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Dismantling Wall Street’s excuses for short selling

Short selling benefits Wall Street – and just about no one else.

supply and demand for wall street mythbusters article

Short selling is a practice that Wall Street defends at every corner. For every one criticism of the practice, there are ten or more articles or ‘news’ stories that contend it has an important place in the market.

The resounding chorus of these oft-repeated defenses points to Wall Street’s need to control the narrative about short selling at large. In reality, short selling not only abuses the real economy, but puts an even higher degree of power and control in Wall Street’s hands.

So we’re going to address their main points to see what’s true and what’s myths that need to be busted.

1: Short selling makes for efficient price discovery

TL;DR: Wall Street – not the market – decides what a company is worth, even if they don’t have a dollar invested

Those entrenched in Wall Street culture often argue that short selling helps to define efficient price discovery.

A Bloomber Businessweek magazine cover defending short sellers

This is objectively false. Short selling distorts the real value of a stock by its very nature.

Even when done properly – that is, not naked shorted – short selling adds artificial sell pressure to the market for which there is no counterweight on the buy side.

The price of a stock is supposed to be a function of supply and demand. If a company does well, more people want to buy its stock and are willing to pay more for it. Share price goes up.

Conversely, if a company performs poorly, shareholders could choose to sell their stock and might be willing to take a lower price for it, share price goes down.

These buy-and sell-dynamics on the share value are neutral in that it could go either way.

Unless a short seller steps in.

By only selling stock they never bought, but rather, borrowed, short sellers are effectively adding borrowed shares into circulation that were never bought nor issued by the company. As far as price discovery goes, it makes no difference is the share is borrowed or not. The sell pressure is still the same as if an investor who did buy the shares sold out of their position.

Say a company issues one million shares at $10 each, giving the company a market cap of $10 million. A short seller can come into the market and sell 500,000 shares they never bought. In effect, there are now 1.5 million shares in circulation.

But because the short seller never paid for the shares – only borrowed them – the market cap is still $10 million. However, now it’s divided over 1.5 million shares. Granted, the short seller will in theory have to buy back the borrowed share eventually.

But until they do, they have dropped the share value over every investor from $10 a share to $6.66 a share.

All the investors who actually put their money in the company lost money.

Importantly, there is no equivalent to the sell pressure short selling creates on the demand side. This imbalance alone highlights the distortion short selling creates. 

The counterweight demand force would be if anyone could remove stocks from circulation, adding the value of those removed shares into the company’s market cap, and kept a tally of how many shares they’ll eventually sell back into the market when they’re good and ready. No such practice exists – nor should it. It would just be too vulnerable to market manipulation. But for some reason, short selling gets a pass.

Companies doing share buy backs have a similar net effect. But share buybacks are not a counterweight to short selling. Share buybacks are the demand-side equivalent of share shelf offerings – they can only be initiated by the company and must be announced in advance.

The financial media will say that short selling prevents company’s from becoming overvalued. Why should people with no actual investment in a company (because remember, short sellers are not investors) get to decide whether or not it’s overvalued? Shouldn’t those with skin in the game – actual shareholders – be able to decide that? How is that ‘efficient price discovery’?

If an investor thinks a company is overvalued, they can simply not invest in it or sell their holdings if they have some. Another investor might think that same company still has plenty of room to run and buy a holding based off the same numbers.

This is not efficiency. It is price distortion by its most fundamental nature.

Bad justification #2: Short sellers sniff out bad actors

TL;DR: They may sniff it out, but still have no vested interest in protecting real investors. A much more common scenario is that they are themselves, the bad actors. 

Unlike bad justification #1, there may be a tiny morsel of truth to this.

In theory, short sellers are incentivized to investigate companies. They may in the course of their investigation uncover fraud before investors do.

It makes sense in theory, but hardly ever plays out that way.

CNBC headline defending shortselling as an efficient price discovery tool

For one, even when short sellers acting in good faith legitimately uncover fraud in a company, they still have vested interest in the company’s failure. A negligible amount of short sellers have tried to correct the situation to protect other investors or the company’s employees.

Rather, they can simply let the situation play out or accelerate it. In fact, intervening ‘in good faith’ could backfire on a short seller. What if the company remedies the situation and recovers? Now the short seller is at risk of losing money. This is not their end goal.

Their investigations and due diligence may detect fraud, but detection doesn’t mean the situation will be corrected or even acted upon.

Contrarian investor Michael Burry of The Big Short detected something massive brewing in the housing market in 2005. The problem was, there wasn’t an established way take out a short position on subprime mortgages at large. Famously, Burry pitched the use of credit default swaps to effectively create the short position.

