Short-seller reports in SPAC litigation: credible evidence or fabricated self-interest?
The use of Special Purpose Acquisition Companies (SPACs) has exploded in recent years. SPACs are an increasingly popular way for private companies to become publicly traded without undergoing a traditional initial public offering. And the securities litigation has followed: between January 30 2019 and February 22 2022, securities plaintiffs filed a total of 51 SPAC-Related Securities Class Actions. There have been a total of 38 SPAC-related lawsuits filed since January 1 2021, with now at least 7 SPAC-related lawsuits filed in 2022.
Plaintiffs in SPAC cases often rely on short seller reports resulting in a stock drop. See, e.g., In re DraftKings Inc. Securities Litigation, case no. 21-cv-05739 (S.D.N.Y.); In re Clover Health Investments, Corp. Securities Litigation, case no. 21-cv-00096 (M.D. Tenn.); In Re Lordstown Motors Corp. Securities Litigation, case no. 21-cv-00616 (N.D. Ohio); In Re Hyzon Motors Inc. Securities Litigation, case no. 21-cv-06612 (W.D.N.Y.). Short-selling allows investors and traders to profit from stocks or other securities when they go down in value. In other words, the short seller succeeds when a company fails.
While some investors will fly under the radar and try to quietly hold these “bet to fail” positions, others actively seek to talk down the price of the securities that they are shorting by publicizing research reports. For example, financial research companies like Hindenburg Research will openly take short positions in publicly traded companies, seeking to expose corporate malfeasance by disseminating the adverse findings to the investing public.
Securities plaintiffs continue to rely on these short-seller reports to substantiate their claims. For instance, a recent survey published on Law360.com concluded, among other things, that “[a]round 21%, or 27 of 131, of fraud-on-the-market securities class actions rely on short-seller research that affected the price of common stock of the defendant company when the negative information was disseminated to investors”.
At first blush, litigation based on short seller reports would appear to hold little merit given the inherently self-interested nature of these disclosures. Indeed, courts have stated that short sellers “operate by speculating that the price of a security will decrease” and that “[a]lthough short sellers can perform a useful function by bringing information that securities are overvalued to the market,” they also “have an obvious motive to exaggerate the infirmities of the securities in which they speculate.” Long Miao v. Fanhua, Inc., 442 F. Supp. 3d 774, 801 (S.D.N.Y. 2020).
However, depending on the nature of the short-seller report, this criticism does not always lead to a litigation off-ramp for defendants. For example, the United States District Court for the Northern District of California recently weighed in on short-seller reports in In re Quantumscape Securities Class Action Litigation, No. 3:21-CV-00058-WHO, 2022 WL 137729, at *9 (N.D. Cal. Jan. 14, 2022). In Quantumscape, the Court held that while a short seller report “may raise credibility issues for a factfinder,” the actual “substance of the report” may be “sufficient to survive a challenge at the pleadings stage,” where the reporting entity interviewed company “employees” and “experts” about its conclusions. Id.
In In re Hebron Tech. Co., Ltd. Sec. Litig., No. 20 CIV. 4420 (PAE), 2021 WL 4341500, at *13 (S.D.N.Y. Sept. 22, 2021), defendants moved to dismiss and argued, among other things, that the action should be dismissed “because it relies almost exclusively on a single short-seller report.” In rejecting these arguments, the Court noted “[t]here is no rule categorically excluding allegations derived from such sources” and stated:
Where there is a basis to view the short seller's factual allegations as reliable as opposed to fabricated based on self-interest—for example, where facts are cited that tend to substantiate these allegations or reveal the basis for the short-seller's factual assertions—those allegations are more apt to be viewed as reliable. Id.
In light of these recent decisions, the fact that a securities litigation is driven by a short-seller report is not the end of the story. Instead, the key issue is the substance of the report. Therefore, when evaluating these lawsuits, defendants and D&O insurers should ask:
- Is there a basis to view the report as reliable as opposed to simply driven by self-interest?
- Does the short-seller report cite specific facts to substantiate the allegations?
- Does the short-seller report rely on actual due diligence such as expert analysis and interviews with company employees?
The answers to these questions can mean the difference between a case dismissed at the pleadings stage, and a case that creates potential exposure for both defendants and D&O insurers. As the frenzy of SPAC litigation continues, we will be watching this issue closely.