The Dark Money Secretly Bankrolling Activist Short-Sellers — and the Insiders Trying to Expose It

Illustrations by Cathyrn Virginia

Illustrations by Cathyrn Virginia

That detailed report on a company’s misdeeds may not be what it seems.

John Fichthorn had been in the hedge fund business for more than 20 years when a half-hour phone call with a stranger put him on high alert.

In December 2017, Fichthorn — a veteran short-seller and the founder of hedge fund Dialectic Capital Management — had joined the board of a troubled small-cap company called Health Insurance Innovations. But when he happened to mention its name to a prospective investor a year later, the man told him an alarming detail.

“There’s a multibillion-dollar fund out there going around with a short report trying to pay people to publish it on their behalf,” Fichthorn recalls the man saying.

“He was very nervous about telling me any of this,” says Fichthorn. Short-sellers soon began pounding the stock, so he called the man back and says he finally convinced him to provide the alleged name behind the offer. According to Fichthorn, that name was a Hong Kong-based hedge fund.

“Who the fuck is that?” thought Fichthorn.

Fichthorn may never have heard of the fund, but it has become well known in short-seller circles for being what’s called the “balance sheet” behind some of the activists who trumpet their short research on social media — a phenomenon that has turned the world of short-selling upside down over the past decade. These noisy activists, many of whom are anonymous and have little money of their own, have taken on outsize importance during a time when the bull market has ravaged short-sellers and a Twitter mention can move a stock.

Fichthorn, of course, is from the pre-social-media era. The 47-year-old launched Dialectic in 2004 after a stint at Maverick Capital, the Tiger Cub headed by Lee Ainslie III, who learned the trade under famed hedge fund pioneer Julian Robertson. Behind the scenes, Fichthorn has been involved in some of the most well-known short bets of recent years, including Wirecard, the German financial firm that collapsed in scandal in June, and MiMedx Group, the Georgia biomedical company whose former CEO was charged with fraud by the Department of Justice — years after Fichthorn contacted the DOJ with such allegations.

“I thought my role in life was to be the cop in the markets,” he says.

That’s of course exactly what the activist short-sellers say. More than a dozen short-sellers interviewed by Institutional Investor in an effort to penetrate this murky terrain say there are numerous players and various permutations of the model that may involve the sharing of ideas and research along with either a cut of the gains on the short trade or a set fee. In fact, some short-sellers believe that almost all of the activists have such backing — even those running small hedge funds themselves.

Wary of both reputation risk and litigation risk — and eager to avoid the drama that swirls around activist short-sellers — some hedge funds even give away their research for free to the activists. The hope is that, once publicized, a damning report will be the catalyst for a downward move in a stock they’ve shorted.

The backdrop for all this is the stock market’s relentless rise, which in recent years has brutalized short-selling. Many short-biased hedge funds have either shut down or bled assets; industry insiders say that more could close shop in 2020.

Into this vacuum has stepped a slew of upstarts, often touting their research on Seeking Alpha and posting links to their blogposts on Twitter. As of October 21, 38 activist short-sellers — many anonymous — had published short research on 128 companies this year, according to Activist Insight Shorts, which tracks the naysayers. The Bear Cave, a weekly online newsletter, reported that during one week in October alone, eight new short research pieces were published.

The trend has raised alarms — and not just from the companies they target. Seasoned short-sellers say the information overload risks “commoditizing” the research and also raises red flags about its originality, accuracy, and depth. Critics also note that reports sometimes arrive just prior to the expiration of options that can send stocks into a tailspin, risking market manipulation allegations. They also fear that these problems could lead to tougher regulation of short-selling, which could make it even less profitable — and allow frauds to go unchecked in the markets.

Short of a court order or federal investigation, however, it is impossible to know who is behind the action.

But there are clues.

Start with Carson Block, the founder of Muddy Waters Capital, who launched the new breed of short-seller activist in 2011 with his blockbuster research on Sino-Forest Corp., a Toronto-listed Chinese company whose investors included then-hedge fund star John Paulson. Block also appears to have pioneered the balance-sheet approach. And now that he runs a hedge fund with more than $200 million under management, Block occasionally offers such financial support to other short activists whose research he deems worthwhile.

“There are some firms out there that are in the balance-sheet business,” asserts Block. “Full disclosure: We are.”