That required him to go bank to bank, explaining his thesis based on years of in-depth research on their own mortgage lending practices. Every major bank and several large hedge funds were informed of Burry’s findings three years in advance of the meltdown. How many of these banks intervened after being briefed on this short sellers findings?

The rest is history.

Burry’s thesis would be proven unequivocally true. Still, in a 2010 op-ed for the New York Times, Burry reflected:

Since then, I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions.

As it turns out, uncovering fraud or poor business practices doesn’t mean anyone who can do anything about it will listen. Not even in retrospect!

Additionally, there comes a time that we have to evaluate our assumptions against the backdrop of history.

There is a much longer history of short sellers being the bad actors themselves. With vested interest in driving down the price of a company’s stock, short sellers have themselves becomes the bad actors. Indeed, there are many more cases of short sellers proactively sabotaging companies with manipulative media tactics, bad analyst ratings, saddling them with frivolous lawsuits, and preventing them from raising capital.

They get away with it more often than not.

Bad justification #3: Short sellers are part of a free market

TL;DR: Short sellers and the framework needed enable it effectively empower Wall Street to crush competition of their other vested interests and stifle innovation. 

This excuse might be the most heinous of them all. It exemplifies Orwellian levels of double think that only Wall Street could package and sell. It’s reminiscent of a child throwing sand in another child’s face on the playground, then citing freedom as their reason for doing it.

As covered in bad justification #1, short selling is a force of price distortion. Period.

Similarly, the legal practice short selling has a long and ugly record of producing bad actors exactly because it empowers them with the ability to manipulate the price. The more money they have, the more they can manipulate.

As such, there’s extensive reason to believe that short selling is used to snuff out innovation, put premature death sentences on struggling American companies with potential for turnaround, and crush competition of short sellers’ other financial interests.

Free market innovation interrupted: Viragen

GameStop-anchored subreddit r/Superstonk members began researching and posting documents from bygone years from companies that had filed complaints with the SEC about short sellers.

One company that caught special attention from the forum was biotech company Viragen. Viragen was among the first to research and develop immunology treatments.

Their trials showed tremendous promise in the late 1990s and early 2000s. In fact, looking at press releases at the time, one might have thought that the company was on the up and up. It gained patents, had promising clinical trials for a cancer treatment, and successfully genetically modified chickens to lay eggs with cancer-fighting drugs to reduce the cost of production, a process that had obvious commercial potential. The company had even done a substantial amount of research on coronaviruses during the 2003 SARS outbreak – research that would have come quite handy seventeen years later.

Yet, despite its many wins and promise, Viragen still fell into the cross hairs of short sellers. The company’s CEO, Gerald Smith, filed complaints with the SEC about abusive short selling. Motley Fool, a usual suspect in Wall Street media smear campaigns, named the stock one of the 10 worst performing of the decade.

As share value continued to decline, the company was caught in expensive litigation. Despite promising clinical trials on some of its products – and even an approval by Sweden’s FDA analog for its drug Multiferon – the company ran out of money. It wasn’t able to raise capital against diluted share price.

With so many promising drugs in the works and several active patents, the bear thesis for Viragen – which ultimately won the day – is hard to understand.

The company was liquidated in 2007.

Redditor u/phoenixfenix created entitled Naked Short Sellers have set our cancer research back decades from their abusive short selling a post that garnered over 20,000 upvotes.

Biotech is a competitive and expensive industry with large upfront investment requirements. Sometimes their research fails to bring their product to market, and they go under.

That might have been Viragen’s fate. If Viragen’s investors had been disappointed with the company’s progress and wanted out, Viragen’s story would be one of failure in a free market. Instead, Viragen’s real investors were forced to watch their investment bleed, despite positive developments.

The company’s value was siphoned out by short sellers. The executive team was forced to invest time and resources defending the company from false bad press on a bear thesis that was both unclear or objectively false.

In one particularly egregious example, an article was published that stated the company’s CEO, ‘Michael Grosbest,’ had sold his stock. The company’s real CEO, Gerald Smith, had not sold stock. Michael Grosbest was an entirely made up name – no such person worked at the company at any point. It begs the question: Why would anyone write a story that is objectively false on multiple fronts?

Viragen was so ahead of its time, the field it was creating with its research – immuno oncology –hadn’t even been named yet.

Today, the field Viragen laid important groundwork for is projected to hit $250 billion in pharmaceutical sales by 2024 – of which the pioneers of the field don’t get a crumb.

In a 2003 complaint to the SEC, Dr. Jim DeCosta, consultant to corporations victimized by short sellers griped:

The sobering reality is that it usually doesn’t matter if the development stage company “has the goods” or not. Even if that new technology or cancer cure is legitimate, the company can’t outmuscle Wall Street.

