An investor “shorts a stock” when they borrow a stock hoping that it will decline in value by a certain date. (Investors can borrow stocks for a fee.) In order to make a profit, the short seller sells their borrowed stocks, hoping the price of the stocks will have fallen by the deadline. If the price of the shares has gone down, the short seller gets to keep the difference. Voila — a quick way to earn money on the stock market, with financial wins for both the shareholder and the short seller.

But those results are far from guaranteed, and investors can lose a huge amount of money by taking a short position. In fact, short selling has unlimited risk. If an investor shorts a stock, and then the price of that stock shoots up, the investor still has to buy it back and return it to its owner. Short selling is therefore quite unsuitable for many investors, and plenty of investors have sued their brokers for taking risky short positions.

For instance, let’s say Peter borrows 10 stocks at $1 per share and sells them, only to have their price go up to $10 per share. Peter would have to spend $100 to buy those shares back. He still has the $10 that he made when he sold the shares, but he has to pay $100 to buy them back, for a net loss of $90.

Because of the opportunity for tremendous losses, the “short position” is riskier than the “long position” investors take with ordinary stocks. Stocks might fluctuate in value over a long period of time, but if they’re issued by a solid company, an investor can reasonably expect at least a modest return on their initial investment. Short selling presents the opportunity to lose a huge amount of money with no time to recoup those losses.

Short and Distort: Short Seller Frauds

Short selling creates plenty of opportunity for fraud. Fraudulent short-sellers might spread negative rumors about a company, hoping to lower the value of their borrowed stocks. The SEC refers to this practice as a “short-and-distort” scheme.

In 2018, the SEC alleged that hedge fund manager Gregory Lemelson had engaged in a short-and-distort scheme by spreading false information about a pharmaceutical company in order to make money off of his short position. Lemelson allegedly claimed that Ligand Pharmaceuticals was “teetering on the brink of bankruptcy.” He had also allegedly told investors that a European doctor took a negative view of the pharmacy’s flagship drug, without disclosing that the European doctor was also a major investor in Lemelson’s fund. As of February 2020, Lemelson has taken the position that the SEC is simply doing the pharmaceutical company’s bidding.

Short Selling on Social Media

Social media has made short selling fraud all the easier. In fact, the SEC has issued a warning specifically targeted at social media rumors that may be motivated by short sellers’ greed. Tesla CEO Elon Musk has complained that his company has been the victim of short-seller rumors, taking to Twitter to refer to the SEC “the Shortseller Enrichment Commission.”

There is a social media campaign dedicated to demonstrating that Tesla is overvalued, but it’s not clear if these accusations amount to fraud. One Twitter user posted pictures of Tesla’s full lots of cars to further their narrative that Tesla’s stock prices do not accurately reflect the company’s worth. Unfortunately for Mr. Musk, it’s not against SEC regulations to make these types of observations.

The Upside of Short Selling

It’s not all bad news. In certain instances, short-sellers have had a positive influence on the market. Warren Buffet has asserted that short-sellers have the potential to reveal fraud. For example, short-sellers sometimes share reports about companies that may have misled investors about their shares’ true worth, as in a report from June 2020 that alleged a Chinese coffee chain had inflated its sales. The anonymous report was based on thousands of hours of research into cafe foot traffic and customer receipts. An independent auditor later confirmed the information found in the report, and the coffee chain has since been delisted.

The Long and the Short

Shorting a stock can be a good position to take and may even be part of a conservative strategy. Investors might want to short a stock simply to hedge their bets if they have invested in a company for the long haul. If they’re worried, but don’t want to sell all of their shares, they might take a short position just to make sure they can recover from a sharp market downturn. This takes quite a bit of experience and definitely isn’t worth the risk to the average investor.

Generally speaking, shorting stocks comes with extreme risk, and brokers shouldn’t play dangerous games with their clients’ money. If you believe your broker may have taken a risky position by shorting a stock, don’t hesitate to reach out to the lawyers at Fitapelli Kurta for a free case evaluation. You can call (877) 238-4175 or email info@fkesq.com to speak with an experienced securities attorney.

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