DoJ Targets Hedge Funds With Investigation Into Short Selling

As far as we can tell, cracking down on short sellers has typically been associated with authoritarian governments (like in China, which has arrested market selloffs by throwing shorts in to a “reeducation camp”) as well as those trying to cover up their own aggressive malfeasance (like when German regulators chose to investigate and pursue short sellers and journalists instead of Wirecard, a former fintech darling that was eventually exposed as a massive fraud).

But now, the practice is coming to the US.

Just as hedge funds are dumping shares to retail while corporate insiders sell shares back to their own companies, the DoJ is reportedly launching a broad-based probe into hedge-fund short selling, with prosecutors with the DoJ’s fraud group based in LA leading the charge into firms that collaborate with researchers to pull off “short and distort” plays that can quickly earn tens of millions of dollars in “alpha” for their LPs.

According to Bloomberg, the investigators are looking closely at trading in at least several dozen stocks, including well-known short targets such as Luckin Coffee, Banc of California, Mallinckrodt and GSX Techedu. Additionally, they’re already scrutinizing the involvement of about a dozen or more firms, although it’s not clear which ones, if any, may emerge as targets of the still-nascent probe.

BBG’s sources confirmed that Toronto-based Anson Funds and anonymous researcher Marcus Aurelius Value are among firms being examined in the probe. It also pointed out that other prominent firms that circulate critical research include Carson Block’s Muddy Waters Capital and Andrew Left’s Citron Research, two of the best-known short-sellers in the US.

As authorities scrutinize relationships between research shops and funds, they’re looking closely at how funds set up their trades to engineer massive drops in target companies’ shares. The goal is to root out abuses that could be prosecuted as insider trading.

According to BBG, it’s not clear yet whether any charges will be filed. But the probe has been quietly moving forward for months.

Government attorneys are trying to determine whether short sellers engaged in some form of deception — say, by misleading the public about their financing of what appears to be independent research, violating confidentiality agreements with authors, or orchestrating stock plunges to panic shareholders and exacerbate selling.

The probe comes at a time when short sellers are already on the ropes. The January surge in meme stocks like GameStop famously saddled hedge funds – most notably Melvin Capital, whose CIO was later dragged in front of Congress – with steep losses. And the Fed’s pandemic-inspired stimulus has driven stocks to ever-higher record highs. By the end of January, Andrew Left’s Citron research had announced that it was giving up on short selling to focus on long-only research.

On the other hand, the probe will likely come as welcome news to dozens of corporate executives who have been pushing for the US government to take a firmer line against short sellers vocalizing criticisms of their businesses. Of course this ignores the fact that the US government’s own investigators often independently collaborate the theses of the best known short-sellers.

Subpoenas have been flying since October, but BBG’s sources say the investigation started months earlier.

A rep for Andrew Left said the probe appears to be “routine” and that Left has nothing to worry about because his firm does “quality research”.

An attorney for Citron said he’s aware of an industry probe but that it’s routine for U.S. investigators to open and close cases. He expressed doubt that their theories would be borne out.

“Citron Capital and Mr. Left are successful because they do quality research and keep their reports secret from other short sellers until publication,” said the lawyer, James Spertus. “There is simply no truth behind any theory that short sellers coordinate amongst themselves before publishing reports, at least in regard to publications by Citron Capital and Andrew Left. I am hopeful that anyone investigating the issue will reach that conclusion as soon as possible.”

The DoJ prosecutors leading this probe have already scored several major victories in the world of high finance. They’re the same people who spearheaded those investigations into spoofing of Treasury futures, spot currency markets and commodities. Those investigations famously ended with massive fines paid by several global megabanks, including JP Morgan, which paid $900MM in penalties (incidentally, one trader who was fired during the post-scandal house-cleaning unleashed by JPM just won a major employment case against his the bank in the UK).

Ideally, the DoJ and SEC would like to hold firms accountable for “short and distort” tactics, whereby a researcher releases exaggerated reports that cause a company’s shares to swiftly drop, allowing a partner hedge fund to quickly pocket massive profits.

One cautionary tale cited by BBG involves Dallas-based Sabrepoint Capital and a researcher whom the firm had on retainer. The researcher in question published a bearish report on Seeking Alpha, prompting a nearly 40% drop in shares of Farmland Partners, before retracting key details of their research.

One cautionary tale emerged in court after Dallas-based Sabrepoint Capital agreed to pay a short-selling researcher a monthly retainer of $9,500 in 2018. Sabrepoint encouraged him to dig into real estate company Farmland Partners Inc. The researcher, who also wrote publicly under a pseudonym, later published an article on Seeking Alpha, setting off a 39% drop in Farmland’s share price. The company sued and used a judge’s order to force him to reveal his identity: Quinton Mathews.

Mathews later said in a statement that he subsequently learned his article “contained inaccuracies and false allegations” and retracted it. He and Farmland reached a settlement. Sabrepoint has said it didn’t know about the Seeking Alpha article.

Farmland also is on the list of stocks that the Justice Department is examining. Lawyers for Sabrepoint and Mathews declined to comment.

Farmland’s shares bounced back, but Sabrepoint got to keep its profits from the trade. Whether the DoJ decides to “rectify” this will be closely watched by the industry, which has benefited from changes in US case law that have made it more difficult for the SEC and DoJ to prosecute insider trading.