He declined to say which activists he has funded. However, Muddy Waters has an investment in Wolfpack Research, which was launched last year by short-seller Dan David.

A decade ago, Block was living in Shanghai and running a money-losing storage business when he authored his first short report, alleging that a New York Stock Exchange-listed Chinese company called Orient Paper was a fraud. The next year, he decided to look for a balance-sheet partner, using one exclusively until 2013.

“When I started out, I had no money. I had negative net worth,” he says. “So I worked with balance-sheet partners.”

Block declined to say who his original balance-sheet partner was. According to The Wall Street Journal, Block sold his research on Rino International Corp., another suspected Chinese fraud, to Oasis Management, as well as to other hedge funds, in 2010. That was just before Block says he turned to the balance-sheet model, offering his research reports to a single fund for a cut of its profits on the trade.

Muddy Waters’ next big short was Sino-Forest, and Oasis was short that Chinese company three weeks ahead of Block’s report, according to a lawsuit Oasis filed in London in an effort to get Morgan Stanley to pay the $9.3 million Oasis claimed it was owed by the investment bank for its Sino-Forest puts.

Oasis founder Seth Fischer and portfolio manager Alexander Shoghi did not respond to requests for comment for this story.

Block defends the practice, saying it is a collaborative effort that benefits both parties.

“Activist short-selling is a hardscrabble life,” he says. “It’s actually a shitty business for a number of reasons. One of the reasons is that it’s subscale. There are very few activist short-sellers who can regularly short names that have real capacity in the trade,” he explains.

Most don’t have enough capital to start a hedge fund. “If your trade capacity is around five to ten to 25 million dollars, that doesn’t justify raising a fund. You won’t be able to generate returns on that.”

Instead, Block says, with a balance-sheet partner “the performance fee is effectively paid by a hedge fund. It has the capital and the institutional pipes.” Short-sellers borrow stock, hoping to pay it back at a lower price and profit on the differential. Hedge funds have relationships with prime brokers at investment banks that can lend them shares — relationships Block found he could not form in the early days.

“A lot of these names — U.S.-listed Chinese scams — were hard to borrow,” he recalls. “We went to the big, pretty institutional primes who had access to borrow, and they told us we were too small and controversial.”

Big hedge funds also have analysts who can call both the companies and sell-side analysts to get information they aren’t going to reveal to a known activist short-seller. Perhaps most importantly, a balance-sheet partner can also provide legal support, which can run up to $1 million if the short-seller gets sued or investigated by a regulator, Block says.

From their end, hedge funds prefer to work in the shadows for a number of reasons — one being that their own investors, particularly institutional investors like endowments and sovereign wealth funds, may look askance at short activism.

One case famous in financial circles involved one of the largest and oldest hedge funds, whose investors know it as one that “never shorts,” says someone familiar with the details.

That hedge fund was the balance sheet behind Harry Markopolos’s short report on General Electric Co., which he released last August.

Markopolos, a former Wall Street portfolio manager whose claim to fame was warning the Securities and Exchange Commission about the Madoff Ponzi scheme years before it collapsed, has since served as a whistleblower to the government in other cases, notably the investigation of insurer AmTrust Financial, which settled with the SEC this summer over charges related to its accounting for losses from insurance claims.

When he took on GE, Markopolos disclosed that he had given the report to a major hedge fund that had veered from its long-only stance to short GE and that he would be paid a percentage of the gains from the bet. He had no control over the trading.

Markopolos also noted that he had turned over the report to regulators. “If you do SEC fraud cases and bust fraud guys, you better be transparent,” says an individual knowledgeable about his thinking.

The stock fell 14 percent on the report, which claimed that GE was under-reserving for its long-term health insurance claims. But the focus quickly shifted to an excoriation of Markopolos’s arrangement with the hedge fund, and the stock ticked back up.

GE investors like Citron Research’s Andrew Left — who is better known as a short-seller — attacked Markopolos’s deal and said he had never been compensated by a third party to publish research. Then hedge fund billionaire Stanley Druckenmiller jumped in, saying he had added to his position in the stock. GE CEO Larry Culp denied Markopolos’s accusations.

“Unfortunately, when Markopolos disclosed that he was working with a balance-sheet firm, he was unable to keep the focus on his work, and the media seemed distracted by what is really a faux salacious detail,” says Block.

