Short sellers are tipping off the U.S. Securities and Exchange Commission ("SEC") for cash...
Traditionally, these investors make money by betting against companies they think will do poorly. And a lot of times, short sellers bet on companies they believe are engaged in fraudulent activity.
After all, if a company is accused of fraud, its stock isn't likely to do well. Fraud accusations can cause a stock to drop double digits... sometimes overnight.
For instance, back in 2015, short seller Citron Research published a report alleging fraud at pharmaceutical company Valeant (now known as Bausch Health). The stock fell 30% overnight... and 90% over the next year.
While this is a well-established approach, short sellers are now taking it a step further. In addition to publishing their short reports and carrying out their short trades, these investors are participating in the SEC's Whistleblower Program.
Put simply, they're sharing their research directly with the SEC. And if the SEC finds a company guilty of fraud and fines it, whistleblowers can collect up to 30% of the proceeds.
This program is having a record year. Whistleblower tips are expected to be up 50% from 2022. And as we'll explain today, it's yet another red flag when it comes to our weakening economy...
Working with the SEC is a profitable strategy...
Since its launch back in 2011, the SEC's Whistleblower Program has awarded more than $1.9 billion to over 397 individuals.
The way the program works is simple...
The whistleblower – who may be an employee of the company that's accused of fraud or even a shareholder – reports suspicious activity to the SEC. If the SEC finds the company guilty of wrongdoing in its investigation, the whistleblower is entitled to a portion of the collected fines.
As we said earlier, whistleblowers can make up to 30% of the total monetary sanctions collected. So this system is a big incentive for folks to come forward about alleged malpractice.
And because short sellers are already researching potential fraud for a living, they're the perfect tipsters to the SEC.
Just take a look at short seller Carson Block, who runs investment-research firm Muddy Waters Research...
Block was early to the whistleblowing party. He began sending in tips soon after the SEC's program started...
In 2022, he was awarded $14 million for research his firm published about Chinese media company Focus Media 11 years earlier. The company's CEO, Jason Jiang, allegedly helped organize an insider deal that benefited company executives.
The SEC didn't even have this company on its radar until it received Block's tip. And Focus Media ultimately settled with the SEC for $55.6 million.
With investors like Block starting to win big payouts, more short sellers have jumped in. In fact, 2023 is expected to be a landmark year for whistleblower tips...
In 2022, the SEC received around 12,000 tips... which was about in line with the year before. This year, that number is expected to rise to more than 18,000.
This is a sign that short sellers are starting to realize just how profitable and low-risk the SEC's Whistleblower Program is.
It's also a sign that companies are under stress today...
Financial fraud can go undetected for years. However, if companies' financials are already strained, it's tougher to stay under the radar. Investors get more cautious and therefore pay more attention...
Bernie Madoff's Ponzi scheme, for example, was discovered thanks to the Great Recession. And part of the reason Valeant finally came undone was because the company was piling up debt. It needed to show extra sales to borrow more money.
Short sellers are sharing more tips today because more companies are under pressure than at any point since the program launched 12 years ago.
While not all of these tips will result in SEC sanctions and fines, it's still a warning that a lot of public companies are struggling... even in ways that aren't obvious to most investors.
In times like these, investors have to be even more careful than usual. You don't want to get caught holding the bag when a company is accused of fraud... or when it's unlikely to survive the next few years.
November 30, 2023
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