That leads us back to the same question: Why should people who never put a dollar into a company be allowed to decide it’s worth? Whether it should even keep operating? Whats to stop bigger industry players from throttling out competition and therefore innovation? Additionally, why should anyone other than the issuing company get to decide how many shares are in circulation?

Speaking of ‘free markets’: In an act of eye-watering hypocrisy, when Wall Street’s own fraud and poor business practices exploded the fall of 2008, the SEC banned short selling of financial stocks only.

Other companies were left to the piranhas. After all, there was a lot of money to be made on shorting a collapsing economy.

This is Wall Street’s idea of a ‘free market.’

Bad justification #4: Short selling provides liquidity

TL;DR: The additional liquidity enabled by short selling can also be used to control price formation. It’s liquidity that only benefits Wall Street – not the market. 

Liquidity! Liquidity! Dear God, someone please think of the LIQUIDITY!

Not five minutes goes by on CNBC without a Wall Street suit and their cronies talking about the holy sacrament that is market liquidity.

Liquidity is by far the most overrated word on Wall Street and in the financial press. Liquidity in the context of short selling is also a shameless contradiction of efficient price discovery (a soundbite Wall Street believes makes them sound very smart and important) and that ‘short sellers have a place in a free market’ arguments.

Let’s examine how the liquidity argument contradicts both earlier points.

Efficient price discovery: To beat a dead horse, price discovery is supposed to be a function of supply and demand.

If buyers and sellers do not agree on a price for a share, there will be low liquidity. But odds are, if they’re both at the point of wanting to buy and sell, they will come to an agreement. Either the buyer will agree to pay more, or the seller agrees to less. The price moves. Someone budges. This is the very mechanism of price discovery.

For a third party to step in an “provide liquidity” by subsidizing the market with shares is a blocker in real price discovery. The “additional liquidity” created by putting IOU supply into circulation is now an x factor in the real price discovery. The more IOUs in circulation, the bigger that x factor becomes.

The seller who has actually invested their dollars is of course hurt the most by this artificial liquidity. It bears repeating: Short sellers are not investors. How is giving someone without a single dollar in the company the power to effect the investment worth of real investors – to the downside only – beneficial to anyone but Wall Street? That is the antithesis of a ‘free market,’ no matter how many times “pundits” parrot it in Wall Street Journal or on CNBC.

The best part about this excuse is that in reality, they’re ‘providing liquidity’ – for short selling. Many stocks are still highly illiquid. That’s the risk investors take when they buy certain stocks, particularly penny stocks or unknown small and mid-cap stocks. This ‘additional liquidity’ they shout from mountaintops does not mean that short sellers or stock lenders will buy shares off of real investors in the event of illiquidity in the form of no one will buy from them. It is one-way liquidity.

What they really mean is that short selling allows more liquidity for themselves, which is then leveraged to manipulate the “free market.”

What is not said about short selling

Wall Street and the financial media are unsurprisingly mum about the real consequences short selling has on Main Street and the real economy.

Short seller profits are Main Street’s loss. When short sellers extract their profit from company market caps, it bleeds out Main Street’s 401ks and pensions, which are generally held as long positions.

When company’s market valuations are eroded, they often have to cut costs. Layoffs are a common byproduct of significant stock value drops.

When hedge funds have vested interest in swaying sentiment one way or another, Main Street is lied to by the media sources cleverly disguised as ‘news sources.’

There have been hundreds, if not thousands of complaints filed with the SEC about abusive short selling. The SEC generally plays dumb, launches investigations that really serve Wall Street’s interests more than anything, and plays babe in the woods as companies being bled out plea for help.

Articles get published using the above justifications verbatim over and over. They never contain concrete examples of a net positive effect on Main Street. That’s because there aren’t any. So they do what they always do: Appeal to ‘academic’ language and abstracts to make it sound like when they take money out of a company on loan with no intention of paying it back, it is something “unsophisticated” people just don’t understand.

The relentless ‘short selling is beneficial’ narrative push by the financial media is reason for pause. After all, Wall Street wants to protect their power and advantages. Short selling enables them to manipulate stock prices and decide which companies they want to pillage for profits and snuff out of the competitive landscape.

With a system so shamelessly rigged in their favor and the market firmly pinned under their thumbs, they have little vested interest in telling the truth.

Notice that the common denominator of all of these new fraud investigations is the Wall Street “professional” taking advantage of his superior knowledge of, access to, and visibility of the markets while picking the pockets of mom and pop investors.The common theme holds true. It’s the Wall Street “professionals” against the mom and pop investors. –Dr. DeCosta

Jack Tazman is a Baltimore, Maryland native. He attended Washington University where he studied political science.

Since then, he worked as a writer for various national news organizations specializing in politics and policy.

He now resides in New York City as a freelance writer and political consultant.

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