Today, the famous whistleblower appears to have been vindicated: GE reported in October that it had received a Wells notice from the SEC — a warning that the agency may take enforcement actions — over the very issues Markopolos had highlighted.

Given the blowback, if Markopolos were to do another short report for a hedge fund, he would insist on more disclosure, says the individual familiar with his thinking. He “would only do it with a hedge fund side by side — and public,” this person says. “It’s easier if the backers are disclosed, and the reason is that the people should focus on the research and not on attacking it for being [tied to] an ‘evil’ hedge fund.”

When it comes to short-selling, however, disclosure is not something most hedge funds want.


John Fichthorn

Short-sellers are part of a clubby, cantankerous community that has derisively been called a cabal. They often share research and reinforce each other with what are called “pile on” trades. There is nothing inherently unusual, or illegal, about that. Market participants say that short-sellers at hedge funds skilled in the strategy, like Eminence Capital, Valiant Capital Partners, Sophos Capital Management, and Kingsford Capital Management, also pass along research to activists — but they aren’t believed to have offered to finance them.

Citron’s Left is one short-seller these men have turned to to get out their message. For example, a blockbuster short report on Nu Skin Enterprises, a multilevel marketing company, that Citron published in 2012 was research undertaken by another party for Third Point, but Jim Carruthers, who ran Third Point’s equity short book, gave it to Left, according to two individuals familiar with the specifics.

In 2014, Carruthers formed Sophos with seed money from Yale University’s endowment; by the end of last year, it had become the largest dedicated short-seller in the world, with $1.16 billion, according to its ADV filing with the SEC. The hedge fund is so secretive it doesn’t even have a website.

(Left says he does not remember the details surrounding the Nu Skin report. Neither Carruthers nor Valiant responded to a request for comment. Third Point, Kingsford, and Eminence declined to comment.)

“There is a lot of pressure on hedge funds to generate short alpha,” says Fahmi Quadir, the founder of Safkhet Capital, a short-only hedge fund that is not an activist. “You’re doing all this work, and you want to make the profits, so you lean on these activists to make sure it happens.”

For many hedge funds, sharing research is better than a financial arrangement with the activist. “By letting someone else put out the research, then you’re not out there at all and you have total flexibility in how you trade the thing,” says one hedge fund manager. “Once you have a fee arrangement, then it’s a bit problematic.”

Potential legal headaches aren’t the only issue. Hedge funds may have a “belief on a position but don’t want to deal with all the blowback and harassment and the doxing,” says Nathan Anderson, whose Hindenburg Research gained notice after its September short call on electric-truck maker Nikola Corp., which led the SEC and the DOJ to investigate the company and the stock to plummet.

Though Anderson is this year’s hot new short-seller — and says he still has a major short in Nikola — the troubles he has faced make him understand why hedge funds prefer to stay in the background.

“People call me and say they’re going to murder me and my entire family,” he says. Anderson, who worked for years behind the scenes as a fraud investigator and whistleblower before becoming a short-seller in 2017, says he was “naïve” about what it would entail. “Being a public activist is an inherently contentious business.”

Hindenburg has been the most prolific short activist this year, launching 21 campaigns, according to Activist Insight Shorts. The volume of Hindenburg’s reports has raised eyebrows among short-sellers, but Anderson says he can do so many because he has five employees working on research. He also uses outside consultants.

And now that he’s famous for the Nikola short, Anderson says he has gotten more than 50 leads a week “from all over the place.”

“Any market participant will talk to a short activist,” he says, adding that “it’s extremely important to independently vet anything.”

As a relative newcomer, Anderson also turns to others for financing and acknowledges he had a balance-sheet partner for the Nikola short. “If there is more capacity in a trade than we can handle on our own, then we seek to augment with a balance-sheet partner,” he says. “I think that’s pretty standard in the industry.”

He declined to name any of those partners, but he says there is no shortage of money wanting to get in on his action. “We’ve had dozens of offers,” he says.

This year, the stocks Hindenburg has shorted were down an average of 25 percent a month after the release of its reports, according to Activist Insight Shorts. That’s evidence that the stocks continue to fall, not just pop back up in a V shape, which critics have noted can happen if a short-seller covers on the day of the report.

