(The opinions expressed here are those of the author, a columnist for Reuters.)
By Alison Frankel
Feb 27 (Reuters) - How much credence should judges overseeing shareholder class actions give to reports by short sellers?
U.S. District Judge Gregory Woods of Manhattan confronted that question in a ruling on Monday in a case accusing the gigantic Chinese real estate brokerage KE Holdings of drastically overstating key financial metrics, including how many agents and stores actively use its online platform.
Shareholder lawyers from Robbins Geller Rudman & Dowd based their allegations almost entirely on a 2021 report by the short-seller Muddy Waters Research, which tagged KE as a “massive fraud” after an extensive investigation.
In their motion to dismiss the shareholder case, KE’s counsel urged Woods to disregard claims based on the Muddy Waters report because, among other things, Robbins Geller failed to conduct an independent investigation to corroborate the short seller’s accusations.
New York federal courts have generally been leery of short-seller reports because outfits like Muddy Waters and Hindenburg Research have an obvious financial motive to drive down the share price of companies they have targeted.
I told you last year, for instance, about a series of recent decisions by U.S. District Judge Paul Engelmayer of Manhattan in shareholder class actions premised on short-seller reports. Engelmayer tossed all three cases — and though he didn’t categorically slam the door on cases that rely on short-seller reports, he said plaintiffs' lawyers have to give judges a good reason to trust short-sellers' assertions.
In Monday’ KE decision, Woods cited Engelmayer’s decisions, agreeing that judges overseeing securities cases should be wary of short-seller reports, especially when the reports include allegations from confidential or anonymous sources.
But Woods pointed out that Engelmayer’s cautionary rulings, including the 2023 dismissal of an investor class action based on a Hindenburg report criticizing DraftKings , “should not be misread as stating a rule that short seller reports are to be disregarded.”
In effect, Woods said that courts have to look at the substance of the underlying short-seller accusations.
In this case, he said, the Muddy Waters report on KE wasn’t based just on anonymous sources. The short-seller developed computer programs to crunch publicly available data from KE’s platform, then sent out investigators to verify its data-based suspicions about how many stores and brokers were actually using the platform. Muddy Waters also used Chinese government data to raise doubts about the number of KE employees in key real estate markets.
This report, in other words, did not merely recite unsubstantiated allegations from anonymous whistleblowers, Woods said. Muddy Waters included data analysis, photographs, screenshots and transcripts to back its assertions. The short-seller’s evidence, the judge said, amounted to “sufficiently reliable support” for shareholder’s claims.
To be sure, Woods did end up dismissing most of the shareholder case. He tossed shareholders’ Exchange Act allegations in their entirety because he concluded that their complaint failed to show KE’s fraudulent intent. He also dismissed claims that KE was required to disclose how many of its purported platform users were inactive.
But Woods ruled that investors can proceed with Securities Act claims that KE’s filings for its $2.3 billion, post-IPO stock offering in 2020 contained false statements about the metrics at the heart of the Muddy Waters report.
A KE spokesperson did not respond to my email. The company, which is represented by Skadden, Arps, Slate, Meagher & Flom and O’Melveny & Myers, has said repeatedly that the Muddy Waters report was fatally flawed because (among other things) it was based only on publicly available data, not on KE’s internal information. (Full disclosure: My daughter works at Skadden but is not in the securities group and was not involved in this case.)
KE told Woods that its audit committee conducted an independent investigation of the Muddy Waters allegations after the short-seller’s report and found them to be unsubstantiated. The company also said that the market quickly shrugged off Muddy Waters’ report, rebounding in a day of trading from an initial 5.75% drop.
Robbins Geller did not offer comment on Woods’ decision. The judge gave shareholders three weeks to file an amended complaint to try to revive their Exchange Act claims.
I don’t want to overstate the implications of Woods’ analysis of the Muddy Waters report. Securities class action defendants, for the most part, have done an impressive job of persuading courts not to rely on allegations from traders whose goal is to drive down a company’s share price.
Indeed, just last week, in a shareholder class action against Chinese entertainment streaming company iQIYI , iQIYI’s lawyers from Skadden told U.S. District Judge Diane Gujarati of Brooklyn about six decisions in the last year that rejected shareholder claims based on short-seller reports.
The judges in all six of those rulings, according to Skadden’s letter brief, concluded that short-sellers were either unreliable — because of their own self-interest or because of flimsy investigations — or were merely repackaging already-public information.
But Woods’ KE decision is a reminder that short-seller reports are not created equal. Shareholder lawyers might want to keep that in mind when they contemplate class actions that depend on short-seller allegations.
Read more:
DraftKings investors can't rely on short-seller report to prove fraud - N.Y. judge
Short-seller Muddy Waters takes aim at Chinese firm KE Holdings
(Reporting By Alison Frankel)
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