COMING UP SHORT: USING SHORT-SELLER REPORTS TO PLEAD LOSS CAUSATION IN SECURITIES CLASS ACTIONS

COMING UP SHORT: USING SHORT-SELLER REPORTS TO PLEAD LOSS CAUSATION IN SECURITIES CLASS ACTIONS

Plaintiffs in securities class actions have increasingly relied on reports published by anonymous short sellers when alleging the element of loss causation. Indeed, short-seller reports are useful for plaintiffs, as they purport to reveal negative information about a targeted company and generally cause a decline in the targeted company’s stock price. Unlike other types of corrective disclosures, however, short-seller reports are unique in that they are written by self-interested parties who benefit financially from driving down stock prices. For that reason, short-seller reports are potential tools for stock-price manipulation. This Note, addressing a recent circuit split on this issue, argues that courts should require more from plaintiffs who rely on short-seller reports for their complaints’ loss causation allegations. In particular, this Note advocates for the judicial assessment of certain facts available at pleading— namely, price reversals, short-seller reputation, and corroborative corrective disclosures—when courts consider a motion to dismiss in cases that rely on revelations contained in short-seller reports. In doing so, courts can reduce burdensome litigation based on manipulative reports while enabling the compensation of genuinely defrauded plaintiffs.

The full text of this Note can be found by clicking the PDF link to the left.

Introduction

In the summer of 2020, Nikola Corp. was in high gear. The company, a purported developer of electric and hydrogen-powered trucks, had attained a market capitalization of $30 billion just days after its initial public offering. 1 Ben Foldy, Electric-Truck Startup Nikola Bolts Past Ford in Market Value, Wall St. J., https://www.wsj.com/articles/electric-truck-startup-nikola-bolts-past-ford-in-market-value-11591730357 (on file with the Columbia Law Review) (last updated June 9, 2020). A firm’s market capitalization is a measure of value of a firm that represents the total value of a company’s stock, calculated as the price of a single share multiplied by the number of shares outstanding. Market Cap Explained, FINRA (Sept. 30, 2022), https://www.finra.org/
investors/insights/market-cap [https://perma.cc/JA7C-LMS4].
This made the startup more valuable than older automakers like Ford and Fiat Chrysler, despite it never having sold a single vehicle. 2 Foldy, supra note 1. Such shareholder optimism was not entirely unwarranted. For instance, the company’s founder, Trevor Milton, claimed that the company had a working prototype of one of its hydrogen-powered vehicles; 3 Corinne Ramey & Ben Foldy, Nikola Founder Faces Securities-Fraud Trial Over Promises About Electric Trucks, Wall St. J., https://www.wsj.com/articles/nikola-founder-faces-securities-fraud-trial-over-promises-about-electric-trucks-11662894001 (on file with the Columbia Law Review) (last updated Sept. 11, 2022). meanwhile, General Motors took a $2 billion stake in Nikola. 4 Mike Colias, GM Stock Jumps on News of Stake in Electric-Vehicle Company Nikola, Wall St. J., https://www.wsj.com/articles/general-motors-takes-stake-in-electric-vehicle-company-nikola-11599568421 (on file with the Columbia Law Review)(last updated Sept. 8, 2020).

