By Steven C. Dilley. Contributor to South-Western Federal Taxation Series
An example of an investor believing the stock price will fall is a short sale of stock. A short sale is when an investor borrows stock from a broker to sell it. The investor wants to replace the stock (close the short-sale) with stock bought for less than the current price. The investor believes that something will happen to lower the stock price.
What if the short sale is a self-fulfilling prophecy? If the investor sells enough stock short the market could interpret the sales as bad news for the company. The stock price could fall, but the investor may make a profit. However, the company may find itself in turmoil.
This blog was written by someone who had experienced a similar situation. The facts will not be disclosed here as the events described remain the subject of litigation.
The friend of the author was a top executive at a publicly traded company. The company had a long history of increasing earnings and a high price/earnings multiple. The 10% shareholder was the executive, which was a significant source of his wealth and earnings from the company.
A well-known “corporate raider”, sold a large block of stock in the company. Around the same time, anonymous rumors began to circulate claiming that the company was in serious financial trouble. The executive said that the rumors were unfounded. The “market” believed the rumors, and the price started to fall rapidly.
One rumor suggested that the company hadn’t disclosed significant information in its filings to the Securities and Exchange Commission. The SEC launched an investigation into the company, further depressing the stock price. The stock exchange stopped trading in the stock of the company after all the negative publicity.
The corporate raider was sued by the company, claiming that he had intentionally spread false rumors and that he was the source of anonymous tips to the SEC. The company suffered a significant drop in earnings due to the high cost of the lawsuit and the fight against the SEC. Customers of the company also cancelled or refused to renew expired contracts, further contributing towards the earnings decline.
The corporate raider, still holding a substantial block of stock in company, moved to add his cronies as directors to the company’s board. This was another negative event for company.
The executive’s salary was cut and he is no longer eligible for any bonuses due to his lower earnings. He’s now at risk of losing his job. His stock is now worth less than it was before these events.
Ideas for Class Assignments
Internet Research
There are many articles in business magazines, blogs, and websites of investment companies. Short sales of stock. Ask your students to access these sources to find similar situations to the ones described above. Next, have a discussion with the class about the implications of what you find.
Students should conduct tax research to determine whether the IRS has made any rulings regarding “predatory stock short sales.” If so, discuss the implications in class.
Tax Policy
Are there tax policy considerations relevant to predatory short-sales like the one mentioned above? What are the tax policy issues relevant to predatory short sales like the one described above? Discuss with students how Congress might approach this policy issue.
Should tax policy be able to ignore situations like those described here, and let the market and/or SEC deal with situations like those described?
SWFT Chapters
Chapters 4 & 16 of SWFT Individuals
SWFT Comprehensive: Chapters 4 & 13
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