The attack on the shorts

Tom Kirkendall and the WSJ write about the infamous SEC subpoenas to journalists arising out of the Overstock.com short-seller controversy, a controversy which is apparently still smoldering despite Cox's backtrack.

This is all part of the age-old attack on short-sellers as market manipulators. The attack is occurring on many fronts. One is “dumping and suing” – my current salvo on that point is up at PointofLaw’s Featured Discussion. Another is the role of hedge funds in takeovers, particular including the Richard Perry/Mylan/King incident. Much more on both in an article by Bruce Kobayashi & me that will be posted shortly.

Short-sellers are inviting regulatory targets for three reasons. First, they are apple-cart-upsetting contrarians. This does not sit well with the powers that be, particularly including incumbent managers, who rely on favorable assessments of the activities to stay in power.

Second, opponents of short-sellers gain traction from naïve populist theories of capitalism. Short-selling seems to be “mere” speculation, therefore zero-sum, not socially productive.

Third, short-selling in fact is often accompanied by bad manipulation – since short-selling is short-term speculation, there’s a temptation to make prices move in the short term by spreading lies. But that's a red herring, because there are general laws against lying and manipulation.

Before succumbing to the temptation to regulate, we must keep in mind that short-sellers are significant potential contributors to market efficiency. Indeed, the SEC rule restricting short-sales (Rule10a-1–10a-2) contributes to market inefficiency by inhibiting arbitrage on the downside. See my Fraud on a Noisy Market for more background. 

The Houston Chronicle's Loren Steffy reminds us (tipped by Tom K) that short-sellers were the first to spot problems at Enron. Short-selling might help nip the next Enron.

The regulation of short-selling is a perfect example of how regulation begets more regulation. For example, if we had more of it, we wouldn’t need to worry as much about analysts being coopted, and hence have less need for the analyst regulation in SOX and for Regulation FD, which is aimed partly at the danger firms will buy off analysts with information.

The attack on short sellers only became a big issue recently when the SEC came after the journalists. (First they came for the short-sellers. . . ). And of course that brings in the First Amendment, which as we all know is designed only for journalists, our most important speakers.

But we shouldn’t let these relatively side issues obscure the essential perversity of attacking short-selling. To the extent that short-sellers break the law, as by manipulating or lying, they should be punished with everybody else. But short-selling is more a solution to market inefficiency than a problem in itself.