverse pumps choose not to use their names. The answer is simple: because that’s what people do on the internet. They use aliases. Mitts doesn’t seem to grasp that. He calls the study “Short and Distort.” He must have run across the term at Seeking Alpha. To set the record straight, it was invented in the early 2000s by a penny stock promoter called Gary Swancey, who posted on several websites as “Georgia Bard.” He was a nice man, but his mission was pumping. He died young in 2004.
Mitts believes these Seeking Alpha contributors are manipulating stocks through their options trading. Why, then, is the DOJ going after people like Left and Block?
In February 2022, Carson Block wrote a blistering response to Mitts’s paper, calling it Distorting the Shorts – A Refutation of Joshua Mitts’ “Short and Distort.” He begins with an objection to what he sees as Joshua Mitts’s conflicts of interest—he works with CEOs who believe their companies have been the victims of abusive shorting, and charges $900 an hour—and moves on to a critique of his methodology:
In other words, Joshua Mitts claims to have studied short sellers, but in fact studied almost entirely something else. He chooses a market cap cutoff that produces a “V” pattern. Mitts misattributes the “V” to report authors (let alone short sellers) when it is clearly driven by earnings announcements. He then trumpets $20.1 billion of mispricing (that doesn’t exist) as showing the significant damage that short sellers are supposedly doing when – forgetting all of the other problems with his analysis – this number is a drop in the ocean of his data. However, the problems with his research extend beyond just these.
That is the relatively nice part of Distorting the Shorts. He goes on to discuss a lawsuit Joshua Mitts lost badly in the U.K. and adds scathingly:
Despite Joshua Mitts not having actually studied short selling, in 2020, Mitts’ research was used as the basis for a petition to the SEC to enact rules on activist short selling that we believe would significantly curtail the industry. In 2021, numerous short sellers were served with search warrants and subpoenas in what appears to be a wide-ranging Securities and Exchange Commission and Department of Justice investigation into activist short selling. On February 7, 2022, the recently departed former chairman of the SEC, Jay Clayton, explained in a CNBC interview that this investigation “would be looking at as a regulator. First of all, there’s ‘short and distort.’” Businesses and lives are being turned upside down by this investigation, which is seemingly catalyzed by Mitts’ misrepresented, error-filled research. The ultimate casualty of a misguided investigation will be market accountability and investor protection.
The rest of the paper is equally brutal, and very much worth reading. Not only has Joshua Mitts consulted for clients convinced they’ve been victimized, but he’s also consulted for the Department of Justice. We do not understand why the Feds decided a person without any practical experience of the subject on which he claims to be an expert should be their new authority on short selling. Block concludes:
Mitts’ “Short and Distort” (2020) is a non-empirical, conflict-laden polemic based on misrepresentation, selective presentation of data, and lack of academic integrity. Its conclusion that pseudonymous activist short sellers manipulate mid- and large-cap stocks is contradicted by Mitts’ own data. If Mitts had written a short report on a company with comparable lack of rigor and misrepresentation, he would likely have significant legal exposure.
Has the Wind Shifted for Short Sellers?
If Mitts has offered a written response to Block, we haven’t found it. But Block did agree to debate Robert Jackson, a former SEC Commissioner, in July 2022. The subject was Mitts’s study. And at the same conference at the UC Berkeley Law School, Mitts did agree to be interviewed by Frank Partnoy, the professor who’d organized the conference and hoped originally to moderate a debate between Block and Mitts. The interview focused on Block’s white paper.
As the conference took place, Justin Weitz, the DOJ attorney in charge of the short-selling case, resigned. It now seems that over the past two years, Mitts’s popularity has faded, and his influence waned. Only 10 days ago, on December 11, 2023, Institutional Investor ventured another article about him, and the tone had changed. Mitts had written a new report, this one about how shorts in Israel had supposedly profited from the war with Hamas because they’d known it was going to happen. That idea was quickly—and, for Mitts, embarrassingly—debunked:
The report was “inaccurate and divorced from reality,” Yaniv Pigot, the executive v.p. of trading on the Tel Aviv Stock Exchange, told Israel’s Globes news outlet last week.
The problem, according to Pigot, is that the research assumed that shares in Bank Leumi were quoted in shekels instead of agorots (1 shekel is worth 100 agorots). That means short sellers earned $8.6 million, not $865 million.
The report was co-authored by Robert Jackson, the former SEC Commissioner who’d debated Carson Block in Berkeley.
