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What is short-selling and why does the DoJ care?

[December 15, 2021] (Reuters) - Short-selling, a bearish investing practice, has become a target of an expansive U.S. Department of Justice criminal investigation.

The DoJ has issued subpoenas as it examines short-selling by hedge funds and their relationships with research firms that publish negative reports on certain companies, according to three people familiar with the matter.

Short-selling entered the spotlight in 2021 as a deluge of retail investors took to social media to criticize the lack of regulation of short-sellers and the havoc they can wreak on company valuations. They also used social media to urge other investors to buy heavily shorted stocks in a crusade to teach short-sellers a lesson.

SO WHAT IS SHORT SELLING?

Investors who 'short' a stock make a bet that the stock's price will fall. They borrow shares to sell immediately and then wait until the price falls before buying the shares back at a lower price. They pocket the difference when they return the shares to the lender.

WHO LENDS OUT SHARES AND WHY DO THEY DO IT?

Borrowed shares can come from brokers' inventories, or from customers that allow brokers to lend their shares. Until the shares are returned, the short seller pays the lender interest. If the price goes up instead of down, then the lender will end up with a more valuable stock.

WHAT IS SHORT-COVERING?

An investor who has sold borrowed shares must at some point buy back the shares to return them to the lender. The act of buying back shares to cover, or close the trade, is called short-covering.

WHAT IS A SHORT SQUEEZE?

To make a profit, an investor who has sold shares short must be able to buy them back at a lower price. Occasionally, a jump in the price of shorted shares can force the short seller to buy back shares at a higher price to limit losses. When there is a rush of demand from short sellers looking to exit bets and this pushes rising stock prices even higher, the result is what is known as a short squeeze.

Some short-sellers, such as Melvin Capital, had to rush to cover GameStop shares they had sold short when in late January the price soared as retail investors piled in. In the GameStop example, the "short squeeze" was thought to have exacerbated the stock's gains. [USN]

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The crest of the United States Department of Justice (DOJ) is seen at their headquarters in Washington, D.C., U.S., May 10, 2021. REUTERS/Andrew Kelly/File Photo

SHARE PRICE IMPACT OF SHORTING?

It is hard to know how much of a day's trading is the result of short-covering or long-buying - when investors buy a share in the hope its price increases. However, if trading volume in a session far exceeds the number of shares shorted, the price action that day cannot be fully explained by short-covering.

SHORT-SELLING RISKS

A short-seller could face large losses, as there is no limit to how high a stock price can rise. They would have pay the market price to cover their bet. Another risk for short-sellers is stock availability, as the short-seller must return the same number of shares they borrowed, even if there are fewer on sale.

MIXED REPUTATION

Some short-sellers have been able to predict price declines by examining company operations and financials for flaws. But they are often criticized when they issue negative reports on stocks they have shorted.

Quinton Mathews, who published research online under the pseudonym Rota Fortunae, reached a legal settlement in June to pay Farmland Partners Inc "a multiple" of his profits from a bet against its shares after admitting to inaccuracies in an article that helped wipe $115 million off Farmland's market value in 2018.

Long-time short-seller Jim Chanos, at Kynikos Associates, however, was vindicated for shorting now-defunct Enron Corp shares before accounting irregularities started to raise red flags on Wall Street in late 2001.

WHAT WE DON'T KNOW ABOUT SHORT-SELLING

While long investors file quarterly reports with U.S. regulators disclosing a detailed snapshot of their stock holdings, short-sellers have far less-stringent regulatory oversight. In a review of this year's meme-stock frenzy, the Securities and Exchange Commission staff said "Improved reporting of short sales would allow regulators to better track these dynamics." Disclosure reform is now on the agenda at the SEC.

(This story corrects dateline)

(Reporting by Sinéad Carew and Saqib Iqbal Ahmed; Editing by Dan Grebler)

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