Just when it appeared that activist short sellers had finally got a tailwind with rising interest rates and a market shakeout, following a challenging 2021, a Department of Justice (DOJ) investigation into short seller tactics threatens to curtail their activity anew.

Federal prosecutors are investigating whether short sellers including Carson Block’s Muddy Waters and Andrew Left’s Citron Research colluded to push down stock prices by sharing damning research reports on companies before making them public, according to news reports. The DOJ has not made any official statements in connection with the probe.

“To the best of my knowledge, no one knows what exactly the investigation is about,” Left told Activist Insight Shorts in an email. Tens of short sellers are reportedly under investigation, yet some of them that were contacted for this article had only heard about the investigation from news reports. Others didn’t respond to emails or declined to comment.

The Justice Department is being advised by activist short selling critic Joshua Mitts, according to the Wall Street Journal. Columbia Law School professor Mitts published a 2020 academic paper called “Short and Distort” that accused short sellers of using illegal trading tactics, such as “spoofing” and “scalping.” Spoofing involves flooding the market with fake orders in an effort to drive the share price up or down while scalping entails a short seller cashing out its position without disclosing it.

Burford Capital used Mitts’ theories as evidence in a U.K. High Court case against Muddy Waters in 2020, but the judge called the evidence speculative and threw the case out.

Tough day job

Publishing a short report in a bull market with the added threat of short squeezes from angry retail investors and plentiful central bank liquidity was already a fearful proposition.

Public activist short campaigns in the U.S. have dwindled since a peak of 188 in 2016, with only 80 new campaigns last year. Defeated in the GameStop short squeeze, Citron founder Andrew Left abandoned activist short selling in 2021, choosing instead to focus on publishing long research. After a bruising campaign against Herbalife, Bill Ackman also bowed out in recent years, saying in 2015 that short selling was not worth the “brain damage.”

Yet those short sellers that are still active should be making good returns. One-week and one-month returns of short campaigns beat the returns of the S&P 500 Index in every year since 2013, according to Activist Insight Shorts data. In 2021, the average one-month short campaign return was 11.8% compared with 2.5% for the S&P 500. In 2020, it was 7.4% for shorts, and negative 0.3% for the S&P 500.

The impact of hostile regulators

These handsome returns are now at risk as the investigation is likely to make short sellers wary of publishing. Short campaigns in Continental Europe have decreased over 70% since 2015, partly due to regulatory pressure on activist short sellers in both Germany and France.

French markets regulator Autorité des marchés financiers (AMF) took umbrage with a 2016 report by short seller Muddy Waters on French grocer Casino and its parent company Rallye, saying it did not meet the principles of “probity, impartiality, clarity, and precision.”

Muddy Waters founder Carson Block told Activist Insight Shorts in 2019 that he refrained from publishing research on French company Solutions30 that same year for fear of regulatory hostility to criticism. There have been no new short campaigns in France since 2017, according to Activist Insight Shorts.

In 2019, German regulator BaFin imposed a temporary ban on short selling in Wirecard’s stock following allegations of fraud by multiple short sellers and news outlets. It was the first time under the EU short selling regime that BaFin had used the measure.

German authorities investigated investors who accused Wirecard of fraud for four years even after a U.K. regulator concluded their evidence against the short sellers was not sufficient and it later turned out that the company had, in fact, inflated its numbers.

Gabriel Grego, founder of short outfit Quintessential Capital Management, told Activist Insight Monthly in 2019 that he did not take an active role in Wirecard because of regulatory pressure.

Another empty threat?

The European actions against short sellers did not amount to anything, and short sellers might be inclined to believe the DOJ investigation will have the same result. A report by the SEC after the GameStop saga also amounted to very little but suggested improved reporting of short sales “would allow regulators” to better prepare for any volatility. The SEC recently opened a comment period on a potential rule change where institutional investors would have to declare short positions.

“I don’t think the DOJ investigation will have much of an impact on activist short selling. I think it’s more of a warning to keep short sellers on their toes and make sure they do the right thing,” Adam Gefvert, head analyst at White Diamond Research, said in an email to Activist Insight Shorts.

“Through our due-diligence and investment research process, when the facts demonstrate corporate fraud and fundamental problems in business, we expose it, just as investigative journalists do. We are going to continue doing this,” Muddy Waters’ Carson Block, told Activist Insight Shorts in an email.