By: Steven C. Dilley, Contributor to the South-Western Federal Taxation series
Short sales of stock are an example of an investor believing that the current stock price will decline. In a short sale, the investor (for a fee) borrows stock from a broker and sells it. The investor hopes to replace that stock (close the short sale) with stock purchased for less than the price at the time of the short sale. In other words, the investor thinks something is going to happen to reduce the stock price.
But what if the short sale is a form of “self-fulfilling prophecy?” If the investor sells enough stock short, the market may take the sales as a signal of “bad news” on the horizon for the company. Consequently, the stock price may decline, the investor can make a profit, but the company may be thrown into turmoil.
The author of this blog recently had first-hand experience with a situation like this. Of course, the facts will be disguised here because the events described are still the subject of litigation.
The author’s friend was a top executive of a publicly traded company. The company had a history of steadily increasing earnings and an admirable price/earnings multiple. The executive was a 10% shareholder of the company—a major source of the executive’s wealth along with earnings from working for the company.
A well-known “corporate raider” sold short a substantial block of stock in the company. At about the same time, various anonymous rumors started to spread that the company was about to suffer substantial financial reverses. According to the executive, the rumors were completely unfounded. However, the “market” believed the rumors and the price began to decline rapidly.
One of the rumors hinted that the company had failed to disclose significant information in its filings with the Securities and Exchange Commission. As a result, the SEC opened an investigation of the company, further depressing its stock price. In the face of all this adverse publicity, the stock exchange suspended trading in the company’s stock.
The company sued the corporate raider, alleging that he had deliberately spread the false rumors and had been the source of the anonymous tip to the SEC. However, the cost of the lawsuit and the fight with the SEC severely drained the resources of the company, leading to a substantial fall off in earnings. Also, customers of the company cancelled existing contracts or did not renew expiring contracts, further contributing to the earnings decline.
At this point, the corporate raider, who still held a significant block of stock in the company moved to add his cronies to the company’s board of directors. Repelling this challenge was another negative event for the company.
The executive’s salary has been cut, he no longer qualifies for any bonuses because of the reduced earnings, and he’s in danger of losing his job. Plus, of course, his stock currently is worth much less than before these events began.
Ideas for Class Assignments
There are numerous business magazine articles, blog posts, investment company websites, etc. related to short sales of stock. Have your students access some of these sources to find situations similar to the facts detailed above. Then conduct a class discussion about the implications of what they find.
Have the students conduct tax research to determine if the IRS has issued any rulings on “predatory short sales of stock.” If there are any, discuss the implications of them in class.
- Are there tax policy issues relevant to predatory short sales like the one described above? If so, what are they? Have the students discuss how the Congress might approach this policy issue.
- Should tax policy stay out of situations like that described here and just let the marketplace and/or the SEC handle situations like that described?
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