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This article appears in the March 2021 issue of Investment ExecutiveSubscribe to the print edition, read the digital edition or read the articles online.

When a group of retail traders used Reddit to gleefully gang up on a handful of hedge funds in January, giving birth to the concept of “meme” stocks, they cranked up an already simmering debate about proper public discourse related to trading. In Canada, a consultation regarding activist short-sellers is the focus of that debate.

Late last year, the Canadian Securities Administrators (CSA) published a consultation paper on the role and regulation of activist short-sellers — traders who publicly air their negative views on the stocks they’re shorting.

Defenders of the practice maintain that vocal short-sellers are the only thing standing between unrelenting upside hype and ordinary investors — i.e., their skepticism and scrutiny help expose corporate fraud and misconduct, aiding naive regulators and investors alike.

“Yes, short-sellers sometimes make money when other investors lose, but that is only the proximate effect of their activity,” stated a submission to the CSA from the Alternative Investment Management Association.(AIMA). “Their long-term effect is a maintenance of the very essence of capital markets,” thus ensuring there’s information circulating in the market that’s accurately reflected in the prices of securities.

Critics, however, argue that activist short-sellers are a scourge on the markets, recklessly bashing good companies with the sole goal of driving trading profits.

The Canadian Investor Relations Institute (CIRI), a trade group for investor relations professionals at public companies, stated in a submission to the CSA that CIRI’s members “are extremely concerned about activist short-selling, particularly given recent activity related to issuers such as GameStop [Corp.] and BlackBerry [Ltd.]” CIRI’s submission cited those episodes as evidence of “the negative impact activist short-selling has on market efficiency and price discovery.”

The meme stock phenomenon appears to have originated with unorganized retail traders attacking hedge funds that held large short positions in certain stocks — driving those stock prices up to seemingly absurd levels rather than downward. The surge in meme stock trading has raised concerns about the growing role of social media as a driver of trading activity.

“While [these] investors would be better defined as activist long-sellers, the effects of the use of social media, the lack of accuracy or logic behind the investment thesis, manipulative intent to distort prices, and the noticeable and documented disruption in the market and on market participants are similar,” stated a submission to the CSA from Vancouver-based mining firm Novagold Resources Inc.

Critics of activist short-selling are concerned that increased social media–driven trading could spawn more activist short-selling, and potentially lead to abusive shorting activity.

For issuers that may be targeted by activist short-sellers online, the growing reach and power of social media makes responding to potentially damaging allegations before the market reacts much tougher for issuers.

“It is now easier than ever for malicious claims against an issuer to be disseminated widely over several markets in virtually an instant,” CIRI’s submission stated.

Indeed, some critics allege that activist short-selling is used as part of larger efforts at outright market manipulation via social media.

Vancouver-based junior miner Northern Dynasty Minerals Ltd.’s submission to the CSA reported that the company has been targeted by “organized high-frequency day traders.” These traders first pump up the company’s stock on social media; then, after driving up the price, they short the stock while pivoting to “negative social media … designed to devalue the share price,” thereby generating trading profits for their short positions.

Critics also stated that the waging of short campaigns over social media is aided by the anonymity the medium provides.

CIRI’s submission proposed the CSA introduce a series of reforms, including increased disclosure requirements for short-sellers, pre-borrow requirements, minimum hold periods for activist shorts and enhanced enforcement.

CIRI’s submission also suggested that activist shorts be required to provide their analysis to issuers before distributing it to the market — giving target companies an opportunity to respond to the short-sellers’ claims before they go public.

Short-selling also was looked at by Ontario’s Capital Markets Modernization Taskforce. The task force’s extensive reform proposals, published earlier this year, included a recommendation that lawmakers create a specific prohibition against making misleading statements about a public company that are intended to affect its stock price, even if that effort isn’t successful. (Similar measures have been implemented in British Columbia.) The proposed measure is designed to make combating misinformation in the market easier for regulators.

That proposal is now getting pushback from some in the investment industry.

AIMA’s submission argued that introducing a prohibition in Ontario against making false statements that are intended to move a stock would amount to “overreactions to a perceived problem based on anecdotal evidence.”

If taking action against activist shorts is made easier, that would have a “significant chilling effect on legitimate short-selling activities,” AIMA’s submission stated.

For regulators, there’s a wide spectrum of activity that falls between the polarized characterizations of short-sellers as either heroic crusaders against corporate wrongdoing or abusive market manipulators. The question is whether the existing regulatory regime guards against serious misconduct while allowing for legitimate skepticism and public debate about a company’s merits.

Drawing a line between legitimate and abusive discourse isn’t easy. Traders with negative opinions on a stock can be wrong about a company. Just because their view turns out to be mistaken doesn’t necessarily mean they should face regulatory enforcement action.

Bringing successful enforcement action against activist short-sellers is difficult for regulators, in part because determining when a short-selling campaign tips over into misconduct is challenging. AIMA’s submission warned that lowering the bar on what constitutes improper activity could stifle productive short-selling and “free speech generally.”

Defenders of activist short-selling also argue that regulators should not seek to unmask anonymous short-sellers. This would expose short-sellers to retaliation from deep-pocketed issuers and potentially from other traders on social media who could use the knowledge of the short-sellers’ positions to mount attacks — i.e., trading to force a “short squeeze,” which is the kind of activity that gave rise to the meme stock phenomenon.

As regulators ponder whether action is needed to deal with activist short-sellers, the growing role of social media as a trading catalyst looms increasingly large in the policy debate.