When Hedge Fund Managers Put Their Mouths Where Their Money Is

Over the last few months the business press has written many stories about hedge fund manager William A. Ackman’s billion-dollar short of nutritional supplement company Herbalife. Ackman is betting that the price of the stock will fall because the company (in his view) is nothing more than an immoral and illegal pyramid scheme. The New York Times has noted, however, that Ackman isn’t leaving anything to chance. He has successfully lobbied members of Congress to call for an investigation of Herbalife, pressured the Federal Trade Commission (FTC) to investigate the company, paid civil rights organizations to help him organize against it, and generally conducted an “extraordinary attempt to leverage the corridors of power” to crush Herbalife. The campaign seems to be making progress: the FTC and FBI recently announced that they have begun investigations into Herbalife, and the company’s stock has plunged as much as 32% this year from its recent high. The New York Times has painted Ackman’s tactics as an extreme (and unusually public) form of an increasingly common phenomenon: financiers “frequently” ask regulators to investigate and punish companies they’re betting against, making “Washington [increasingly] a battleground of Wall Street’s financial titans.”

Whether or not we want to call this sort of influence activity “corruption” (which, as Matthew pointed out in a previous post, is the subject of a longstanding debate), it raises difficult questions about how to regulate the influence of wealth on the political, regulatory, and — recently — law enforcement processes. Although Ackman’s concerns about Herbalife may very well be legitimate, the opportunity to abuse government resources and manipulate the market exists if investors push for investigations in bad faith — for no other reason than to make a buck and use law enforcement to do it.

Should we be worried about this conduct? And if so, should government agencies police against possible abuses of the law enforcement process?

Regulating lobbying activities like Ackman’s can be very difficult for a simple reason: much of this lobbying activity is good and important, and it’s difficult to tell the bad from the good. At its best, allowing people to bet against companies while pressuring for an investigation gives people an incentive to bring their concerns to the government’s attention, since they stand to gain financially if the government follows through. But it can be very difficult to tell whether someone is lobbying for an investigation because they truly believe a company is predatory, or because they want to make money by shorting the stock, or both. A prophylactic rule banning self-serving influence activities like Ackman’s would throw out the good reporting with the bad. If given a choice between shorting a stock they think should fall or bringing malfeasance to the government’s attention, many investors may choose the former, depriving the government of important sources of information.

But that’s not to say that defending against abusive enforcement lobbying is impossible. Rather than banning the behavior ex ante, an agency could investigate abuses of the behavior ex post. For instance, an agency such as the SEC could investigate enforcement-influencing behavior it considers abusive or manipulative under authority similar to the SEC’s ability to prosecute market manipulation, which it defines in part as “intentional conduct designed to deceive investors [including by] spreading false or misleading information about a company.” While identifying intentional conduct in bad faith can be difficult, it may not be more difficult than other motive-driven, fact-intensive investigations undertaken by the SEC and other federal agencies that enforce anti-manipulation rules. The SEC would probably need to promulgate a new rule banning manipulative or abusive bad-faith lobbying of enforcement agencies, but it should have statutory authority to do so under Section 10(b) of the Securities Exchange Act. Taking such a step would allow the government to defend itself from abusive interference with the law enforcement process while keeping an open front door for investors seeking to report commercial misconduct in good faith.

I can think of a number of obvious philosophical and practical objections to this approach. First, it may be difficult to craft a rule instituting this new kind of liability without over-deterring good faith reporting. Depending on how the rule is written and enforced, the risk of government sanction may convince many investors simply to play it safe and avoid pressing their cases. Second, one could argue that it’s the government’s responsibility to resist public lobbying, and that if the FBI or FTC decides to launch a meritless investigation, it is their decision, and not the investor-reporters’ fault.

But a smart regulatory designer could probably account for at least the practical concerns. For example, the rule could create a variety of safe harbors, such as exempting from scrutiny reports made to enforcement agencies through formal, official, and standardized processes — targeting only the indirect, cloak-and-dagger campaigns waged by investors like Ackman, while preserving a separate avenue for information presumed to be offered in good faith.

