Short Reports: The Latest Litigation Threat?

“Short reports,” also known as “short-seller attacks,” are investigative-type reports with negative allegations about a company published by short sellers.

The “bombshell” revelations can include things like financial trouble, fraud, overvaluation, or other problems, all of which the short seller will describe as previously undisclosed for nefarious reasons.

When one of these reports is published about a public company, the company’s share price often drops. If the publisher of the report also had a short position in that company’s stock—meaning the publisher holds a derivative contract that is “in the money” when the stock price drops—the publisher is able to make a tidy profit.

As controversial as this tactic is, short reports are nothing new. However, research shows they have increased substantially in recent years (35 reports per year between 2010 and 2018 versus 2.5 reports per year between 1996 and 2009).

The D&O DataBox, Woodruff Sawyer’s own proprietary data set, shows that in the past five years, 102 of 1,098 securities class action cases filed against issuers of common stock traded on US exchanges involved short reports. That’s just over 9%.

Companies that are the subject of short reports have to deal with the fallout of these reports, including deciding whether and how to respond. Indeed, research shows companies respond only about one-third of the time.

Companies will have to respond, however, in the form of mounting a legal defense if the short report and related stock drop lead to a securities class action suit. As QuantumScape Corporation recently learned, this can be tricky business.

The Lawsuit

Founded in 2010, QuantumScape went public through a special purpose acquisition company (SPAC) in 2020.

A competitor issued a short report against them on SeekingAlpha.com (found here), and one short seller, Scorpion Capital, issued another (found here).

QuantumScape’s stock price fell precipitously after, and plaintiffs filed a securities class action suit against QuantumScape alleging violations of securities laws, including Section 10(b) of the Securities Exchange Act of 1934.

In QuantumScape Securities Class Action Litigation, Judge William H. Orrick of the Northern District of California in January denied QuantumScape’s motion to dismiss the suit. His decision was premised in part on the information contained in a short report about the company.

The plaintiffs asserted that QuantumScape, a solid-state battery maker for electric cars, made multiple misrepresentations about the batteries’ progress and effectiveness over time. To support their allegations, the plaintiffs cited the two short reports that highlighted the company’s purported shortcomings.

QuantumScape denied the allegations and would have been pleased for the court to ignore these reports. After all, the short seller has an economic incentive to hurl terrible allegations against the company because a stock drop profits investors that hold a short position in the company’s stock.
As noted in the decision:

On the Scorpion Capital report, QuantumScape argues that Scorpion Capital is a short-seller of QuantumScape’s stock. … It also argues that the report relies entirely on anonymous former employees and experts and, so, should not be credited.

Unfortunately, the court did not regard this profit incentive as a reason to wholly disregard the short report.

Judge Orrick stated that because “Scorpion Capital was allegedly short on QuantumScape may raise serious credibility issues for a factfinder.” Having said that, he went on to say, “QuantumScape overstates the caselaw by arguing that it makes the report’s conclusions ‘inherently unreliable.’”

Judge Orrick clarified that the cases cited by the defendant were actually “concerned with the nature of the revelation more than it coming from a short-seller … The substance of the report shows that it is sufficient to survive a challenge at the pleadings stage.”

In his conclusion, Judge Orrick writes:

The Morin article in Seeking Alpha and the report from Scorpion Capital both revealed to the market what QuantumScape allegedly misrepresented: that its tests were compromised, its results misleading, and its product not at the stage of development presented. … Immediately after both were published, QuantumScape’s stock price plummeted. … As the Ninth Circuit has explained, ‘[t]hat a stock price drop comes immediately after the revelation of fraud can help to rule out alternative causes.’ … So it is here. It is plausible that the Seeking Alpha article and Scorpion Capital report caused the stock price drop due to their timing; taking as true the allegations, that means that the revelation of alleged fraud was at least a substantial cause of the loss of value. QuantumScape responds that the articles should not be credited, an argument I reject for the reasons explained above.

What about the Safe Harbor for Forward-Looking Statements?

In arguing for its motion to dismiss, QuantumScape also asserted that the challenged disclosures forming the basis of the complaint were protected by the safe harbor for forward-looking statements under the Private Securities Litigation Reform Act (PLRSA) of 1995. The court rejected this contention for a number of reasons, including the fact that (most of) the statements in question were not forward-looking.

Short Reports Will Remain Popular

When class actions allege Section 10b-5 violations in federal court, defendants have won their motions to dismiss about 40% of the time in the past decade, according to the D&O DataBox. When Section 11 suits are filed, that dismissal rate drops to a little over 30%.

Judge Orrick’s decision will be a real boost for the short reports industry and the plaintiffs’ bar, no doubt. The decision is an encouraging one for plaintiffs, giving them the kind of fodder they need to survive defendants’ motions to dismiss.

Short reports more recently seem to be targeting de-SPAC transactions. Of the 34 securities class action suits filed against companies that went public through a SPAC transaction in 2021, 14 involved short reports.

Of the remaining 148 securities class action cases filed in 2021 against public companies, 21 involved short reports. In other words, in 2021, 41% of securities class action suits targeting de-SPAC transactions involved short reports, compared to 14% for everyone else.

SPAC or not, cases involving short reports have produced large settlements. In the past five years (2017–2021), our research shows that seven securities class actions involving short reports settled—and many of them in the multimillions:

• $187.5 million: Luckin Coffee Inc.
• $50 million: FleetCor Technologies, Inc.
• $11 million: Health Insurance Innovations, Inc.
• $7.5 million: TAL Education Group
• $5 million: MOMO Inc. (now Hello Group Inc.)
• $1.25 million: Vivint Solar, Inc.
• $610,000: NMC Health

There are no “casual” securities class action suits. It is also increasingly clear that the plaintiffs’ bar has realized that short reports are an effective strategy to bolster their cases.