Will US investigations expose a link between investment research and market manipulation?

Regulators are asking whether it is akin to insider trading if a short-selling firm is allowed to publish negative research and is also free to benefit from a subsequent share price crash which it may have personally precipitated.

For years we have warned about companies being targeted by precipitous and damaging investment research which causes share value to plummet and plunges them into crisis. We have worked with companies pre-emptively, to put in place measures which promote transparency for stakeholders and reduce the chances of a short-selling attack, as well as working with those enduring this particular brand of unpredictable third-party damage, which can really take them by surprise.

Now, the US Department of Justice has expanded its ongoing investigation into the conduct of tens of short-sellers, investment research firms and hedge funds, looking for evidence of coordinated trading and market manipulation. The DoJ has now issued its second round of subpoenas, and - for all we know - the net may be spread wider yet, as it looks to understand the relationship between hedge funds and the short-selling firms publishing negative reports on publicly traded companies.

Hardware (including mobile phones), trading records and private communications have all been seized as part of their sizeable investigation into this area generally, with the focus appearing to be on whether short-sellers may be illegally driving down share prices for their own profit, via early-released damaging research reports.

Short-sellers make profits by betting that the share price will fall. The grey area here is to what extent they are reporting on genuine market conditions versus pessimistically reporting prospects which then induce loss of belief – and value - in that company. Regulators are asking whether it is in fact akin to insider trading if a short-selling firm is allowed to publish negative research (whether accurate or inaccurate) and is also free to benefit from a subsequent share price crash which it may have personally precipitated.

Should so-called participatory “coordinated trading” – boosting trading volumes and driving prices down – be prohibited? And should stakeholders have a right of reply if third party investment research causes avoidable financial loss to them?

To give them their due, investment research firms have been able to expose corporate scandal, fraud or longevity issues in a publicly traded company, as well as foretell the financial crash, and this realism has been of overall benefit to stakeholders in the past. An investor not au fait with the markets will quite reasonably look for sensible investment research advice, which, of course, should be available to them by way of hand-holding expertise over their investment.

It is certainly the case that ethical, independent investment research firms have long reported the facts of the matter in a bid to demystify the markets, and will want to separate themselves from their less benign colleagues who may be reporting as a tool to influence the landscape.

There is no doubt that short-selling can dramatically affect share price and inflame stakeholders. Last year, GameStop’s share price was driven up by Reddit followers and retail traders in organised retaliation against short-sellers who had raised their ire by betting against the company. Some short-sellers suffered catastrophic losses and left the market altogether as a consequence, and others said that this instance alone would cause them to no longer publish short-selling research. Only the larger, most high-profile companies would be able to rally such a large and impactful defence by loyal shareholders.

No-one has yet faced charges, and an investigation alone of course does not necessitate a prosecution, but it is possible that this enquiry may result in increased regulation going forward and/or organised crime charges of the illegal trading ilk.

Within the last 5 years, we have seen cases in the US and UK courts brought by companies who have suffered terrible losses as a consequence of false or misleading investment research, but the courts have found the question of whether the research caused or exposed the imminent precipitous drop akin to the conundrum of chicken and egg, not to mention that judges are reluctant to order the disclosure of confidential trading data. It has been an uphill struggle for those companies to secure an apology or financial redress. This area of litigation may finally have teeth – in the US at least - if the freedoms of this precarious industry are to be tightened with bespoke regulation.

I mentioned earlier that we have helped companies survive exactly this type of unfairly damaging investment research, evaluating and rebutting the substantive allegations, undermining the findings to avoid adoption and propagation by more credible outlets and using legal tools to vindicate reputation in the face of false allegations. These steps settle stakeholders and provide reassurance; vital components for shortening the length of a crisis. Further legal and investigative techniques can attack and defend; exposing the identities of accusers and demonstrating links to parties with vested interests, whilst also highlighting motive and rebuilding brand.

What has long been a hot topic for us now has the attention of the Department of Justice, and we will await the outcome of their investigation with interest in the hope that it will act to increase protection against crisis for publicly listed companies.