But the existence of the V-shaped pattern elsewhere has led to calls for more disclosure from several places — including, interestingly, from inside the world of short-selling.

In April, outspoken short-seller Marc Cohodes stunned the short-selling community when he teamed up with Joshua Mitts, associate professor at Columbia Law School, to author an op-ed in the Financial Times calling for a mandatory ten-day holding period by a firm or individual after the public dissemination of market-moving information.

To protect themselves from market-manipulation accusations, short activists typically say upfront that they are short the stock of the subject of their report. Buried in the fine print, however, are more details — as well as caveats.

In a recent report, Muddy Waters, whose generic disclosure has been used as a template by others, states that as of the publication of the report, the firm was either long or short the name, “possibly along with or through its members, partners, affiliates, employees, and/or consultants, Muddy Waters Related Persons clients and/or investors and/or their clients and/or investors.” It states these parties may be trading the securities and adds that “neither Muddy Waters Research nor Muddy Waters Capital will update any report or information on its website to reflect changes in positions that may be held by a Muddy Waters Related Person.”

Such language allows the activist — and any balance-sheet partner — to trade in and out at will. But Cohodes argues that it’s not good policy.

“Whether you own shares or are betting against a company, I believe it is misleading to tell investors that you have a specific view on a company and then profit from a trade in the opposite direction,” he wrote.

Cohodes alleged that “many bloggers and social media personalities who promote or attack stocks do not conduct a deep investigation of the companies involved. Instead, they republish theses acquired elsewhere and buy and sell quickly to make a fast buck.”

In a rulemaking proposal to the SEC in February, Mitts, Columbia securities law professor John Coffee, and ten other law professors asked the SEC to force short-sellers who publicize their position to “promptly” say when their disclosure of being short “no longer reflects current holdings or trading intention.” They want short-sellers to make that disclosure within 24 hours of a change in trading or by the beginning of the next day’s trading.

“Rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5,” they argued, referring to the SEC’s anti-fraud rule.

Short-sellers like Block rail against Mitts, dismissing him as a “shill” for corporate clients. (Mitts has worked for corporate plaintiffs in lawsuits filed by at least two known targets of short-sellers, Farmland Partners and Burford Capital; Muddy Waters is short Burford.)

Moreover, activists say the work is so hard that it’s almost imperative to take the money — or at least some of it — and run. It’s simply risk management.

“The vast majority of short activists would not even be viable if their balance sheet wasn’t getting really concentrated in each name . . . then closing out a decent portion of that position,” says one short-seller.

“If you don’t take advantage of the elevated volume, in subsequent days you could start bleeding some money and giving back,” he explains. “You know that on day two, the company comes back with everything they’ve got. And you don’t know how long it’s going to take for the market to become skeptical of management,” he adds. “In the meantime, you could get hit with a lawsuit.”

Short-sellers in the U.S. are protected by the First Amendment, which gives them broad discretion to offer their view on a company as long as it is stated as an opinion they believe to be true. While making false statements is not protected, and companies frequently claim “market manipulation,” cases against short-sellers have been few and far between — as proving illegality hinges on intent.

Mitts says short-selling is good for the markets but nonetheless argues that if the intent of the report is to “crash the price so that you induce a panic and a bunch of selling that wouldn’t have occurred otherwise, that strategy is going to be illegal.”

He is critical of the role of balance-sheet providers and thinks more transparency regarding their involvement would be “better for our markets.”

“If all I’m doing is just putting out my opinion about the company, and I have my short position, why do I need a massive hedge fund?” he asks. “But if the purpose of a balance-sheet partner is to inject so much selling into the stock that it mechanically drives the price down because there’s not enough demand anymore, and that in turn triggers stop losses and triggers other people to sell . . . that may be evidence of manipulative intent.”

“Is the market really reacting to the information, or is the balance-sheet partner crashing the price?” he wonders. “That’s a big question that needs to be asked.”

Mitts also mentions the short-sellers’ use of the word “catalyst” — a term commonly used by traders that refers to what will make the stock move.

“By ‘catalyst’ do you mean you need something to start the snowball so that it starts to pick up momentum on its own and makes a lot of money? And if that’s what we’re talking about, then it’s not clear to me that is legal,” he says.

