You all know the pattern: a short seller publishes a splashy report with attention-grabbing revelations about the operations or financial results of a listed company; the company’s shares decline; and a plaintiffs’ securities class action law firm files a securities class action lawsuit, often based solely on the accusations in the short seller’s report. The defendant company will of course file a motion to dismiss – but how will the court assess the accusations in the short seller’s report for purposes of determining the sufficiency of the plaintiffs’ allegations? In a November 2, 2023, Law360 article (here), Richard Zelichov of the DLA Piper law firm considers the way that courts should consider allegations based on short-seller reports.

Background

These questions surrounding short seller reports takes on a particular urgency because securities class action complaints are so frequently based on short-seller reports. As Columbia Law School Professor Joshua Mitts noted in a post on The CLS Blue Sky Blog (here), the short-sellers and plaintiffs’ securities class action lawyers “enjoy a kind of de facto symbiosis” that is “mutually profitable for both.” 

According to the 2022 Cornerstone Research report on securities class action litigation, there were 23 traditional federal securities class action lawsuits filed in 2022 based on allegations from short-seller reports, representing about 12% of all traditional securities suits filed during the year.  Allegations based on short-seller reports have been a key part of the many SPAC-related securities suits that have been filed in recent months; according to my analysis, 24 of the 66 SPAC-related securities suits that have been filed since January 1, 2021, have involved allegations based on short-seller reports.

A Split of Authority

A split of authority has developed among courts assessing allegations based on short-seller reports as part of motions to dismiss in securities class action lawsuits, according to the Law360 article. One school of thought takes the position that the reliability of short-seller reports is a question of fact that courts cannot resolve on a motion to dismiss. The other school takes the position that courts should apply more careful scrutiny to allegations from short-seller reports, assessing both the reliability of the sources and of the allegations.

The DraftKings SPAC-Related Securities Suit

As an example of a case in which this more careful scrutiny is applied, the Law360 article cites the court’s motion to dismiss ruling in the DraftKings SPAC-related securities class action lawsuit. As discussed here, in July 2021, DraftKings and certain of its directors and officers were sued in a securities suit alleging that DraftKings merger partner had an undisclosed “long and ongoing record of operating in black markets where online gambling is illegal.” As the court noted, almost all of the factual allegations in the complaint were based on a short-seller report.

As discussed here, in January 2023, Southern District of New York Paul Englemayer granted the defendants’ motion to dismiss. “a global deficiency spanning [the plaintiff’s complaint’s] theories of fraud.” The plaintiff’s allegations concerning the merger partner’s business practices “are virtually entirely based on the [short-seller’s] Report, which in turn was largely based on unsourced or anonymously sourced allegations.” Judge Englemayer said that the “threadbare sourcing and the conclusory quality” of the lawsuit’s allegations “are ultimately fatal.”

In reviewing the complaint’s allegations based on the short-seller report, Judge Engelmayer noted two specific ways in which the complaint’s reliance on the short-seller’s report was “problematic.” The first is that, given the short seller’s economic incentive, a short seller’s allegations “must be considered with caution.” Second, the short-seller’s report itself is based on unidentified and unspecified confidential sources; allegations based on confidential sources must meet certain standards to corroborate their reliability – standards that Judge Engelmayer said had not been met here. To the contrary, after reviewing the anonymous sources quoted in the report, Judge Engelmayer say that the statements “suffer from all the indicia of unreliability that have led courts often not to credit attributions to unnamed sources in short-seller reports.”

Given that the complaint “does not adequately allege the fact of operations in black-market countries during the class period, it necessarily does not plead a failure to disclose the risks therefrom.” Because the plaintiff had already twice previously amended his complaint, Judge Engelmayer’s dismissal of the case was without leave to further amend.

Discussion

While no one suggests that allegations based on short-seller reports should be categorically disregarded, there are a host of good reasons why courts assessing allegations based on short-seller reports should go slow and subject the allegations to scrutiny.

First of all, there is an unfortunate history that should not be overlooked of fictitious short-seller reports, with supposed allegations that turn out to be mere fabrications, as discussed here. These concerns are particularly notable when it comes to anonymous or pseudonymous short seller reports. The fact that this kind of thing can happen suggests that everyone, courts included, should approach short-seller reports with caution, particularly when it comes to the identity of the report’s author and the bases and sources on which the reports are based.

As the Ninth Circuit said in the BofI Holding securities lawsuit (here), “we should not credit anonymous posts on a website notorious for self-interested short-sellers trafficking in rumor for their own pecuniary gain.”

Second, the reports often are based on statements of anonymous confidential witnesses. These allegations of course should be subject to the same scrutiny as confidential witness statements in any securities lawsuit complaint. For pleading purposes, the sufficiency of pleadings based on confidential witness statements in short seller reports should require that the witness is described with sufficient particularity to establish their reliability and personal knowledge and the information in the statement is described with sufficient reliable and personal knowledge to be indicative of scienter.

As the Law360 article points out, the usual rules with regard to use of confidential witness statements should apply with even greater force to complaints based on short-seller reports given the short-seller’s economic interest in seeing a company share price decline.

In addition, the confidential witnesses quoted directly in a securities complaint, by contrast to the confidential witness statements in a short-seller’s report, are subject to the corroboration and scrutiny of the plaintiffs’ attorney who is an officer of the court and subject to Rule 11 sanctions. The economically motivated short-seller is subject no such obligations.

Judge Engelmayer’s ruling in the DraftKings case discussed above is significant because of his skeptical reading of the plaintiff’s allegations based on nothing more than the short seller’s report. Judge Engelmayer’s skepticism started with the short seller’s obvious financial incentives to try to drive down the value of DraftKings’ stock. The short seller report’s reliance on unnamed confidential sources, whose statements lacked the requisite indicia of reliability, further deepened his skepticism.

To be sure, Judge Engelmayer did not say that complaints based on short seller reports could never meet the requirements – but the standards are high, and Judge Engelmayer’s analysis suggests that many of the short-seller based complaints may not make it past the pleading stage.

One final note. The Cornerstone Research report cited above with respect to the number of securities class action lawsuits filed in 2022 based on short-seller allegations had one further interesting observation. That is, with respect to the 23 traditional securities class action lawsuits filed in 2022 based on allegations from a short-seller’s report, 19 (or about 83%) were made by just three law firms: The Rosen Law Firm; Pomerantz LLP; and Glancy Prongay & Murray LLP. These firms’ share of the filings referencing short-seller reports greatly exceeded their share of all traditional federal securities class action lawsuit filings in 2022 (54%).