Outsider Trading
May 3, 2012 2:49 AM Subscribe
Suppose I was in a position to financially damage a company. Assume that I have no involvement whatsoever with the target company. Would it be illegal/immoral to short their stock right before doing so?
Scenario 1) I’ve just invented cold fusion. Yay, postscarcity society! Terrible news for GE Wind Energy, though, since basically free power will compete them out of business. I short their stock the day before I make the announcement.
Scenario 2) I’ve discovered that McDonald’s hamburger meat is soylent green is people! Suppose I can prove it. I short their stock the day before I go public.
google google Previously, Mark Cuban, owner of Sharesleuth, has made Scenario 2 his business model.
This is different from making false statements to manipulate the short term behaviour of the market. Falsely declaring “Iphones cause smallpox!” to exploit credulous people is very illegal. I’m talking about causing real, long-term damage by suddenly exposing the target company to competition or scorn.
What do you think? Does it change your answer if I’m open about what I’m doing? “Cold fusion! By the way, I just shorted GE wind and so should y’all.” I’m not sure whether saying that would be pleasantly transparent or whether it would only make things more complicated.
I'm asking because this seems to be widely considered to be shady, though I don't quite understand why. What obligation does someone like Cuban have to protect people who own shares in a bad company?
I'm asking a hypothetical question. No, you are not my lawyer, nor do your comments here constitute legal advice.
Scenario 1) I’ve just invented cold fusion. Yay, postscarcity society! Terrible news for GE Wind Energy, though, since basically free power will compete them out of business. I short their stock the day before I make the announcement.
Scenario 2) I’ve discovered that McDonald’s hamburger meat is soylent green is people! Suppose I can prove it. I short their stock the day before I go public.
google google Previously, Mark Cuban, owner of Sharesleuth, has made Scenario 2 his business model.
This is different from making false statements to manipulate the short term behaviour of the market. Falsely declaring “Iphones cause smallpox!” to exploit credulous people is very illegal. I’m talking about causing real, long-term damage by suddenly exposing the target company to competition or scorn.
What do you think? Does it change your answer if I’m open about what I’m doing? “Cold fusion! By the way, I just shorted GE wind and so should y’all.” I’m not sure whether saying that would be pleasantly transparent or whether it would only make things more complicated.
I'm asking because this seems to be widely considered to be shady, though I don't quite understand why. What obligation does someone like Cuban have to protect people who own shares in a bad company?
I'm asking a hypothetical question. No, you are not my lawyer, nor do your comments here constitute legal advice.
To me, an important ethical consideration is: Are you only taking advantage from honest circumstance that came your way, or did you set out to profit by wiping out market value?
I see the former as ethical. I think Scenario 1 qualifies, regardless of whether you're transparent about what you're doing. You believe the product of an unrelated company will fail because you believe you can make a better one. That's fair game in every sense.
The later (setting out specifically to find ways of wiping out value) might be ethical, but may not be, depending on more factors. Obviously, even doing this in the most malicious fashion can be doing the free market a service if you are uncovering knowledge that aids investors/shareholders in making genuinely and significantly more informed decisions, or you help level the playing field by ruining a dirty player. But it can also harm the free market, for example, if all companies had skeletons in the closet, but the people exposing the skeletons selectively and unfairly target companies by agenda, creating a false perception that certain kinds of company are better than others, leading to investment becoming misdirected. That agenda may happen by default. For example, people looking for skeletons will seek the lowest hanging fruit, and it might be the case that companies that invest heavily in R&D instead of tax-shelter lawyers might simultaneously be better for society and more vulnerable to having their skeletons revealed, than a company that spends their money on hiding the evidence of the same wrongdoing.
Whether free markets themselves are ethical is beside the point, having been already addressed by society having made the decision to have one. Since there is a market, and society wishes and intends it to be a free market, then whether you actions overall are supporting or sabotaging that endeavour is the ethical consideration.
The law, as always, is a necessarily crude (and unnecessarily corrupt) attempt at reflecting ethics, and legalities may or may not reflect what is ethical. The last few years have shown pretty clearly that a lot of extremely unethical behaviour is perfectly legal, and naturally much suffering has resulted.
posted by -harlequin- at 3:23 AM on May 3, 2012 [2 favorites]
I see the former as ethical. I think Scenario 1 qualifies, regardless of whether you're transparent about what you're doing. You believe the product of an unrelated company will fail because you believe you can make a better one. That's fair game in every sense.