Mitts raised some of these issues in a declaration filed in support of a defamation lawsuit brought in Colorado federal court in 2018 by Farmland Partners against short activist Rota Fortunae, a front for Quinton Mathews, the managing member of QKM, a Dallas-based registered investment adviser with no assets under management, according to its most recent ADV filing with the SEC. This year, Mathews was forced by the judge to reveal his identity. The short-seller later disclosed the name of the Dallas hedge fund, Sabrepoint Capital Management, that was paying him for his short research on a monthly retainer basis. Sabrepoint is now also a defendant in the case, which is pending. Both Mathews and Sabrepoint have denied the accusations.

Before the Farmland report was issued, put positions were opened in thousands of contracts, according to the Mitts declaration. The trading activity showed that traders had bet the stock would drop precipitously on, or soon after, July 11, 2018 — the day of the report — and had taken an extraordinary derivatives position that would have the effect of inducing a massive sell-off in Farmland stock, Mitts wrote in the court filing.

Here’s how it works in theory: As the stock starts to fall, the puts become more valuable, and market makers who have sold them have to short more shares to hedge against those puts, known as delta hedging. Such selling is likely compounded by algorithmic or high-frequency trading, putting more pressure on the stock and forcing the market makers to continue shorting.

Farmland’s stock has never recovered from the pounding it took, which to Mathews’ mind means he was correct in his assessment of the company. “Nearly two years ago, I published my research on [Farmland Partners]. Six days later, the company issued a public rebuttal that failed to address any of the questions raised in my report or deny any of my findings. Shortly after, the company sued my pseudonym,” he wrote on Seeking Alpha in June.

But companies say it can be hard to recover from an assault that makes creditors and customers wary.

At least that’s how Fichthorn sees it.

Fichthorn declined to give the name of the short-seller who alleged a hedge fund was offering to pay activists to publish its short thesis on Health Insurance Innovations.

But for the next year and a half, short-sellers battered the company on Twitter and elsewhere. One anonymous short activist, Marcus Aurelius Value, wrote five reports on Health Insurance Innovations, starting in November 2018 and ending in June of this year.

Aurelius Value did not respond to a Twitter message asking if he had worked with a balance-sheet partner on the short and, if so, whether the partner provided him with research.

The Capitol Forum, a subscription-based news service that often covers short targets, also wrote articles that hammered the stock. Its stories sometimes came out on the Friday of options expiration, says Fichthorn. “At 11:00 a.m, the stock would start going down, and at 12:00 the company would learn of the article,” he says. “We had an hour to respond.”

At one point, the options action made Health Insurance Innovations the biggest short in the market, with more than 100 percent of the shares shorted, says Fichthorn. “It was kind of ironic that I, as a professional short-seller, was on the board of the company that was the most shorted stock in the market.”

When II approached Capitol Forum reporter Vikas Kumar about the stories, he demanded proof from II’s editor-in-chief that this writer was working for II. Eventually, Jake Williams, Capitol Forum’s COO, told II that it was not approached by a hedge fund to run negative research about Health Insurance Innovations. “We’re an objective investigative news organization and would not accept such an offer from any company or on any topic,” he said in an email.

For their part, short-sellers say they based their case on the company’s use of boiler-room tactics to sell worthless insurance products. At least one lawsuit by individuals claiming to have been victimized by the company is still pending.

But Fichthorn says Health Insurance Innovations only offered a platform for brokers to sell products and that state insurance regulators had found no wrongdoing. Moreover, he says he joined the board because new management was trying to “clean up” the company and any legacy problems associated with prior CEOs had been dealt with.

“The reality is if enough of them pile on and write enough bad stuff, they can destroy companies. I watched it from the inside. They called our customers and they were making shit up,” bemoans Fichthorn, pointing specifically to a short-seller rumor that the FBI was at the company’s headquarters. It wasn’t.

In July, the company — which renamed itself Benefytt Technologies earlier this year — was sold to private-equity firm Madison Dearborn Partners for $31 per share — a 40 percent premium to where it was trading at the time.

Before the short-selling drama began, Fichthorn had effectively sold his hedge fund to B. Riley Financial. He recently left that firm and is relaunching Dialectic, but says he is out of the short-selling business for now.

“Someday,” he says wistfully, “it will be worth shorting stocks again.”