Nikola’s fortunes changed, however, on September 10, 2020. On that day, a short seller 5 Short sellers are investors who sell securities they have borrowed, hoping that the price of the security will decline, allowing them to replace the borrowed security for a lower price than which they sold the security. GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 196 (3d Cir. 2001). published a report declaring that the company was an “intricate fraud,” having mischaracterized the state of the technology it was developing and the value of the reservations it had booked. 6 Nikola: How to Parlay an Ocean of Lies Into a Partnership With the Largest Auto OEM in America, Hindenburg Rsch. (Sept. 10, 2020), https://hindenburgresearch.com/nikola/ [https://perma.cc/R52V-UEAP]. In response to this report, Nikola’s stock price declined by over 11% and fell by another 14.5% the following day. 7 Consolidated Amended Class Action Complaint at 135, Borteanu v. Nikola Corp., No. CV-20-01797-PHX-SPL (D. Ariz. filed Jan. 24, 2022), 2022 WL 1081539. Milton resigned from the company shortly thereafter and was eventually charged with—and convicted of—securities fraud. 8 Corinne Ramey & Ben Foldy, Nikola Founder Trevor Milton Convicted of Securities Fraud, Wall St. J., https://www.wsj.com/articles/nikola-founder-trevor-milton-convicted-of-securities-fraud-11665779578 (on file with the Columbia Law Review) (last updated Oct. 14, 2022). The company’s stock price hovered at just over $3 as of October 2022, down from over $40 just before the short seller published its report. 9 Id. Unsurprisingly, Nikola shareholders sued the company in a private securities class action, seeking compensation for their losses associated with the publication of the short-seller report and other subsequent developments. 10 See Consolidated Amended Class Action Complaint at 10–12, Borteanu, 2022 WL 1081539 (alleging damages following a 76% decrease in the price of Nikola shares between September 2020 and July 2021).

Contrast the plight of Nikola with recent events at Farmland Partners, a real-estate investment trust. 11 Justin Baer, Short Sellers Upended a Small Farm Real-Estate Company. This Is What It Looked Like., Wall St. J. (Sept. 25, 2022), https://www.wsj.com/articles/short-sellers-upended-a-small-farm-real-estate-company-this-is-what-it-looked-like-11664076506 (on file with the Columbia Law Review). Real estate investment trusts own and operate real estate. Real Estate Investment Trusts (REITs), SEC, https://www.investor.gov/introduction-investing/investing-basics/investment-products/real-estate-investment-trusts-reits [https://perma.cc/M3PS-P7JN] (last visited Feb. 25, 2024). On July 11, 2018, an anonymous short seller published a report on the website Seeking Alpha, claiming that the company’s lending practices to related parties put it at risk of insolvency. 12 Sinéad Carew, Farmland Partners Shares Skid on Short Seller Report; CEO Disputes Findings, Reuters (July 11, 2018), https://www.reuters.com/article/us-farmland-prtnrs-stock/farmland-partners-shares-skid-on-short-seller-report-ceo-disputes-findings-idUSKBN1K12LA [https://perma.cc/M793-4DG8]. That day alone, Farmland’s stock price declined 39%. 13 Baer, supra note 11. As with Nikola, investors in Farmland Partners sued; in their complaint, Farmland’s shareholders alleged that the company defrauded them and sought to recover damages resulting from the decline in the share price following the report’s release. 14 Amended Class Action Complaint for Violations of the Federal Securities Laws at 57–58, Turner Ins. Agency, Inc. v. Farmland Partners Inc., No. 18-cv-02104-DME-NYW (D. Colo. filed Mar. 11, 2019), 2019 WL 1613308.

The issue, however, was that the allegations contained in the short-seller report were not true. Instead, the author of the article, who was working on stock research for a hedge fund that held a short position in Farmland Partners, later admitted that his report was incorrect. 15 Baer, supra note 11. Indeed, Farmland’s auditors confirmed that the company was not lending to related parties. 16 Id. Nonetheless, Farmland’s stock price took over two years to return to its price before the short-seller report had been published. 17 Id. Moreover, Farmland spent years fighting the class action suit brought by its shareholders, which was only dismissed in May 2022, nearly four years after the short seller published its report. 18 Press Release, Farmland Partners Inc., Farmland Partners: ‘Short and Distort’ Class Action Lawsuit Officially Concluded (May 9, 2022), https://www.businesswire.com/news/home/20220509005246/en/ [https://perma.cc/FQC7-X9HJ].

