TCS Daily

Cuban Revolution: Short-Selling by Journalists

By Larry E. Ribstein - June 23, 2006 12:00 AM

Maybe Mark Cuban will be consoled for his Mavs' loss in the NBA finals by his new media venture. As discussed in Business Week, Cuban's planning an online publication that will engage in investigative business journalism. The tricky part is that Cuban evidently plans to trade on the information the journal finds, before publication. Presumably this means that he will sell "short" the stocks the journal investigates, and then buy them after the revelations puncture the price.

Is there anything illegal here? Not on the face of it. Unlike Foster Winans, a journalist anti-hero of a past famous insider trading scandal, nobody's planning to trade on misappropriated information, which the Supreme Court's O'Hagan case made the trigger for insider trading liability. Here the person who paid to get the information plans to do the trading.

Nor should we be concerned about the journalists' writing being tainted by the trading. Some readers might feel cheated if they learned the writer had an ulterior motive (although they actually should be comforted, as discussed below). But no problem here as long as Cuban tells his readers he'll be trading on the stories.

There might be a legal problem if the reporters pay corporate insiders for the information. The profiting insiders might be breaching their duty to their employers under the Dirks case, and the trading publisher might be knowingly participating in their breach. But in order to reach this conclusion we would have to recognize the company's property right in information concerning its own fraud -- a rather dubious proposition.

The only remaining "problem" here is that these journalists have an advantage over the ignorant traders they're selling to. Is this unfair? Only if you buy into the argument the Supreme Court has never accepted -- that everybody's entitled to trade securities with equal information. There's no social benefit from requiring equality of information, and a significant social cost in reducing incentives to produce the information that makes markets efficient.

Since Cuban, like other publishers, can just sell ads and subscriptions, does he really need to be able to trade? After all, the Wall Street Journal is collecting kudos and credibility from its backdating expose, all of which eventually adds up to advertising and sales. Cuban plans to use his media companies to profit from the frauds he exposes, for example by making another Smartest Guys in the Room.

But as a mere publisher Cuban first has to get readers. And it isn't going to be easy for a startup to blow open startling frauds that everybody wants to keep well hidden. As a trader, Cuban doesn't need to build readership or hit homeruns with big, splashy exposes. All he needs is information the market doesn't have. If the information is good, the market will react to the truth and the trades will be profitable. That's the beauty of insider trading -- the market provides a built-in high-quality incentive device. The trader's work is judged not by some dumb boss or lazy bureaucrat, but by the "wise crowd" of the stock market.

The idea of business journalists staking real money in the stock market on their stories refreshingly improves on mainstream business journalists' usual incentives. As I discuss in my article, The Public Face of Scholarship, and in my weekly analysis of the NYT's Gretchen Morgenson, you tend to see a political agenda about giving "shareholders" (e.g., labor activists) more power, promoted by harping on option backdating or other scandal of the day. This frivolous entertainment usually says very little that's new or useful about what's really going on inside the companies -- that would take too much energy and expertise. A short-selling business journalist, by contrast, makes money only if the market judges that the story is not only true, but has real significance for the value of the company.

Critics might still insist that there's something sleazy about profiting from bad news. Think about those dreadful short selling vultures betting against paragons of capitalism. Trading on negative information gives the traders negative incentives.

The supposed problems of short-selling problems are overblown. Insiders might sabotage the company, but this is less a worry for an outsider like Cuban's journalists. Outsiders have an incentive to lie and buy back at the lie-distorted price, but there are remedies for lying to the market.

Even if there are dangers from trading on negative information, there are also significant benefits, and therefore costs of regulating the trading. There is credible theory that the incentives to disclose negative information are weaker than those to disclose positive information. Evidence indicates that short-sellers contribute to market efficiency. The law already restricts short-selling, adding to traders' general risk of staking significant money on what the market will do in the short term. More regulation would further deter this beneficial activity.

Let's not forget that it was one of those nasty traders, Jim Chanos, who shorted Enron back in November 2000. No one complained more loudly about the Enron shorts than Jeff Skilling. Sometimes corporate insiders don't want the markets to have all of the facts and sometimes, as in Enron, nobody, from executives to outsider directors to auditors, does much to find out the truth.

When everybody is lining up to bolster a company, the market's only friend may be the short-seller. Usually employees -- who may have the best information -- have a strong incentive to just lie low. Job protection for whistleblowers under laws like Sarbanes-Oxley doesn't accomplish much other than making it harder to fire incompetent employees. If you were an employee with information, would you bet your job on protection from OSHA, the agency charged with enforcing the SOX whistleblowing provisions? "Qui tam" laws give whistleblowers only a small fraction of the value of their information. Hence whistleblowers are likely to be of the modest sort, like Sherron Watkins, who kept the facts about Enron buttoned up in the company.

There is a particular advantage in combining short-selling with journalism. The seller's or his boss's investment in the journal and its reputation in a sense "bonds" the accuracy of the disclosure. A short-selling journalist's short-term profits from lies may be more than offset by the long-term hit to his reputation.

So instead of thinking about regulating this sort of trading, we should consider de-regulating it. We could start with a law clarifying that those who trade on information about fraud are not liable. The law might, for example, clarify that an employee who sells information about fraud to one who trades on the information is not misappropriating the information for purposes of the insider trading laws.

Once we've cleared up what to do about Cuban's idea, there are analogous situations that may deserve similar attention. For example, there have been stories recently about trading on advance knowledge of lawsuits, also known as "dumping and suing" debated here. There are other stories about dumping and boycotting, where a prospective boycotter shorts the shares of the company he plans to boycott.

As Bruce Kobayashi and I explain in Outsider Trading as an Incentive Device, while these situations might seem unsavory, they actually reveal the advantages of markets in providing incentives for the discovery of information. If the trader commits bad acts in order to profit, we can punish those acts. Regulating trading risks punishing legitimate conduct and weakens one of capitalism's most potent incentive devices.

So we should wish Cuban's new venture well as one of many possible ways that free markets can help cleanse themselves of fraud. Government has had its chance: Sarbanes-Oxley has produced a nightmare of paperwork for thousands of innocent firms. There must be a better way.

Larry E. Ribstein is Corman Professor of Law at the University of Illinois College of Law. Ribstein's weblog focusing on business law is and his webpage is


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