The later (setting out specifically to find ways of wiping out value) might be ethical, but may not be, depending on more factors. Obviously, even doing this in the most malicious fashion can be doing the free market a service if you are uncovering knowledge that aids investors/shareholders in making genuinely and significantly more informed decisions, or you help level the playing field by ruining a dirty player. But it can also harm the free market, for example, if all companies had skeletons in the closet, but the people exposing the skeletons selectively and unfairly target companies by agenda, creating a false perception that certain kinds of company are better than others, leading to investment becoming misdirected. That agenda may happen by default. For example, people looking for skeletons will seek the lowest hanging fruit, and it might be the case that companies that invest heavily in R&D instead of tax-shelter lawyers might simultaneously be better for society and more vulnerable to having their skeletons revealed, than a company that spends their money on hiding the evidence of the same wrongdoing.
Whether free markets themselves are ethical is beside the point, having been already addressed by society having made the decision to have one. Since there is a market, and society wishes and intends it to be a free market, then whether you actions overall are supporting or sabotaging that endeavour is the ethical consideration.
The law, as always, is a necessarily crude (and unnecessarily corrupt) attempt at reflecting ethics, and legalities may or may not reflect what is ethical. The last few years have shown pretty clearly that a lot of extremely unethical behaviour is perfectly legal, and naturally much suffering has resulted.
posted by -harlequin- at 3:23 AM on May 3, 2012 [2 favorites]
There's some debate about whether it's sketchy, however. For instance, the famed short seller David Einhorn asked a couple skeptical questions during a Herbalife earnings call just the other day --- the stock immediately dropped 20%.
The SEC can also put in place regulations over shorting -- they temporarily banned it during the financial crisis. This was not regarded as one of their brighter moves, but just pointing out that there have in the past sometimes been restrictions on this activity and there could be again.
posted by Diablevert at 3:30 AM on May 3, 2012 [1 favorite]
The SEC can also put in place regulations over shorting -- they temporarily banned it during the financial crisis. This was not regarded as one of their brighter moves, but just pointing out that there have in the past sometimes been restrictions on this activity and there could be again.
posted by Diablevert at 3:30 AM on May 3, 2012 [1 favorite]
As I understand, it's not de facto illegal. There may be an investigation if there's enough market movement to constitute allegations of fraud or manipulation.
To think through it:
If it's not insider trading, and you are not making fraudulent accusations, then essentially you are speculating that whatever amazing news you have will move the market. It's a bet, essentially. In both examples provided, I don't think it's logical that the stocks would tank.
You invent cold-fusion. Nobody's going to believe you until you prove it. Even when you have proven it, it has to be tested, approved, replicated etc. That all takes time and whilst GE's value may dwindle in time, I doubt you would crash the stock, especially because many of the barriers to renewable energy today are not technology-driven but have to do with subsidies and regulation.
As far as the McDonalds example, it's just not true, is it. It's impossible to even deal with that hypothetical because it's fantasy.
A more likely example would be if you came up with an internal combustion engine with 60% thermal efficiency (2x gas mileage. 60mpg cars get 120mpg instantly). That is disruptive. Should you short Ford or BMW? Probably not because the market isn't going to care. So you have invented a new engine. So what. Let's say you had a factory ready to go and produced 500k cars already available at the announcement. And all those cars sold instantly. That's a small fraction of the global auto market, and your competitors still have a valuable asset base and cash sales.
For a good example, look at the BP during the deep water horizon problem. The stock loses 50% of it's value in two months. But it's not a drop off a cliff nor obvious at the time where bottom is. So how do you short that stock? It could go either way and in essence you're taking a bet.
posted by nickrussell at 3:33 AM on May 3, 2012
To think through it:
If it's not insider trading, and you are not making fraudulent accusations, then essentially you are speculating that whatever amazing news you have will move the market. It's a bet, essentially. In both examples provided, I don't think it's logical that the stocks would tank.
You invent cold-fusion. Nobody's going to believe you until you prove it. Even when you have proven it, it has to be tested, approved, replicated etc. That all takes time and whilst GE's value may dwindle in time, I doubt you would crash the stock, especially because many of the barriers to renewable energy today are not technology-driven but have to do with subsidies and regulation.