These episodes highlight a growing dilemma for courts overseeing private securities fraud cases: whether short sellers, who by definition have a strong incentive to drive down a stock’s price, can be relied on to show that securities fraud took place. As the Nikola saga suggests, short-seller reports can expose corporate fraud. Accordingly, investors misled by statements made by corporate executives or contained in corporate filings deserve recompense when short sellers expose those misrepresentations. On the other hand, the events at Farmland Partners show how easy it is for a short seller to manipulate the market and create investor losses. While such malicious activities might harm investors, companies should not face yearslong litigation and the threat of large settlement payments to their shareholders when they have done nothing wrong.

Short-seller reports have played an increasingly prominent role in securities class actions, and plaintiffs’ attorneys often rely on such reports in their complaints to serve as corrective disclosures. 19 See Cornerstone Rsch., Securities Class Action Filings: 2023 Year in Review 29 (2024), https://www.cornerstone.com/wp-content/uploads/2024/01/Securities-Class-Action-Filings-2023-Year-in-Review.pdf [https://perma.cc/QTA2-5TFW][hereinafter Cornerstone Rsch., 2023 Year in Review] (“In 2023, 19 core federal first identified complaints, or about 9%, alleged stock price drops related to reports published by short sellers . . . .”); Peter Molk & Frank Partnoy, The Long-Term Effects of Short Selling and Negative Activism, 2022 U. Ill. L. Rev. 1, 14, 32 (finding eighty-four securities class actions that relied on short-seller reports from 2009 to 2016); Nessim Mezrahi, Stephen Sigrist & Carolina Doherty, More Securities Class Actions May Rely on Short-Seller Data, Law360 (Jan. 10, 2022), https://www.law360.com/securities/articles/1453499/ (on file with the Columbia Law Review) (stating that, in 2021, “[a]round 21%, or 27 of 131, of fraud-on-the-market securities class actions rel[ied] on short-seller research that affected the price of common stock of the defendant company”); see also Andrew R. Gray, Ryan A. Walsh, Spencer L. Chatellier, Nguyet Nguyen & Torben Voetmann, Counterfactuals in Securities Class Actions—An Illustration Using Third-Party Corrective Disclosures, 23 Hous. Bus. & Tax L.J. 105, 106 (2022) (noting that short-seller reports have been “used by plaintiffs to substantiate fraud-on-the-market claims in several securities class actions in recent years”); Gideon Mark, Cannabis Securities Litigation, 46 Seton Hall Legis. J. 557, 574 (2022) (“A significant share of cannabis [event-driven securities litigation] has followed the publication of negative reports by short seller investors.”); Joshua Mitts, Short Sellers and Plaintiffs’ Firms: A Symbiotic Ecosystem, CLS Blue Sky Blog (Oct. 14, 2020), https://clsbluesky.law.columbia.edu/2020/10/14/short-sellers-and-plaintiffs-firms-a-symbiotic-ecosystem/ [https://perma.cc/5LGR-2JXE] [hereinafter Mitts, Symbiotic Ecosystem] (observing that “short seller reports are often followed by plaintiffs’ firms rushing to file a complaint which quotes the short report at great length as revealing of the truth”); Emily Strauss, Can Shareholder Lawsuits Police Companies’ Climate Disclosures?, CLS Blue Sky Blog (Nov. 18, 2022), https://clsbluesky.law.columbia.edu/2022/11/18/can-shareholder-lawsuits-police-companies-climate-disclosures/ [https://perma.cc/4J2G-SSAJ] (“[V]irtually all consequential climate-related shareholder litigation consists of follow-on lawsuits, based either on investigative findings by a government regulator or a short-seller report.”). In recent cases, the circuit courts have taken differing approaches to this issue. The Ninth Circuit has taken a restrictive approach and has concluded that certain anonymous short-seller reports cannot serve as corrective disclosures. 20 See In re Nektar Therapeutics Sec. Litig., 34 F.4th 828, 839–40 (9th Cir. 2022); In re BofI Holding, Inc. Sec. Litig., 977 F.3d 781, 797 (9th Cir. 2020). Meanwhile, the Second Circuit—along with several district courts—has taken a permissive approach, refusing to assess the credibility of short-seller reports at the pleadings stage. 21 See Lea v. TAL Educ. Grp., 837 F. App’x 20, 27–28 (2d Cir. 2020).

