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Is It Legal for a Highly Influential Investor to Bash a Stock He's Shorting?

By Motley Fool Staff - Oct 14, 2017 at 12:30AM

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Listener Mike is amazed that it's OK for a Wall Street big gun to trash a stock he’s shorting, when his comments are bound to make it fall, thus profiting him.

In this segment from the Market Foolery podcast, host Chris Hill and Motley Fool Asset Management's Bill Barker discuss a specific case of a Wall Street behavior that seems to generally concern and confuse retail investors.

This week, Andrew Left of Citron Research took a public and hyperbolic hatchet to the business model of e-commerce service provider Shopify (SHOP -2.89%), a company whose stock he has heavily sold short. So we have a big name on Wall Street, using his personal bully pulpit to spread negativity about a company in a way that will make him money. Isn't that similar to a "pump-and-dump" scheme? Shouldn't there be regulations to prevent it? The Fools explain.

A full transcript follows the video.

This video was recorded on Oct. 11, 2017

Chris Hill: From Mike Booth in Petawawa, Ontario: "I wanted to take a minute and thank you for what you do and show some appreciation. I listened to the entire bonus episode recently, although I did ask myself why I was still listening around the 40-minute mark, when you yourselves posed that question." Again, if nothing else from the hour-plus long bonus episode that we did with our colleague Roger Friedman, if nothing else, we really tried to emphasize, there are better ways to spend your time than to listen.

Bill Barker: Oh, yes. And we'll do that again. However, what I will say, for my money, and I don't have any money on this, but the 40-minute mark is when it actually started to get modestly decent. So I could certainly see getting to the 40-minute mark and saying, "[sighs], when is there going to be something worth listening to here?"

Hill: And then it picks up. "Right now."

Barker: Because we got into the comedy influences.

Hill: Exactly. Mike goes on to ask -- because, when you email marketfoolery@fool.com, you can ask stock questions. Mike asks, "With the recent Citron short of Shopify, your commentaries got me thinking. Since Andrew Left," who heads up Citron, "is apparently known for making sensationalized reports about companies he's shorting, is there no such law that prohibits people of influence from commenting on companies in which the outcome of those comments will invariably make them money? It seems like this ought to be illegal."

That's a great question. And several people have emailed me some version of that question. Since you're a lawyer, or you were, once upon a time, I think part of why we get this question has to do with the fact that it's shorting. Therefore, particularly in the case of this report about Shopify, the hyperbole was pretty damn high, when you come out and say that Shopify is a scheme worse than Herbalife (NYSE: HLF). It's not just calling into question, "We think this stock is overvalued," or, "Hey, we think there might be some sort of shenanigans going on at Company X." They really brought the heat with this report.

So to Mike's question, and the question we've gotten from others, it kind of does seem like there should be, if not some law, some sort of regulation about people with skin in the game being able to short like this.

Barker: Yeah, it does come into question more often from a reaction to a publication by a short seller. To start up with what the business is here, and then to address problems there might be with it, Citron and others look for companies that are overvalued, stocks which are overvalued, maybe just because they're in a bubble, maybe because there's an accounting question, which will turn into an accusation in the published research, typically, or that it's a pyramid scheme. Then you go through the research -- say, the market is misunderstanding this company; I'm going to short it, because the value of the stock is way too high. Sell the shares, and then cover later and make money as the stock goes down. Having done the research and made that bet, it is in your interest to publicize the reasons why you feel that, so that the market can see your research and react to it.

Now, Citron has a good record, so in doing so, the market typically does sell off a stock. Now, people may believe, think, that Citron then quickly covers its position. Having generated a headline, make a quick buck and get out off of the sensational headlines. I don't understand that to be their business. They stay in it for the long term. They publicize the results of what the stocks have done from the time of their publication so people can see and judge for themselves what their record amounts to, and they don't get everything right. So it's not -- I'll take issue with the word "invariably" as being one of the outcomes here.

Now, are they or anybody else honest or dishonest as they go about this? I have no reason to believe that Citron is dishonest in the way they've done their business. So if it's, as some people might think -- I'm not saying the writer here believes this, but certainly many people think that short sellers are just trying to manipulate stock prices. And the positive phrasing of that is, they're trying to reveal the true value. Just as, if you buy a stock after due diligence and like it and like its story and think it's undervalued, and say, "These are the reasons this company's worth investing in," as The Motley Fool does with research, it publishes evaluations of companies as being worth investing in for the long term, you publicize the research, you're putting your words behind your money. So there's nothing intrinsically illegal about doing that as a short-seller. There is something intrinsically illegal about manipulating stock prices with falsehoods.

Hill: As there should be.

Barker: Right. Although it's very hard to actually catch somebody in a knowing falsehood, because there's always a rich tapestry to the story behind every stock and its valuation.

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