Illustration by II
Last June, a relatively obscure short seller shook the financial world by settling a defamation lawsuit regarding his 2018 short of Farmland Partners, a real estate investment trust. Such settlements are rare, but in this case, Quinton Mathews, a Dallas-based researcher writing under the pseudonym Rota Fortunae, admitted making false statements about Farmland in a Seeking Alpha blogpost and profiting from short-dated put options ahead of its publication.
Mathews’ admissions, made in a federal court case for what has been billed as a “short and distort” scheme, appear to have put him in the crosshairs of the Department of Justice. Before he settled the lawsuit, Mathews was personally questioned by Justin Weitz, the acting principal assistant chief of the DOJ’s criminal division’s fraud section in Washington, D.C., according to an individual with knowledge of the situation.
Weitz is the top prosecutor in a wide-ranging probe of short sellers, according to that individual. While the probe’s existence is well known, Weitz’s role has not previously been reported.
Activist short sellers who’ve received subpoenas and warrants for trading records, phones, computers, emails, and other materials have told Institutional Investor that they don’t know what the feds are after. But the Farmland saga connects some of the dots.
Two short sellers Mathews worked with on a short of Banc of California — Muddy Waters’ Carson Block and pseudonymous short seller Marcus Aurelius Value — were among those who came under investigation within months of Mathews’ settlement. (Mathews did not return repeated requests for comment, while Block and Aurelius Value declined to comment on the probe.)
Meanwhile, the DOJ’s Weitz has ties to Columbia Law School associate professor Joshua Mitts, who was an expert witness in the Farmland case and is also a consultant to the DOJ. He is working with it on the investigation.
In his academic research, Mitts — who has invited Weitz to speak at his class at Columbia — referred to Weitz’s writings on a relatively new statute that broadens the scope of securities fraud prosecutions. That law has been used in cases of market manipulation known as spoofing — and spoofing is one of the theories the DOJ is considering in its investigation.
Farmland was the first corporate consultancy gig Mitts took on just months after publishing an academic paper titled “Short and Distort,” which outlined his theory of market manipulation by short sellers. Within a year, he had been hired by at least two other companies that have tangled with short sellers: Burford Capital and Banc of California.
While the concept of short and distort first gained widespread public attention during Farmland’s lawsuit against Mathews, it now appears to be a driving force behind the probe. In fact, the professor’s role led Block to call Mitts the “tip of the spear in the War Against Shorts” on Twitter.
Mitts claims to have found that shares in companies subject to short reports published on Seeking Alpha by pseudonymous bloggers crashed, then recovered quickly in a V-shape pattern — which the professor argues is evidence of manipulation. However, as I first reported in The New York Times, Block has shown that Mitts’s conclusions are flawed, in part because almost 80 percent of the authors whose reports he analyzed said they weren’t actually short the stocks they wrote about. Much of the elevated trading Mitts found simply occurred around earnings announcements, according to Block.
In a recent white paper, the Muddy Waters founder alleged that the professor’s conflicts of interest “raise the prospect that his conduct rises to the level of academic fraud.” (Mitts declined to comment on the accusations.)
Companies targeted by activist short sellers typically face a high bar in winning defamation cases, and not just because truth is a defense. Opinions are shielded by the First Amendment, and in many states, anti-SLAPP (strategic lawsuits against public participation) statutes add another layer of protection for critics. Moreover, the short sellers don’t typically base their reports on material nonpublic information about companies, so they aren’t likely to be prosecuted for insider trading.
Mitts’s short-and-distort analysis provides another cudgel for companies and regulators by arguing that the trading around the reports is, or should be, illegal market manipulation. Block calls it an “end-run around the First Amendment.”
A core tenet of Mitts’s thesis is that the activist short sellers not only cover their shorts once a report is released but, knowing their allegations are false, immediately go long the stocks and profit on the turnaround. (In one instance where Block was accused of just that, he made a point of denying it in a federal court filing, saying Muddy Waters “was never net long” the stock in question and that “any equity purchases were made to cover short positions.”)
Weitz says false allegations aren’t even necessary for a crime to have been committed. In an article titled “A Workhorse Statute for Prosecutors,” published in the DOJ’s Journal of Federal Law and Practice in 2018, Weitz and his colleague Sandra Moser, acting chief of the fraud section in DOJ’s criminal division, wrote that reforms enacted in the Sarbanes-Oxley Act of 2002 have led courts to rule that deceptive conduct need not include false statements or misrepresentations. They mentioned two spoofing cases to make their point.
But it may be difficult to make spoofing charges stick to activist short sellers. Spoofing involves making a trade, then quickly canceling it — and doing that over and over again to lower the price of a security in order to buy it on the cheap. One of the difficulties in proving a spoofing case is that activist short sellers say they do not have the technological capability to do the rapid-fire trading in massive scale that it requires.
Indeed, the prior cases involving spoofing have involved algorithmic or high-frequency traders — the type of traders that short sellers worry may be trading ahead of them.
As Bloomberg columnist Matt Levine noted about spoofing, “It is small-scale, in both price and time. Spoofing is a way to buy stock at $10.00 instead of $10.03; it’s a way to save a couple of pennies, at most, on a trade.”
Says Levine: “If you are making your living as a criminal spoofer you are doing it a lot, back and forth all day every day. If you are an activist short seller the way you make the stock go down is by publishing your report, and if that works the stock goes down a lot, once. Adding spoofing to that doesn’t really make sense.”
In the only case involving activist short sellers where spoofing has had a hearing, the theory was debunked. In London litigation financier Burford Capital’s effort to obtain trading records from the London Stock Exchange regarding a Muddy Waters short, Mitts argued that the trading, based on data he had obtained, amounted to spoofing.
(The judge did not allow them to go on a fishing expedition based on Mitts’ analysis of the trading data. The trading data doesn’t show who is trading, and without that, Burford couldn’t sue individuals or firms.)
The London judge overseeing the Burford case eviscerated Mitts in his ruling. Justice Andrew Baker repeatedly called out the professor’s arguments about spoofing, saying they were “speculative” and lacking “evidence,” and repudiated them for their “inherent weakness.” He then dismissed the case.
Justice Baker quoted the London Stock Exchange to explain what actually happened: “The fall in the share price needs no explanation beyond sustained selling in response to the Muddy Waters tweets and the herd behavior of the (genuine) market.”
Despite what may be limitations to Mitts’s theories, the professor’s analysis of the trading in a specific short target still might be at least part of the probable cause needed to get a search warrant, securities attorneys say.
Following the issuance of subpoenas and search warrants by the DOJ last October, the wide-ranging federal investigation appears to be progressing slowly. People familiar with the details say there has been a shakeup in the DOJ staff, as one of the key prosecutors left the government last December.
Alex Wyman, who was an assistant U.S. attorney for the Central District of California — and whose name is on the subpoenas — left to join law firm Latham & Watkins that month. He will be in familiar company: According to emails II has seen, several partners at Latham have represented companies that pressed both the Securities and Exchange Commission and the DOJ to investigate the activist short sellers who targeted them.
