Public companies are under attack by manipulative short sellers. In prior work, I’ve shown how pseudonymous attackers drive down stock prices by buying put options prior to posting hit pieces on blogs and social media. Victim firms are often unaware of how to identify manipulative patterns in trading data, instead bringing defamation lawsuits that fail on First Amendment grounds. Too often, boards of directors are caught flat-footed, lacking the tools to monitor derivatives markets and demonstrate to investors the manipulative nature of a short attack.
This essay makes four claims. First, a short-and-distort attack using derivatives like put options often constitutes illegal market manipulation. Second, trading ahead of the publication of whistleblower allegations can be illegal insider trading under Dirks and Martoma II. Third, manipulative options trading undermines loss causation in a shareholder lawsuit against the firm over the price decline. Finally, management and the board of directors should monitor derivatives trading and be ready with a rapid response to restore investor confidence after a short-and-distort attack.
‘Farmland Partners‘ and the “Death Spiral” of Options Trading
On July 11, 2018, a short seller using the pseudonym “Rota Fortunae” launched an attack against Farmland Partners, alleging, among other things, that the firm inflated revenues by making loans to related parties. As a result of the attack, the stock fell nearly 40 percent that day and remained depressed for some time, despite the firm’s detailed rebuttal of the allegations. Options trading data strongly suggest that FPI was the victim of market manipulation. The ratio of outstanding put to call options was 10-to-1 prior to the attack, before falling by 80 percent thereafter.
Where did all this options trading come from? In May, the average daily volume of FPI options was 41.48 contracts. In June, someone bought over 4,200 put option contracts expiring July 20 with a strike price of $7.50. Each of these contracts gives the holder the right to sell 100 shares of FPI stock at $7.50. Suppose the price of FPI stock fell to $6.50. The holder would instantly receive $420,000 (i.e., 420,000 shares x $1 difference between $7.50 and $6.50).
But massive profits to the option holder result in massive losses to the option writer. Put option writers will protect themselves against anticipated price declines by selling the underlying stock. On June 1, FPI’s stock was trading around $8.50 a share and had rarely dipped below $7.50. The risk of loss seemed small, so these options were cheap—$0.20 per share. And because these options were expiring so soon, it’s hard to find an economic rationale for their acquisition other than the anticipation of a massive price decline. As soon as a price decline below $7.50 starts to seem more likely, option writers may lose hundreds of thousands of dollars. A sudden decline in price, even if modest, would cause option writers to sell massive amounts of FPI stock rapidly to limit those losses.
Like a chain of dominoes, publication of the article set off a “death spiral” of selling because of these outstanding put options. Hedging 4,200 puts means selling 420,000 shares—nearly twice as much as the average daily trading volume of 226,000 shares over the prior month. That drove the stock price down, causing even more investors to sell in the ensuing panic. On July 11, this death spiral led to FPI’s stock closing at $5.28, a decline of nearly 40 percent in a single day.
Market manipulation violates Section 9(a)(2) of the 1934 Act as well as Rule 10b-5. See, e.g., Sharette v. Credit Suisse Int’l, 127 F. Supp. 3d 60, 78 (S.D.N.Y. 2015). In ATSI Communications, the U.S. Court of Appeals for the Second Circuit held that “[t]o be actionable as a manipulative act, short selling must be willfully combined with something more to create a false impression of how market participants value a security.” ATSI Commc’ns v. Shaar Fund, Ltd., 493 F.3d 87, 101 (2d Cir. 2007).
Consider the sequence: (1) acquiring a very large quantity of put options shortly before (2) the publication of a meritless attack article that (3) induces options writers to engage in massive selling to hedge their positions, thereby causing (4) a stampede sell-off. This is certainly “something more” than mere short selling. The one-two punch of derivatives trading and publishing a hit piece artificially manipulates prices by skewing supply and demand for the firm’s stock, which courts have held to be the “gravamen of manipulation.” Gurary v. Winehouse, 190 F.3d 37, 45 (2d Cir. 1999) (citing Schreiber v. Burlington Northern, 472 U.S. 1, 12, (1985)).
Lack of evidence linking the author of the manipulative short attack to options trading may pose a challenge for bringing a private damages claim for market manipulation under the heightened pleading standards imposed by FRCP 9(b) and the PSLRA. Fed. R. Civ. Proc. 9(b); 15 U.S.C. §78u-4(b)(2). However, the Second Circuit has held that a plaintiff “need not plead manipulation to the same degree of specificity as a plain misrepresentation claim” but only “set forth, to the extent possible, what manipulative acts were performed…and what effect the scheme had on the market for the securities at issue.” ATSI, 493 F.3d at 102 (emphasis added). A detailed analysis of options trading data may satisfy this pleading standard.
