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Thursday, May 05, 2005

First sell short, then sue (from Overlawered)

Overlawered asks an interesting question. If a lawyer short-sells a stock and then sues the company in a class action suit, should they be deemed insiders?:

"There is some evidence that plaintiffs and their attorneys are profitably short-selling the stock of the companies they intend to sue," writes Moin Yahya of the University of Alberta law faculty in a new paper called "The Legal Status of 'Dump & Sue'" (SSRN, Mar. 9). Strategic litigants or their attorneys thus stand to capture two distinct strands of revenue: one from the eventual settlement of the suit, the other from the profits they capture after their adversary's stock declines on the announcement of the suit. (Alternatively, some lawsuits might be rendered profitable by the gains from short-selling even though they never win settlements at all.) Does insider-trading law as it currently stands prohibit such goings-on? Not necessarily, since litigants and their lawyers don't ordinarily count as "insiders" in conventional terms. But given securities regulators' goal of upholding what they call market integrity, it's hard to see why they would not want to prohibit the sleazy practice. For a dissenting view, see Larry Ribstein (Apr. 11).
My question is why the lawyers short-sell when they could buy a high-delta (delta is the change in option price from a unit change in the price of the underlying stock) put option, since taking that tack would have higher expected profits. The obvious reasons are:
  1. Unwillingness to make the up-front commitment of $$ necessary to buy the option (the short-sale takes no immediate cash
  2. The higher risk inherent in the option strategy.
  3. The firms chosen as targets don't have traded options.
The last possibility is that lawyers can't figure out the optimal strategy. Given the predilection of lawyers to make money, I doubt that's a credible explanation.

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