Short Sellers, Short Squeezes, and Securities Fraud.

• Author: Hurt, Christine

1. INTRODUCTION 107 II. BACKGROUND: PRIVATE SECURITIES FRAUD LITIGATION 110 A. Securities Fraud and the Class Action Mechanism 111 1. The Private Securities Litigation Reform Act and the Plaintiff 113 2. Plaintiffs in a Securities Fraud Class Action 115 3. Rule 23 Requirements for Federal Class Actions 116 B. Reliance and the Securities Fraud Class Action 112 III. WHO ARE THE INVESTORS? 118 A. Typical Investors 118 B. Atypical Investors 119 1. Cyberinvestors 119 2. Short Investors and Other Options Traders 120 i. Short Sales 116 ii. Options Trading. 122 3. Financial Institutions 123 C. Atypical Investors and Damages 124 1. Short Sellers 125 2. Options Trader 125 IV. ATYPICAL INVESTORS AND THE SECURITIES FRAUD CLASS ACTION 125 A. Atypical Investors and Standing 126 B. Atypical Investors and Reliance 126 1. Short Sellers 127 2. Other Options Traders 128 C. Atypical Investors and Loss Causation 128 1. Short Sellers 129 2. Options Traders 129 D. Atypical Investors as Members of a Class Action 130 V. LESSONS FROM LEAD PLAINTIFF CONTESTS: ATYPICAL INVESTORS IN THE SPOTLIGHT 130 A. PSLRA and Lead Plaintiffs 131 1. Lead Plaintiff Contests 133 2. Largest Financial Interest 134 3. Typicality and Representativeness 135 B. 2017 Dataset: How Typical are Atypical Lead Plaintiffs? 136 C. In re Tesla, Inc 138 1. The Lead Plaintiff Contest 139 2. Can Only Typical Investors Be Lead Plaintiffs Now? 139 3. Showdown at Trial? 140 VI. SHORT SELLERS AS SECURITIES FRAUD VICTIMS. 141 A. Market Manipulation Against Short Sellers 142 1. Reddit, WallStreetBets, and the Game Stop Short Squeeze 142 2. Short Sellers as Plaintiffs 145 B. Market Manipulation by Short Sellers 147 VII. SAVING SECURITIES FRAUD LITIGATION. 148 A. Amend the Definition of "Security" for Purposes of Section 10 of the Exchange Act 148 B. Adopt Shareholder Holding Periods 149 C. Change Calculation of Damages 149 D. Codify a Reality-Based Rule for Reliance 150 VIII. CONCLUSION 150 I. INTRODUCTION

   Imagine that a products liability class action lawsuit has been filed against an automaker for a design defect that causes the automobile's brakes to fail. Under the law of products liability, owners of the implicated make and model year are potential members of a plaintiff class. One would not expect, however, that class to include the two neighbors who wagered about whether their friend's qualifying vehicle's brakes would fail. Welcome to the wacky world of modern securities fraud class action lawsuits.

   In 1988, the United States Supreme Court in Basic v. Levinson embraced a revolutionary approach to securities fraud litigation. This approach saved the plaintiff securities fraud class action form, (3) and by extension, most private securities fraud litigation under Rule 10b-5. Basic did so by holding that each plaintiff in a purported class did not need to show actual reliance on a particular fraudulent statement of the issuer; instead, a class would get the presumption of reliance because they purchased the shares in a market in which the market price signals to investors all publicly available information. (4) This holding, however, affirmed by Halliburton Co. v. Erica P. John Fund, Inc. ("Halliburton II") (5) is premised on the assumption that investors purchase shares in publicly-traded companies because they believe that the market price, a product of all publicly-available information, reflects the fundamental price. As Justice Thomas noted in his concurrence in Halliburton II, this assumption is not correct. (6)

   Though a typical investor at the time of Basic may have purchased shares in a corporation based on some signal from the market price, many investors in the 2020s do not. In fact, many investors purchase or sell shares because they believe that the market price is false and they intend to benefit from a future market correction. The atypical investor may also trade to hedge positions or trade as a result of predetermined programming. Most notably and controversially, short-sellers most definitely do not rely on the market price signal. Therefore, the concept of a short seller having a securities fraud cause of action does not seem consistent with either the assumptions of Basic or with theories of tort compensation generally. Short-sellers would not rely on the brakes' integrity; they would bet on the brakes to fail.