Moreover, the SEC can easily discover the identity and trading history of derivatives traders via subpoena. Enforcement staff are more likely to open an investigation when presented with rigorous economic analysis showing that options trading had the effect of manipulating supply and demand for the underlying security. This requires a careful study of intraday trading data.
Insider Trading on Whistleblower Allegations
Reporters often write about governmental investigations into allegations by a whistleblower-employee. An investigation into allegations of potential misconduct at a firm invariably drives the stock price downward, even though these allegations have not yet been verified. The stock-price decline can deliver a handsome profit to short sellers who open a short position prior to publication of the news article.
The employee clearly has a fiduciary duty to shareholders not to trade on the knowledge that a whistleblower complaint has been filed. See, e.g., Chiarella v. United States, 445 U.S. 222, 228 (1980). What about tipping? In Dirks v. SEC, the court held that a whistleblower (Secrist) did not receive a “personal benefit” by disclosing information about an alleged fraud, even though recipients traded on that information. The Court emphasized that “the tippers were motivated by a desire to expose the fraud” (Dirks v. SEC, 463 U.S. 646, 667 (1983)) and that “[w]hether disclosure is a breach of duty depends in large part on the purpose of the disclosure.”
There is a crucial difference between tipping the market about misconduct—even if doing so happens to confer a profitable trading opportunity—and tipping the market that an allegation of misconduct has been made. The former reflects a motivation to “expose the fraud” because disclosure of the allegations gives investors an opportunity to evaluate the claims and the firm a chance to respond. The latter only gives traders an opportunity to exploit the salacious nonpublic news that a complaint has been filed. Such a tip does little to “expose the fraud” but does “benefit the tippee with inside information” which “proves that the tipper has received a personal benefit in breach of a fiduciary duty” (United States v. Martoma, 894 F.3d 64, 75-76 (2d Cir. 2018)) as the Second Circuit put it in Martoma II.
Short-and-distort attacks are frequently followed by shareholder litigation over the price decline on the day the attack is published. Shortly after publication of the hit piece by “Rota Fortunae,” several class action lawsuits were brought against Farmland Partners, relying on July 11, 2018 as a “corrective disclosure” date. But to bring a Rule 10b-5 claim, plaintiffs must establish loss causation, i.e., that a price decline does not reflect “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.” Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 343 (2005).
Manipulative options trading is a “firm-specific fact, condition or other event” that accounts for a lower stock price, not because of the information contained in the article but because option writers sold into the price decline to limit their potential losses. The options trading data show that much of the decline in the price of Farmland Partners’s stock was not attributable to the content of the article. This sort of trading activity will rebut an allegation of loss causation.
Preparation, Readiness and Real-Time Response
Perhaps the most compelling use of derivatives trading data is equipping the board of directors to prepare for and rapidly respond to a short-and-distort attack. Recall that for weeks, someone was accumulating FPI put options with so much potential hedging demand that FPI’s share price took a nosedive when it became apparent that option writers were facing significant losses. The accumulation of these options began nearly six weeks before publication of the short attack. These short positions are not disclosed on Schedule 13-D, but this kind of information is easily discoverable in public trading data and could have been brought to the board’s attention so that investors could be alerted to the vulnerability of the firm’s stock to a price decline.
Effectively preparing for these attacks means not only identifying the demand for derivatives but also how the share price might respond to the publication of an attack article. Much like bank “stress tests,” the key is to simulate a range of scenarios and estimate the sensitivity of a price decline to the trading environment. A major factor is the underlying liquidity of the firm’s shares, which turns not only on the magnitude of the hedging demand relative to the firm’s typical trading volume, but also on the size of the firm’s public float and the market microstructure environment in which the firm’s shares are traded.
This sort of proactive preparation enables victim to quickly approach the SEC with a complaint alleging market manipulation and/or insider trading. Preparing a detailed analysis of trading data will make it easier for enforcement staff to open an investigation. A formal investigation into the attacker’s trading behavior sends a strong signal to shareholders to treat the allegations with suspicion. Ultimately, the goal is to preserve investors’ trust and confidence in management and the board. And that means working with shareholders to unmask short-and-distort attacks for what they are: brazen attempts to manipulate stock prices and trade on inside information.
Joshua Mitts is an associate professor of law at Columbia Law School. The author would like to thank John C. Coffee Jr. as well as Perrie Weiner at DLA Piper for insightful conversations on this topic. The author consults on regulatory and litigation matters related to short-and-distort campaigns.