Block also took the occasion to go after the short sellers’ nemesis, telling Institutional Investor in an email that the report is another example of how Mitts “chooses his narrative first. Next, he backfills by cherry-picking data, drawing unsupported — and often outright illogical — conclusions, which he then camouflages with a bunch of finance and math mumbo jumbo that his legal academy peers can’t see through.”
Two years after the DOJ investigation became public, no charges have been filed. The two top prosecutors have left the agency. Back in May, Avi Perry, head of the DOJ’s market integrity team, promised action on the case “in the next two months.”
There are signs the SEC does not share the DOJ’s deep suspicions about the activist short sellers. For the past five or six years, Nate Anderson’s Hindenburg Research has been producing research reports that have almost always proved deadly accurate. We don’t know if they’ve been questioned about the DOJ probe, but the SEC seems to approve of their work and finds it useful.
On June 6, 2023, Hindenburg announced it had taken a short position in Tingo Group, a Nasdaq-listed issuer. The accompanying research report revealed Tingo to be a sham company selling nonexistent products to nonexistent people, and making literally unbelievable claims in its financial reports. The report is long and well worth reading. It closes with:
Tingo is a word in the Pascuense language of Easter Island meaning, “to borrow objects from a friend’s house, one by one, until there’s nothing left.” For a company that did an otherwise terrible job trying to pretend to be a real business, it landed on an absolutely perfect name. We expect Tingo will not be long for this world—another cautionary tale.
Anderson was correct. Tingo quickly replied, nonsensically denying Hindenburg’s criticisms. Hindenburg responded at the end of August.
The SEC was following along. On November 13, it suspended trading in Tingo Group (TIO), the Nasdaq company, and in Tingo, Inc. (TMNA), an OTC issuer. The latter is also known as Agri-Fintech Holdings, Inc. The Commission wasn’t finished: a little more than a month later, on December 18, it sued both companies and Mmobuosi (Dozy) Odogwu Banye, their CEO. It also applied for and was granted a freeze on the companies’ and Mmobuosi’s assets. In the complaint, it’s noted that:
The scope of the fraud is staggering. Since 2019, Defendants have booked billions of dollars’ worth of fictitious transactions through two Nigerian subsidiary companies Mmobuosi founded and controls, reporting hundreds of millions of dollars of non-existent revenues and assets. For example, Tingo Group’s FY 2022 Form 10-K filed in March 2023 reported a cash and cash equivalent balance of $461.7 million residing in Tingo Mobile’s Nigerian bank accounts. Authentic bank records for the same accounts, however, show a balance of less than $50 for that period.
The complaint mentions Hindenburg’s work, calling the activist “Analyst A.” The attorneys also indicate that they opened their own investigation in early June. That was when Anderson published his first report. Clearly, the SEC found Anderson’s work helpful in their own investigation of the Tingo scam, and appears to harbor no suspicions about his intentions. We wonder if we’ll be hearing no more, or at least very little, about Mitts’s theories concerning Seeking Alpha posters.
One question remains. The suspensions of TIO and TMNA ended one minute before midnight on November 28. TMNA was moved to the Grey Market. TIO was immediately halted by the Nasdaq; the halt continues with no end in sight. What of the shorts in this situation? Something similar occurred in early May 2015 with Riviera Tool Company (RIVT). RIVT was an abandoned shell company. The company that had once inhabited the public shell had been spun off as a private entity some years earlier. And in 2015, that private company had been acquired by Tesla. Quite a few people jumped to the wrong conclusions and began to load the boat. An article appeared in an online publication, foolishly confirming the public shell company’s mistaken identity. Some people shorted. It was a sure thing.
Only 20 minutes before the close, FINRA imposed a U3 halt, used in situations that raise concerns about settlement or clearance. It was expected that the halt would continue for at least four days, so that RIVT would lose compliance with Rule 15c2-11 and be delisted to the OTC Markets Grey Market. But it seemed that FINRA had completely forgotten about it. It wasn’t until the first week of December that the halt was lifted.
That was unfortunate for everyone with a position in the stock. Longs lost whatever their stake had once been worth, but that had happened long before. Short sellers, however, had to continue to pay their daily stock borrow fees. Eventually, some who were active on message boards arranged with each other to ask their brokers to do wash trades for them, wiping out their positions.
We hope Tingo short sellers who didn’t cover before the suspension won’t be trapped forever, but will find a way to exit their positions. No trader should lose money for being right.
To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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