   In the decades that have followed Basic v. Levinson, attempts to prune the "judicial oak" of private securities fraud claims "grown from little more than a legislative acorn" (7) have continued to threaten its existence. Neither Congressional overhauls (8) nor pro-defendant Supreme Court rulings, (9) however, have rationalized this odd cause of action.

   Moreover, class action securities litigation plays out in an absurd plane. Each side is trying to end the game earlier or later, but neither wants to let the litigation play out until the bitter and expensive end, where the result may either be a finding with no attorney fees for the losing plaintiffs or a potentially enormous damages judgment that results in bankruptcy.

   This Article explores a relatively unexamined legal fiction: the Supreme Court's continued acceptance of the assumption that most investors participate in the market in reliance on the integrity of the market prices and application of rules designed for "typical" investors to an unknown cohort of "atypical" investors, including short-sellers, options traders, algorithmic and high-speed traders, and institutional investors.

   Of all the strange aspects of the class action securities fraud lawsuit, one of the most bizarre is that the courts do not know the identities or investment holdings of the members of the class until a damages phase, if any, or a settlement claims process. (10) The identities and investment positions of class members can be revealed to the public in the contest to be the lead plaintiff for the class, however. Recent cases involving short sellers applying to be lead plaintiffs reveal that short sellers are probably not rare among the universe of investors in the United States capital markets. (11) Though Chief Justice John Roberts reasoned that only "the occasional investor" will be an atypical investor that does not rely on the signal of the market share price, (12) these atypical investors may in fact be the most typical investor.

   Little scholarship has seriously considered how short sellers and other atypical traders fit into the existing securities fraud paradigm. In particular, the existing literature does not address whether, when, and to what extent atypical investors should be lead plaintiffs or plaintiffs at all, given the goals of the securities fraud cause of action and, more specifically, congressional and judicial attempts to rationalize securities fraud class actions. Building on an analysis of all securities fraud cases filed in federal court in 2017, this Article paints a more accurate picture of the universe of traders than the universe presumed by the Supreme Court in Basic and Halliburton II. In addition, this Article examines the most vigorous lead plaintiff contest in recent memory, arising in litigation surrounding Elon Musk's August 2018 "taking Tesla private" Twitter post; the tweet that launched a thousand lawsuits. (13) This data and the lead plaintiff fight among atypical traders in Tesla securities (14) highlights the importance both of understanding existing district court practice and of developing normative theories to help regulators and judges assess atypical investors' lead plaintiff motions going forward.

   This inquiry is made even more cogent and timely by recent examples of short sellers not only being lead plaintiffs in securities fraud lawsuits, (15) but also being alleged targets and perpetrators of securities fraud and market manipulation themselves. (16) Generally, when an issuer makes false statements, its motivation is to avoid shareholder losses and maintain share price. However, securities fraud class actions have been filed against Tesla, Inc. (17) and Overstock.com (18) alleging, with evidentiary support, that the makers of false statements did so with the intent to harm traders with short positions in the stock. The enmity between issuer and short seller is well understood, but the use of securities fraud lawsuits as a remedy for the "short squeeze" tactic is not. This issue is even muddier when those traders initiating the short squeeze are not associated with the issuer, as in the recent case involving GameStop Corp. (19)

   This Article contends that preventing short sellers from participating in securities fraud class actions promotes not only the public interest goals of securities fraud lawsuits, but also the efficiency goals of the Private Securities Litigation Reform Act ("PSLRA"). Making short sellers ineligible improves the manageability of a class action lawsuit and the choice of lead plaintiff. In addition, excluding damages that emanate from short positions shrinks the universe of potential damages, creating less of an incentive for defendants to settle or invest huge resources in class certification fights rather than proceed to trial. Most importantly, this Article argues that short sellers should not benefit from the Basic presumption; therefore, their inclusion in any prospective class of typical traders should jeopardize class certification.

   Part II provides background on securities fraud class actions, and Part III explores the different types of investors in the modern securities markets. The atypical, or nontraditional, investor is then placed into existing securities fraud class action jurisprudence in Part IV to throw in stark relief some of the misalignments between atypical investors and securities fraud doctrine. Part V focuses on atypical investors acting as lead plaintiffs in securities fraud cases, including the Tesla litigation, and Part VI specifically examines short sellers in various securities fraud contexts. Part VII...