Opinion ID: 499747
Heading Depth: 2
Heading Rank: 2

Heading: Short Selling

Text: 8 Because this case turns to some extent on the nature of short selling as an investment strategy, we set out here our understanding of that process. Where the traditional investor seeks to profit by trading a stock the value of which he expects to rise, the short seller seeks to profit by trading stocks which he expects to decline in value. A typical short seller expects decline because, based on his view of the underlying strengths and weaknesses of a business, he concludes that the market overvalues the business' stock. As demonstrated by the allegations, these underlying facts can concern the present--such as the fact that a stock trades at fifty times its earnings--or they can concern the future--such as the fact that a business will face increased competition. 2 9 Short selling is accomplished by selling stock which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee or rate of interest. At this point the investor's commitment to the buyer of the stock is complete; the buyer has his shares and the short seller his purchase price. The short seller is obligated, however, to buy an equivalent number of shares in order to return the borrowed shares. In theory, the short seller makes this covering purchase using the funds he received from selling the borrowed stock. Herein lies the short seller's potential for profit: if the price of the stock declines after the short sale, he does not need all the funds to make his covering purchase; the short seller then pockets the difference. On the other hand, there is no limit to the short seller's potential loss: if the price of the stock rises, so too does the short seller's loss, and since there is no cap to a stock's price, there is no limitation on the short seller's risk. There is no time limit on this obligation to cover. 10 Selling short, therefore, actually involves two separate transactions: the short sale itself and the subsequent covering purchase. We reject appellees' suggestion that the two components of selling short be considered one transaction. 3 When the short seller transfers borrowed stock to a buyer, its obligations to that buyer are ended. His only obligation is an open-ended one to the person who loaned him the stock. A short seller's default on this obligation will not affect the prior transfer. Also, the short seller exercises real discretion in choosing when to purchase shares, and this latter transaction actually determines his profit or loss. 4 Thus, this investment, like most investments, involves two transactions: a purchase and a sale. That the sale occurs before the purchase does not affect our consideration of each separate transaction for the possible effects of fraud.