This Note will argue that both approaches raise issues. The former approach—rejecting short-seller reports as corrective disclosures as a matter of law—is too restrictive, as it prevents courts from considering whether the reports actually did disclose new information to the market. The latter approach—simply not assessing the credibility of short-seller reports at the pleadings stage—is too permissive, as most securities litigation cases never proceed to a fact-finder (or even to summary judgment) and instead settle, potentially leaving corrective disclosures based on short-seller market manipulation in the suit (and thereby making eventual settlement amounts excessive). 22 See Laarni T. Bulan & Laura E. Simmons, Cornerstone Rsch., Securities Class Action Settlements: 2022 Review and Analysis 14 fig.13 (2023), https://www.cornerstone.com/wp-content/uploads/2023/03/Securities-Class-Action-Settlements-2022-Review-and-Analysis.pdf [https://perma.cc/K8U7-Q6BD] (showing that the vast majority of securities class actions settle before the filing of a motion for summary judgment).

Most importantly, these conflicting approaches could undermine the primary justifications of securities class actions—appropriate compen-sation of investors victimized by fraud and the deterrence of securities law violations by securities issuers 23 Jill E. Fisch, Cause for Concern: Causation and Federal Securities Fraud, 94 Iowa L. Rev. 811, 864 (2009) [hereinafter Fisch, Causation and Federal Securities Fraud]. —as well as undercut the operations of the financial markets themselves. Indeed, while issues associated with pleading in securities class actions might seem theoretical and abstract, markets burdened by fraud or manipulation obscure investment incentives and lead to the misallocation of resources in the economy, reducing the economy’s long-term productive capacity. 24 Merritt B. Fox & Joshua Mitts, Event-Driven Suits and the Rethinking of Securities Litigation, 78 Bus. Law. 1, 13–14 (2022). More directly, securities fraud falls disproportionately on mom-and-pop investors who rely on their personal investments to store their wealth and save for retirement. 25 Alicia Davis Evans, The Investor Compensation Fund, 33 J. Corp. L. 223, 233–34 (2007). Finally, companies under the cloud of a misleading short attack and subsequent securities litigation may struggle to obtain capital, impairing their ability to invest and create jobs. 26 See Jules H. van Binsbergen, Xiao Han & Alejandro Lopez-Lira, Textual Analysis of Short-Seller Research Reports 5 (2023) (unpublished working paper), https://ssrn.com/
abstract=3965873 [https://perma.cc/AH93-2QSW] (“[S]hort-sell research reports are associated with significant reductions in future real investment and stock issuances . . . .”).
These effects impact ordinary people, and a well-functioning securities litigation regime can help to mitigate them.

This Note stakes a middle ground between the conflicting approaches provided by the circuit courts. In Part I, this Note will summarize the state of the law of securities class actions, the role securities class actions play in compensating investors and deterring fraud, and the function of short sellers in modern financial markets. In Part II, this Note will discuss the recent rise in the use of short-seller reports in securities litigation and how short sellers can use their reports to manipulate stock prices. That Part will also discuss the recent circuit split over whether anonymous short-seller reports can serve as corrective disclosures. Finally, in Part III, this Note will discuss two possible approaches to addressing this issue. First, it will suggest reading extant case law to allow courts to delve into the merits of claims based on short-seller reports at the class certification stage, earlier in the lawsuit than is traditionally permitted. Second, this Note will suggest that judges seek information probative of short-seller reliability at the pleadings stage of the securities class action. These approaches, this Note argues, can facilitate investor compensation without deferring to self-interested short sellers. Ultimately, this would better enable securities litigation to fulfill its twin goals of compensation and deterrence.