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Short Seller Lawsuits - The Rise of Activist Investing

Short selling hedge funds have aggressively adopted activist investment strategies in recent years. These funds take large short positions in target companies while publishing negative reports alleging business problems or financial misconduct. The reports often precipitate sharp stock drops allowing the funds to profit on their short bets. Targeted companies frequently fight back with defamation lawsuits and other litigation. Securities attorneys are seeing escalating legal battles between short sellers and publicly traded firms as activist short selling proliferates.

This post examines the trend of activist short sellers, the litigation it spawns, and key considerations for companies responding to short attacks. As short campaigns grow increasingly confrontational, legal risks abound on both sides.

Rise of Activist Short Selling

Activist short selling has risen dramatically. Key trends include:

• - Increased Frequency: Short sellers published over 200 activist reports in 2021, triple the amount in 2016. Reports from high-profile short firms like Hindenburg Research and Spruce Point Capital are becoming regular occurrences.
• - Higher Stakes: Short sellers are taking larger and bolder positions. Spruce Point accumulated a $100 million short stake against software provider DigitalOcean before issuing its negative report in February 2022. Trading losses from short reports now regularly reach billions.
• - Maximum Publicity: Short sellers promote their activist reports for maximum impact, using Twitter, cable news appearances and flashy websites. Eye-catching domains like CitronResearch.com and HindenburgResearch.com showcase the reports.
• - Severe Stock Drops: Share prices of targeted companies often plunge 20-50% immediately after the publication of a short seller’s report, allowing them to quickly profit on their short positions.

Activist short selling has evolved into a headline-grabbing Wall Street strategy. With lucrative payoffs, these campaigns are likely to increase in frequency and intensity.

Common Legal Claims

Negative short reports frequently trigger lawsuits against the activist investor on various grounds: - Defamation: Because the reports typically involve allegations of corporate wrongdoing or fraud, defamation claims arguing the statements are false and injurious to reputation are common.

• - Tortious Interference: By spurring business partners, suppliers and customers to avoid the target company, the reports can ground claims for tortious interference with business relationships. - Securities Manipulation: Targets often allege the reports themselves triggered the stock drop rather than any valid revelations, amounting to illegal market manipulation.
• - Abusive Short Selling: Some claims assert the coordinated short selling around the reports represents abusive “short-and-distort” schemes.

However, short sellers tend to be sophisticated market players who are careful to avoid straightforward legal errors. Successful claims require nuanced legal theories and convincing evidence.

Short Seller Defenses

Common defenses raised by activist short sellers against lawsuits include:

• - Truth Defense: If the factual assertions in their reports are supported, truth of the damaging statements is an absolute defense to defamation.
• - Free Speech: They argue their opinions and reports are protected First Amendment opinion speech, not defamatory factual declarations.
• - Public Figure Standard: As public companies, targets must prove “actual malice” - that the short seller intentionally published false information. A high bar.
• - No Evidence of Manipulation: They contend their research reveals legitimate problems at the target firms, rather than manipulating markets.
• - Diversification: Short sellers assert they take many different long and short positions at a time, rather than illegally concentrating on select targets.

Skilled activist short sellers aims to avoid outright false statements and are prepared to show their activities fall within bounds of law. They rarely make unforced errors. This complicates targets’ path to winning litigation.

Key Considerations

For companies weighing potential legal action against activist short sellers, critical considerations include:

• - Assess the severity of alleged falsehoods: Do the report’s inaccuracies amount only to minor errors or represent truly defamatory fabrications? How much business injury occurred?
• - Gather evidence supporting manipulation: Can emails, trading records or other evidence establish illegal coordination or intent to distort markets? Or was trading activity legitimate?
• - Estimate realistic recoverable damages: Quantify actual losses and reputational harm. Many reports only temporarily impact stock prices and business relationships.
• - Anticipate vigorous defenses: Activist short sellers are sophisticated parties prepared to defend their legal First Amendment rights and truthful research. Expect an uphill fight.
• - Weigh public relations impact: Lawsuits pitting public firms against “David vs. Goliath” short sellers may not play well in the media or among shareholders.

Corporate counsel should carefully weigh risks before jumping to litigation. Success requires nuanced legal strategies and compelling evidence of truly false, distortive and abusive short selling activity. With no slowdown in activist short campaigns expected, legal clashes will only intensify.

Conclusion

Activist short selling has emerged as a controversial but common Wall Street strategy. The inflammatory reports of short sellers fuel predictable lawsuits by target companies and increase risks for investors on both sides of trades. Securities attorneys will be busy guiding clients through the legal minefields. As short selling polarizes markets, litigation battles pitting corporations against short activists will only multiply.