Short and Distort: Bear Market Stock Manipulation

There's nothing wrong with short selling, the long-standing strategy of speculating on a decline in a stock. Nor can short-sellers be faulted for expressing an opinion about a stock, just like any other market participant. But when opinions give way to falsehoods in the name of a personal gain from a stock's decline, that's something the U.S. Securities and Exchange Commission (SEC) calls "short-and-distort," an illegal market manipulation scheme.

Short-and-distort is the bearish counterpart of the pump-and-dump, the more common scheme to promote a stock and then profit from selling it, which more often leads to criminal prosecution. Like the pump-and-dump, short-and-distort can work in bull as well as bear markets.

Short Selling vs. Short-and-Distort

Short selling is the practice of selling borrowed stock in the hope that the share price will soon fall, allowing the short seller to buy the stock back for a profit. There are good reasons why it has long been a legal and legitimate trading practice.

Most importantly, allowing speculation on share price declines as well as gains gives the markets additional information. Short sellers often engage in extensive due diligence research to uncover facts supporting their belief a stock is overvalued.

In recent years short-sellers have flagged improprieties at companies including Sino-Forest Corp., Valeant Pharmaceuticals International Inc., and Wirecard AG. They've also attacked many legitimate companies anonymously, and such attacks also don't amount to short-and-distort if they don't traffic in falsehoods.

Rather than adding to a market's store of useful information, short-and-distort traders pollute it with false claims in an effort to provoke shareholders to sell, driving the share price lower. As with other market manipulation schemes, short-and-distort often uses social media, taking advantage of the anonymity it offers and the ease with which misleading claims can spread online.

Short-and-distort isn't just some anonymous poster on a stock forum yelling in all-caps about how XYZ will soon be a zero, however. That fact-free opinion would likely qualify as protected speech under the U.S. constitution. In 2012, the New York State Supreme Court dismissed a defamation suit against U.S. short-sellers, ruling their skepticism about a Canadian mining company's reported production figures was protected speech.

Another recent defamation case brought against a company critic was settled after a U.S. district judge refused to dismiss it, however. The settlement required the defendant to acknowledge that many key statements in the report were false and to admit the idea for it came from a hedge fund client that was shorting the stock.

The veracity of their information aside, short-sellers have also been accused of engaging in market manipulation by leveraging options trades to spur additional selling, and by order spoofing with the same goal. To counter such abuses, some have proposed restrictions on trading by short-selling activists.

Identifying and Preventing Short and Distort

Here are some tips for avoiding being burned by a "short-and-distort" scheme:

1. Do your own due diligence before buying stocks.
2. Do not believe everything you read—verify the facts.
   
3. The SEC requires publicly traded companies to disclose material information that could affect their share price in an 8K filing. Searching a company's investor relations website or the SEC's database for such filings is one way to verify negative information.
4. Try not to overreact to big share price moves based on unverified or incomplete information.
   

You could also ask your broker to transfer your stock to you directly rather than holding it in a street name. Shares held directly can't be lent out by the brokerage to short-sellers, and if every shareholder took that step there would be no stock available for borrowing to short.

In practice, the stock is likely to be available for borrowing elsewhere, while shareholders holding stock directly rather than through a brokerage will need to take additional time-consuming steps if they later decide to sell it.

The best way to protect yourself is to research the stocks you own before and after buying them. By doing your own homework, you should feel much more secure in your decisions. In an event of a short-and-distort attack, you will be better able to detect the distortions and be less likely to fall prey to spurious claims.

How to Identify Good Research

Ask yourself these questions to spot the key characteristics of a good research report:

1. Is There Disclosure?

The SEC requires that everyone providing investment information or advice fully disclose the nature of the relationship between the information provider (the research analyst) and the company that is the subject of the report. The absence of such disclosure is a red flag.

2. What Is the Nature of the Relationship?

Investors can get good information from pieces published by investor relations firms, brokerage houses, and independent research companies. Using all of these sources will provide information and perspectives that can help you make better investing decisions. However, you need to evaluate their conclusions in light of the compensation (if any) that the information provider received for the report.

3. Is the Author Identified and Contact Information Provided?

Generally speaking, if the author's name and contact information are on the report, it shows the author is willing to put their reputation, if any, on the line, and provides investors with a way to request additional information.

Research reports from legitimate brokerage firms post the author's name and contact information near the top. If the author's name is not provided, investors should be skeptical of the report's contents.

4. What Are the Author's Credentials?

A professional certification after a name does not necessarily mean the author of the report is a better analyst, but it does demonstrate the analyst's qualifications in finance and investing.

5. How Does the Report Read?

If the report contains grandiose words and exclamation points, beware. This is not to say that good analysts are boring, but good reports don't read like a tabloid headline. A reputable analyst would never use exaggerations like "sure things" or "going to zero."

Objective research reports provide reasoned arguments to buy or sell a stock, citing verifiable facts about company operations to support their conclusions.

The Bottom Line

Unscrupulous short-and-distort tactics can leave investors holding the bag. Fortunately, high-quality stock reports are not easily confused with stock manipulators' frequently dramatic claims.

Keep your cool when analyzing a stock, and avoid getting caught up in online hype or big change in the share price. By analyzing potential investments carefully and objectively, you can protect yourself from falling prey to short-and-distort—and make better stock picks in the bargain.