As far as the McDonalds example, it's just not true, is it. It's impossible to even deal with that hypothetical because it's fantasy.
A more likely example would be if you came up with an internal combustion engine with 60% thermal efficiency (2x gas mileage. 60mpg cars get 120mpg instantly). That is disruptive. Should you short Ford or BMW? Probably not because the market isn't going to care. So you have invented a new engine. So what. Let's say you had a factory ready to go and produced 500k cars already available at the announcement. And all those cars sold instantly. That's a small fraction of the global auto market, and your competitors still have a valuable asset base and cash sales.
For a good example, look at the BP during the deep water horizon problem. The stock loses 50% of it's value in two months. But it's not a drop off a cliff nor obvious at the time where bottom is. So how do you short that stock? It could go either way and in essence you're taking a bet.
posted by nickrussell at 3:33 AM on May 3, 2012
Best answer: Another consideration: Are you making money from the difference between the market before the news, and the market after having evaluated the news or are you, rather of attempting to inform the market, actually kind of attempting to maximise shock/panic/fear so you can exploit a the difference between the market before the news, and the market in the midst of flinching before it recovers somewhat once its had a chance to more fully digest and evaluates the news.
Unstable markets may be good for traders but are bad for society, therefore actions that have the intention of increasing instability are ethically questionable.
posted by -harlequin- at 3:43 AM on May 3, 2012 [2 favorites]
Unstable markets may be good for traders but are bad for society, therefore actions that have the intention of increasing instability are ethically questionable.
posted by -harlequin- at 3:43 AM on May 3, 2012 [2 favorites]
As far as the McDonalds example, it's just not true, is it. It's impossible to even deal with that hypothetical because it's fantasy.
Not really. If it helps, replace the words "soylent green" with "soylent pink". Ie the pink slime scenario which just did happen. The consumer disgust meter only goes to 3 instead of up to 11, but it's otherwise the same scenario. (Soylent green, like pink slime, was legal)
posted by -harlequin- at 3:50 AM on May 3, 2012
Not really. If it helps, replace the words "soylent green" with "soylent pink". Ie the pink slime scenario which just did happen. The consumer disgust meter only goes to 3 instead of up to 11, but it's otherwise the same scenario. (Soylent green, like pink slime, was legal)
posted by -harlequin- at 3:50 AM on May 3, 2012
So then by this logic you also have to opposed to whistleblower laws that offer a monetary reward.
Assuming 1) the controversy is legitimate 2)You entered into a short position and announced the news in a very timely fashion, then its hard to see what is unethical about this.
Short-selling doesn't really create market volatility, whether you have a position in the shares before the news is announced or not those share will behave in a similar fashion. Actually if you waited until after the news was announced, you would be adding to the volatility because you would be another person selling when there are no buyers.
But it can also harm the free market, for example, if all companies had skeletons in the closet, but the people exposing the skeletons selectively and unfairly target companies by agenda, creating a false perception that certain kinds of company are better than others, leading to investment becoming misdirected. That agenda may happen by default. For example, people looking for skeletons will seek the lowest hanging fruit, and it might be the case that companies that invest heavily in R&D instead of tax-shelter lawyers might simultaneously be better for society and more vulnerable to having their skeletons revealed, than a company that spends their money on hiding the evidence of the same wrongdoing.
This is just an insane speculation fueled by a misunderstanding of what short sellers are all about. BTW - heavy tax-shelter users are always going to raise flags with the fraud hunting short guys, R&D guys won't. The more exotic you do things to avoid taxes, maximize short-term profits, the more that says to skeptical outsiders "These guys are capable of doing something that is outright fraud"
The reality is that most of the high profile short sellers are yelling into the wind about imbalances out there. Enron, Tyco, Sub-Prime Mortgages and the Investment Banks, the entire Housing Bubble, For-Profit Education, Internet Bubble. Those guys were showing up at investment conference for years telling people what was really going on, and they were at best ignored, at worst laughed at.
posted by JPD at 5:45 AM on May 3, 2012
Assuming 1) the controversy is legitimate 2)You entered into a short position and announced the news in a very timely fashion, then its hard to see what is unethical about this.
Short-selling doesn't really create market volatility, whether you have a position in the shares before the news is announced or not those share will behave in a similar fashion. Actually if you waited until after the news was announced, you would be adding to the volatility because you would be another person selling when there are no buyers.
