Why The Justice Department Is Going After Short Sellers

Federal prosecutors are reportedly ramping up a probe into the activities of short sellers, serving subpoenas and seizing hard drives and mobile phones of prominent "activist" short sellers.

What Happened? In a story originally reported by Bloomberg News last year, federal investigators have subpoenaed nearly 30 hedge funds and other short sellers as part of an investigation into potential illegal trading activities.

On Wednesday, the Wall Street Journal reported that investigators have seized records and devices from prominent short seller Carson Block, founder of Muddy Waters Research.

Related Link: Stanphyl Capital's Value Stock Pair Trade: Short Tesla, Long GM & Volkswagen

Why It's Important: Short selling has always been a controversial topic on Wall Street. Most veteran investors and finance experts view short selling as an important tool in correcting stock prices that have become overinflated due to hype or fraud.

Short selling is unpopular among many retail traders and companies that have been targeted by firms like Muddy Waters.

While short selling is perfectly legal , the Wall Street Journal reported the Justice Department is focusing on investigating the potential use of illegal market manipulation among short sellers, including "spoofing" and "scalping."

Spoofing is the practice of flooding the market with fake orders to push stock prices up or down. Scalping occurs when a short seller closes out their positions in a stock without disclosing it.

In addition to Block, Citron Research's Andrew Left is reportedly part of the federal investigation. Left famously stopped publishing his short-selling research on Jan. 29, 2021 after supporters of GameStop Corp. GME allegedly threatened him and harassed his underage children.

Left had previously been vocal in his view that GameStop shares were overvalued at the time. In more than a year since Left dropped his short selling research, GameStop shares are down more than 60%.

Block and Left have repeatedly defended short selling and have touted their successes in uncovering frauds. Block was an early critic and short seller of German fraud Wirecard, which collapsed in 2020.

Left famously accused Bausch Health Companies Inc BHC, then known as Valeant Pharmaceuticals, of "channel stuffing," or artificially increasing prescription fulfillment of its own expensive drugs via its relationship with specialty pharmacy Philidor Rx Services. The scandal ultimately resulted in the prosecution of two former executives of Valeant and Philidor for their roles in a kickback scheme.

Benzinga's Take: The GameStop and AMC Entertainment Holdings Inc AMC crowds have insisted throughout the rise and fall of the meme stock trading frenzy that short sellers like Block and Left are acting illegally and manipulating the share prices of heavily shorted stocks.

The seemingly in-depth Justice Department probe will soon settle the matter once and for all.