(The opinions expressed here are those of the author, a

columnist for Reuters.)

By Alison Frankel

Oct 16 (Reuters) - Short sellers pursing securities

fraud claims in Colorado, Kansas, New Mexico, Oklahoma, Utah and

Wyoming got two kinds of bad news in a federal appellate

decision issued on Monday in a case against online retailer

Overstock.

The Denver-based 10th U.S. Circuit Court of Appeals refused

to revive a securities class action led by short seller Mangrove

Partners, which alleged that Overstock misled investors about

its sales prospects in early 2019 and then concocted a

complicated scheme - more on that later - to squeeze short

sellers and drive up its share price. One of the goals of the

scheme, according to Mangrove, was to allow Overstock's founder

and former CEO Patrick Byrne to maximize his profits when he

exited the company and sold off his stake after the revelation

of his romantic relationship with a Russian spy.

The 10th Circuit ruled, first of all, that Mangrove's case

must be dismissed because the short seller was not entitled to

invoke the fraud-on-the-market presumption of reliance on

Overstock's allegedly false statements. The court's reasoning:

As a short seller, Mangrove bought Overstock shares in order to

meet its contractual obligations to cover its short position,

not because it was misled by the company's allegedly fraudulent

representations about revenues.

The presumption of reliance, as you know, is the bedrock of

shareholder class actions. It's based on the idea that fraud

taints the entire market for broadly-traded shares, impacting

every investor that buys or sells until the fraud is revealed.

Companies defending shareholder class actions can rebut the

presumption by, for instance, arguing in briefs opposing class

certification or seeking summary judgment that misstatements did

not impact their share price. But generally speaking, securities

fraud plaintiffs do not have to worry about reliance in the

preliminary stages of their cases.

That's no longer a given for short sellers litigating in the

10th Circuit after the Overstock case. Judges Joel Carson,

Carlos Lucero and Veronica Rossman concluded in an opinion

written by Carson that Mangrove failed to allege reliance

because it admitted in its pleadings that it was forced to buy

Overstock shares to cover its short position.

Mangrove "cannot have it both ways," Carson wrote. "If

bought its shares to avoid breaching its lending

contracts, it cannot also have bought its shares because of

[Overstock's] alleged misstatements."

The 10th Circuit said in footnotes that it was not adopting

a blanket rule barring short sellers from invoking the

presumption of reliance, citing an amicus brief by several state

pension funds that warned such precedent would create problems

for institutional investors.

But you can be sure that defendants facing fraud claims by

short sellers in courts within the 10th Circuit will point to

this decision to argue that because shorts have different

motivations than ordinary investors - particularly when they are

being squeezed to cover their positions - short sellers cannot

count on the presumption of reliance. The ruling could also be a

factor for courts picking investors to lead shareholder class

actions and for judges weighing whether to certify classes.

But that's not the only part of the decision that should

trouble short sellers. The 10th Circuit also agreed with a Utah

trial judge's ruling that Overstock did not engage in market

manipulation because the company fully disclosed its

short-squeezing tactics.

The alleged manipulation involved Overstock's announcement

of a plan to issue a blockchain-based dividend that would not be

registered with the U.S. Securities and Exchange Commission. I'm

simplifying, but because Overstock said the digital dividend

would be an unregistered security, shareholders would not be

able to trade the dividend for six months.

That prohibition put a squeeze on short-sellers, who had to

buy shares to cover their positions before being locked into

liability for the untradeable digital dividend.

The market quickly figured out the implications of the

unregistered dividend plan. Byrne himself said in public blog

posts that the maneuver was specifically intended to squeeze

Overstock short-sellers he'd been battling for years.

The tactic, moreover, worked: The company's share price shot

up as shorts bought stock to cover their bets, before falling

again when market-makers said shorts could use cash to hedge

their positions. Byrne allegedly made $90 million from selling

his shares in the midst of the short squeeze. (The SEC

investigated Byrne's trades but informed him in August 2024 that

it would take no action. His lawyer, Robert Driscoll of

Dickinson Wright, declined to provide a statement on the 10th

Circuit case.)

A distinguished group of securities law professors and two

investor-minded public interest groups joined Mangrove in urging

the 10th Circuit to rule that investors adequately alleged

market manipulation.

But the 10th Circuit said market manipulation demands an

allegation of deceit - and Mangrove hadn't shown that

Overstock's digital dividend plan fooled the market.

"The market received notice that short sellers might buy

Overstock stock to cover their positions before the dividend's

record date," the appeals court said. "Buyers and sellers

possessed sufficient information to form judgments about how

Overstock's dividend would impact Overstock's share price."

The key issue, according to the 10th Circuit, was timing.

Regardless of what Mangrove knew when it opened its short

position on Overstock, the appeals court said, by the time the

fund bought Overstock shares to cover the short, the market

understood the company's digital dividend strategy to squeeze

short sellers.

Overstock, wrote Carson, did not send "a false signal to the

market," so it cannot be liable for market manipulation.

I emailed Mangrove counsel Michael Eisenkraft of Cohen

Milstein Sellers & Toll, who argued the appeal for investors

back in February 2023. He didn't get back to me. Overstock lead

counsel John Dwyer said in an email message that he is out of

the office and unavailable. Overstock, which is now part of

retail conglomerate Beyond, did not respond to an email

query.

Class actions stemming from short squeezes are a relatively

small subset of securities class actions. And the 10th Circuit

is certainly not a hotbed of investor class actions. But I have

a feeling the Overstock decision is going to turn up in

unexpected places.

Read more:

Overstock to issue stock to be traded on blockchain platform

Overstock.com CEO Patrick Byrne resigns after revealing

involvement in FBI-Russia probe