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.
This made the startup more valuable than older automakers like Ford and Fiat Chrysler, despite it never having sold a single vehicle.
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;
meanwhile, General Motors took a $2 billion stake in Nikola.
Nikola’s fortunes changed, however, on September 10, 2020. On that day, a short seller
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.
In response to this report, Nikola’s stock price declined by over 11% and fell by another 14.5% the following day.
Milton resigned from the company shortly thereafter and was eventually charged with—and convicted of—securities fraud.
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.
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.
Contrast the plight of Nikola with recent events at Farmland Partners, a real-estate investment trust.
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.
That day alone, Farmland’s stock price declined 39%.
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.
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.
Indeed, Farmland’s auditors confirmed that the company was not lending to related parties.
Nonetheless, Farmland’s stock price took over two years to return to its price before the short-seller report had been published.
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.
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.
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.
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.
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).
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
—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.
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.
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.
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.