But it can also harm the free market, for example, if all companies had skeletons in the closet, but the people exposing the skeletons selectively and unfairly target companies by agenda, creating a false perception that certain kinds of company are better than others, leading to investment becoming misdirected. That agenda may happen by default. For example, people looking for skeletons will seek the lowest hanging fruit, and it might be the case that companies that invest heavily in R&D instead of tax-shelter lawyers might simultaneously be better for society and more vulnerable to having their skeletons revealed, than a company that spends their money on hiding the evidence of the same wrongdoing.
This is just an insane speculation fueled by a misunderstanding of what short sellers are all about. BTW - heavy tax-shelter users are always going to raise flags with the fraud hunting short guys, R&D guys won't. The more exotic you do things to avoid taxes, maximize short-term profits, the more that says to skeptical outsiders "These guys are capable of doing something that is outright fraud"
The reality is that most of the high profile short sellers are yelling into the wind about imbalances out there. Enron, Tyco, Sub-Prime Mortgages and the Investment Banks, the entire Housing Bubble, For-Profit Education, Internet Bubble. Those guys were showing up at investment conference for years telling people what was really going on, and they were at best ignored, at worst laughed at.
posted by JPD at 5:45 AM on May 3, 2012
Are you only taking advantage from honest circumstance that came your way, or did you set out to profit by wiping out market value?
Again - assuming what you are doing is truthful, and you don't have a relationship with the company you are short selling, this doesn't matter. The truth is inevitable. Revealing the charade is the right thing to do. If you happened to come across it while seeking to make a profit, it doesn't matter.
The only unethical behavior here is being perpetrated by the company in example 2, because they've lied about what Soylent Green is.
Now - I think the ethics of things like short selling Lehman Brothers or Herbalife, and then going around telling everyone what you think is going on there, but don't have definitive proof of, is a more gray area. I can see why people object, I happen not to, but I get it. But outright definitive fraud? No question, its not only ethically appropriate, its the right thing to do.
posted by JPD at 5:52 AM on May 3, 2012
Again - assuming what you are doing is truthful, and you don't have a relationship with the company you are short selling, this doesn't matter. The truth is inevitable. Revealing the charade is the right thing to do. If you happened to come across it while seeking to make a profit, it doesn't matter.
The only unethical behavior here is being perpetrated by the company in example 2, because they've lied about what Soylent Green is.
Now - I think the ethics of things like short selling Lehman Brothers or Herbalife, and then going around telling everyone what you think is going on there, but don't have definitive proof of, is a more gray area. I can see why people object, I happen not to, but I get it. But outright definitive fraud? No question, its not only ethically appropriate, its the right thing to do.
posted by JPD at 5:52 AM on May 3, 2012
You are neglecting the important possibility that you might be wrong. The fact of cold fusion SOUNDS like something that would be bad news for GE Wind, but markets are funny things. What if no one believes you? What if not enough people understand the impact? What if GE Wind convinces people that wind power is STILL viable?
Even if nothing goes wrong that way, these things take time, too. It might take WEEKS for the institutional big money to start moving their bets. Considering that you can only short on an up-tick, and that you only have 3 days to cover your losses, you might lose a lot on this. So it's not wrong because even though you know something no one else knows, you can't be sure how the market will react when it finds out. It's still a crapshoot!
posted by ubiquity at 7:37 AM on May 3, 2012
Even if nothing goes wrong that way, these things take time, too. It might take WEEKS for the institutional big money to start moving their bets. Considering that you can only short on an up-tick, and that you only have 3 days to cover your losses, you might lose a lot on this. So it's not wrong because even though you know something no one else knows, you can't be sure how the market will react when it finds out. It's still a crapshoot!
posted by ubiquity at 7:37 AM on May 3, 2012
A short sell is an educated guess, same as any other investment. You may think you have more/better information that allows you to outplay the market, but so do 90% of the other investors out there. It doesn't seem in any way unethical to me. As for legality, it's totally legal for the same reasons (as long as the information revealed is true, of course).