Any new rule would require complex cost/benefit balancing and the possibility of very real tradeoffs. But the increasing interference in federal law enforcement of “Wall Street’s financial titans” raises important questions about whether and how to protect federal agencies from becoming tools for market manipulation, rather than market protection.

5 thoughts on “When Hedge Fund Managers Put Their Mouths Where Their Money Is

  1. Thought-provoking post, Eden. ICE deals with an analogous issue: how should it treat a potentially accurate tip from a source with illegal motives? E.g., an employer illegally retaliating against a worker for organizing by offering a tip to the INS that its facility contains many undocumented immigrants. ICE’s policy is to exercise its discretion in such situations, declining to pursue these tips unless there are special circumstances. I guess the analogy here would be having the FTC, FBI, etc. adopt some sort of a more demanding standard of review when the complainer has a financial interest in the downfall of a company? Something like a presumption against acting on it? It would constitute an ex ante check in addition to your ex post ones. https://www.ice.gov/doclib/secure-communities/pdf/domestic-violence.pdf

  2. I think the safe harbor option you propose is revealing in that it wouldn’t actually do anything to deter investors from acting in bad faith. Imagine I am a purely economic rational actor. If I was shorting a company, had potentially damaging information about that company, and knew I could divulge that information to the government through a safe harbor without fear of investigation, I would do it, even if I didn’t care at all about the public good. Disclosure could potentially lower the value of the company with no risk to me. The fact that a safe harbor system still strikes us as a solution leads me to think that our real concern isn’t that the Ackmans of the world are acting with improper motives, it’s that their holding themselves out as altruistic is causing government actors to give their information more credence than it deserves. In other words, Ackman is creating an information asymmetry and that is what is damaging, not his motives themselves. That being the case, I would design a regulatory system focused less on punishing “bad faith” tips and more on ensuring that government actors understand the potential biases of the tippers giving them information. Maybe instead of a standardized process for submission of tips, what we really want is a safe harbor that allows tippers access to safe harbor if they clearly disclose their financial interests. (Or perhaps, what we are really concerned about is just that people like Ackman wield too much influence over government officials in general, which gets to much larger questions about agency capture and money in politics.)

  3. A fundamental anti-corruption ethic should be: never mind the source or reasons for the tip off – is it true? If it is not true then all malice or self-interest fails. If it is true then it has to be prosecuted.

  4. I’m not sure that it’s even theoretically possible to differentiate between good faith and bad faith tips. Is the standard whether the tipper is going to profit from the disclosure? How could a regulator determine someone’s subjective intentions, and should these even matter? I also wonder if, in the absence of falsehood, this might even implicate first amendment rights.

  5. Eden – I agree with Sam that the primary problem isn’t that people with a financial stake in the enforcement decision are trying to tip off the government but rather that they aren’t disclosing the interest so that the government authorities can properly evaluate the credibility of the claim. I think you agree with this point since the safe channel you offer doesn’t prevent people like Ackman from tipping off the government, it just tries to shift their efforts from the shady world of lobbying and influence-peddling to the presumably more transparent formal tip mechanism.

    But I have a more general concern with permitting enforcement actions to be taken against those who offer “bad” tips. I understand that enforcement authorities (and juries) are often asked to parse the subjective motivations of private actors, but I feel like there will always be a strong presumption that a tipster with a financial interest in an enforcement action was acting in bad faith if the government is unable to uncover sufficient evidence to undertake an enforcement action. The problem for me is that the tipster’s financial interest may become a proxy for their subjective motivations even if bad faith tips are not highly correlated with the strength of the tipster’s financial interest. I think that’s why I’m far more pessimistic that this proposal would over deter healthy tips.

    Taken together, I think this proposal would probably overdeter and underdeter. It would overdeter because I think that the tipster’s financial stake would likely cut in favor of a “bad faith” determination, even just as an evidentiary matter. And it would underdeter because actors like Ackman could still push for the same enforcement actions, they would just have to shift their actions to different channels (i.e. your “safe harbor”).

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