This week, in Defeo v. IonQ, the Fourth Circuit headed down a path of holding that short seller reports categorically can never reveal the truth of a fraud to the market – and therefore cannot establish loss causation in a Section 10(b) case – before pulling up at the last minute and concluding maybe they can, if the report is backed up by empirical facts.  In general, though, according to the court, since the reports often rely on anonymous sources that they admit are selected and paraphrased to paint a
negative narrative, they cannot support the element of loss causation in the usual course.

We’ve been here before. It is bizarre to me that courts would look at actual market movement in response to an accusation of fraud and decide, on the pleadings, that no reasonable investor would take the accusation seriously.  They did!  They did take it seriously, right there. You can tell because the stock price went down.

The concern that is transparently motivating the court is that the short seller may be misrepresenting the evidence of fraud.  But if that’s the case, there’s an element for that – falsity.  If the plaintiffs cannot establish falsity, that’s reason to dismiss the complaint.  But the Fourth Circuit received the appeal in a procedural posture where loss causation was the only issue on the table, and so that’s what it went with.

Consider the implication here.  Suppose the short seller got it right, and exposed a real fraud.  Later, the company admits to everything.  At that point, the stock price doesn’t move because the truth was already baked in.  Now, injured shareholders have no recourse –  unless courts do that other bizarre thing they do which is assess loss causation not based on what caused the stock price movement, but on whether an allegation that resulted in price movement was ultimately proved to be true at a later date.  Which, once again, is an attempt to express doubt about a claim through the loss causation element even when, by hypothesis, falsity and scienter are well-pled.  That is not the role that loss causation is supposed to play in a securities class action.

Now, one could imagine a scenario where a short seller makes wild, unsubstantiated accusations, triggering a stock price drop, the plaintiff investigates, and it turns out – by pure, stopped-clock luck – the accusations turn out to be true.  In that scenario, the one might say the losses really weren’t caused by the fraud – they were caused by wild accusations.  But, as I previously blogged, doctrinally, the argument would be that wild accusations were an intervening cause unrelated to the original fraud.  Which is a totally fine argument!  But hardly something that can be assessed on the pleadings, and surely not the most plausible inference at the motion to dismiss stage.

No doubt, there is manipulation in the short seller market.  And, apparently, at least some of the time, traders who react to a short seller report are not, in fact, relying on the report in a traditional sense – they’re using it as a kind of Schelling Point to coordinate pump and dumps.  If that’s the case, then, yes, I agree, traders did not “believe” the report and the report should not have been taken to have informed the market.  But, once again, that cannot be assessed based on the pleadings alone – that’s the kind of thing you need real evidence on, which surely can be gathered (looking at commentary on message boards, the history of that particular short-seller and responsive trades, etc).  The Fourth Circuit’s armchair financial analysis, which just assumes away actual market evidence, substitutes doctrine and, perhaps, a distaste for securities litigation, for empirics.

And another thing. On this week’s Shareholder Primacy podcast, Mike Levin and I talk about one of the pending securities class action lawsuits arising out of Elon Musk’s acquisition of Twitter, and about the notion of a Certificate of Bad Corporate Governance.  Here at Apple, here at Spotify, and here at YouTube.