Extensive DOJ Investigation into Questionable Practices of Short Selling Firms

The US Department of Justice and the Securities and Exchange Commission has set their sights on investment firms and analysts who are engaged in short selling, as part of a larger campaign to identify and root out trading abuses.

According to sources familiar with the investigation, the FBI has seized computers owned by Andrew Left, the founder of Citron Research, about a year ago. Mr. Left is well known for short selling, and following the seizure of his computer, dozens of other market participants have been subpoenaed to provide records pertaining to their trading activities.

Some well-known short sellers contacted by Bloomberg Law are worried about these probes and are not sure how to defend themselves as they are yet to be accused of any wrongdoing. 

The list of firms included in the DOJ and SEC probe reads like a who’s who of short sellers. In addition to Citron, the list includes Atom Investors, Kerrisdale Capital Management, GrizzlyRock Capital, J Capital Research, Silverado Capital, Spruce Point Capital Management, Bybrook Capital, Valiant Capital Management, Marcus Aurelius Value, Melvin Capital Management, Muddy Waters Capital, Orso Partners and Sophos Capital Management. The list extends to research firms such as White Diamond Research, Bonitas Research, Viceroy Research and Hindenburg Research. Some market rumours allege that in the case of Mexican lender Credito Real, inside information might have been passed to short sellers ByBrook Capital led by Nicholas Ian Chalmers and Stifel Financial Corp.

The DOJ and SEC were under pressure to investigate short sellers in the past few years, as some corporate executives such as Tesla’s Elon Musk accused short sellers of attacking businesses for profit at all cost. In some instances, members of the public lost money on their stock investments due to short selling activities. What makes investigations more difficult is the variety of approaches short sellers can use which are no longer limited to borrowing shares. Short sellers can buy put options, sell call options, or engage in short selling of trading vehicles such as ETFs which may include their targets. 

This probe adds to the pressure on short sellers after a difficult year. Monetary and fiscal stimulus have supported capital markets giving rise to the phenomenon of meme-stocks. Large numbers of retail investors bought up shares of popular short targets, causing shorts to book significant losses. Short selling involves borrowing and selling shares, which means that to close the position shared must be bought. During strong rallies in a stock, short sellers are forced to close their position in what is often referred to as a “short squeeze”.  Some prominent short sellers such as Citron threw in the towel and vowed to focus on long bets rather than shorts.

With stock markets correcting in the first quarter of 2022, we can expect more fingers pointed as short sellers as possible culprits in market declines, accelerating the investigations. As wild fluctuations in stock prices affect the portfolios of ordinary citizens, lawmakers are increasing pressure on the Government to intervene and investigate.