posted by wolfdreams01 at 10:17 AM on May 3, 2012
posted by wolfdreams01 at 10:17 AM on May 3, 2012
It's fair to say when you know enough about how 'news' is going to truly affect a given company, you'll know it's not going to be by much. At least not with news of new competition. You're far more likely to gain from a short by having news that directly harms or conflicts with something the company is already doing or selling. Just saying you've got something "better" does not mean the other company will fail. Such a naive argument fails to take into account just how the other company does business overall, and how your 'revelation' would overcome that. Just announcing news of a better mousetrap does not immediately devalue the other mousetrap makers. Because it's how the whole 'ecosystem' (for lack of a better term) consumes those existing mousetraps that you're competing against, not just the trap design itself. You've got to prove your design overcomes all of the supply chain issues more profitably. This is not likely to happen on a timescale that fits with playing shorts. Nor are you likely to be able to get everything lined up well enough in secret such that an overnight announcement would make the short work.
posted by wkearney99 at 10:54 AM on May 3, 2012
posted by wkearney99 at 10:54 AM on May 3, 2012
Response by poster: It looks like there's some degree of agreement that scenarios 1 and 2 are legal under North American law (a majority plus plausible arguments against points made by minority dissenters). Yeah, I was pretty sure it was legal.
The ethical question is the harder one, and the one I was most interested in. It's interesting to me that business news reporting on Mark Cuban treats him like what he's doing is radioactive. One might almost think that business news reporters are comfortable with shady corporations having impunity to conceal wrongdoing.
I tagged -harlequin-'s comment as best answer because he did a good job of putting into words my nebulous concerns. Making money off of information that will negatively affect a company's value is legitimate, but hyping that information in such a way as to cause (say) a run on the bank just so as to maximize personal profit could perhaps constitute market manipulation even if the information is true.
I see an exception. As of this far in the conversation, I think it would be legitimate to hype the true damaging information in such a way as to cause maximum damage only if the hype is intended as a self-fulfilling prophesy. If the person disclosing the information believes that the information being disclosed reveals ethical/legal wrongdoing so serious that the person disclosing believes the targeted company should be damaged as much as possible, ideally forced to close its doors, then by all means break out the megaphone.
The point I take -harlequin- to be making is that this is ethical only if your intention in shorting is to take advantage of the impact this true information will have on the fundamental health of the company. The reputational danger is that it may be difficult to make it unambiguously clear that you are not trying to manipulate the market -- it might seem sketchy to other people even if your conscience is legitimately clear.
You are neglecting the important possibility that you might be wrong.
Scary thought. I take it that making damaging declarations non-negligently and in good faith would be both legal and moral even if the information later turns out to be false, but boy, I wouldn't want to have to try to prove that good faith in a court of law.
posted by justsomebodythatyouusedtoknow at 11:26 AM on May 3, 2012 [1 favorite]
The ethical question is the harder one, and the one I was most interested in. It's interesting to me that business news reporting on Mark Cuban treats him like what he's doing is radioactive. One might almost think that business news reporters are comfortable with shady corporations having impunity to conceal wrongdoing.
I tagged -harlequin-'s comment as best answer because he did a good job of putting into words my nebulous concerns. Making money off of information that will negatively affect a company's value is legitimate, but hyping that information in such a way as to cause (say) a run on the bank just so as to maximize personal profit could perhaps constitute market manipulation even if the information is true.
I see an exception. As of this far in the conversation, I think it would be legitimate to hype the true damaging information in such a way as to cause maximum damage only if the hype is intended as a self-fulfilling prophesy. If the person disclosing the information believes that the information being disclosed reveals ethical/legal wrongdoing so serious that the person disclosing believes the targeted company should be damaged as much as possible, ideally forced to close its doors, then by all means break out the megaphone.
The point I take -harlequin- to be making is that this is ethical only if your intention in shorting is to take advantage of the impact this true information will have on the fundamental health of the company. The reputational danger is that it may be difficult to make it unambiguously clear that you are not trying to manipulate the market -- it might seem sketchy to other people even if your conscience is legitimately clear.
You are neglecting the important possibility that you might be wrong.
Scary thought. I take it that making damaging declarations non-negligently and in good faith would be both legal and moral even if the information later turns out to be false, but boy, I wouldn't want to have to try to prove that good faith in a court of law.
posted by justsomebodythatyouusedtoknow at 11:26 AM on May 3, 2012 [1 favorite]
This thread is closed to new comments.
Also there is a long list of guys who do what Cuban does, but do it better.
posted by JPD at 3:19 AM on May 3, 2012