Short-seller Carson Block defends the practice, says trying to expose fraud is 'pretty American'

KEY POINTS

• Short-seller Carson Block told CNBC Wednesday the practice is important to root out fraud.
• "We have, globally, eight delistings of companies and two other regulatory actions that have led to sanctions," the founder of Muddy Waters Research said.
• "That, to me, seems to be pretty American when we're out there protecting investors," he said.

Carson Block defended the practice of short-selling Wednesday, telling CNBC it provides a crucial role in protecting investors by identifying companies that could be misleading investors.

"I got into this business 11 years ago by helping to eliminate a number of frauds from China that were listed in the U.S.," the founder of Muddy Waters Research said "Squawk Box." "We have, globally, eight delistings of companies and two other regulatory actions that have led to sanctions. That to me seems to be pretty American when we're out there protecting investors."  

Block has been a closely watched short seller ever since betting against Sino-Forest, which was ultimately delisted from the Toronto Stock Exchange in 2012, in the aftermath of Muddy Waters' 2011 report. It accused the Chinese timber firm of fraud. In 2018, plaintiffs in a civil case against Allen Chan, co-founder and CEO of Sino-Forest, were awarded billions of dollars in damages.

Last week, Block publicized his latest short position, accusing XL Fleet of exaggerating its sales pipeline to justify future revenue projections.

XL Fleet, which makes electrification drive systems to convert traditional commercial and municipal vehicles into hybrids, forcefully rejected the allegations from Muddy Waters in a statement Monday. Boston-based XL Fleet said the short-selling report "contains numerous factual inaccuracies, misleading statements, and flawed conclusions."

The practice of short selling — essentially a bet that a stock will fall —has come under scrutiny in the wake of the Reddit-fueled short-squeeze in GameStop that began in January. The video-game retailer's stock had massive short interest, which some retail investors realized and started to buy GameStop shares and call options that helped move the price upward.

Short-sellers borrow shares of a stock and then sell them back into the market, with the goal of purchasing them back later at a lower price. Then, they return the borrowed shares and profit off the difference. When the opposite happens, like with GameStop, shorts may seek to buy back the stock at current higher prices to limit their financial losses.

Hedge funds such as Melvin Capital that shorted GameStop believed the company's value would continue to fall as the brick-and-mortar retailer battled a shift toward e-commerce and more gamers turned to digital downloads instead of buying the physical disk. Melvin's founder, Gabe Plotkin, explained the firm's reasoning for shorting GameStop at a congressional hearing in February.

Block's Muddy Waters picks its short targets differently, often betting against firms it believes are misleading investors, rather than just having a languishing business in secular decline.

Another company Muddy Waters bet against was Luckin Coffee — announcing a short early last year, believing the Chinese firm was committing fraud. An internal investigation from Luckin Coffee later determined its chief operating officer fabricated sales, and the stock was eventually delisted from the Nasdaq months later.

Block, like all short sellers, has financial incentives for his target-stocks to fall and his firm's public disclosures of positions are known to move share prices, even if it may be just temporary. Because of that, some people criticize people like Block for going on television, for example, to discuss his firm's bearish bets.

Asked directly by CNBC's Andrew Ross Sorkin about those who want to place restrictions on short selling or contend that Block's public campaigns against companies is "not the American way," Block pushed back.

"The other side of that is, my perspective is, you're effectively saying then well, 'Cheating, scamming, exaggerating and getting money for it is the American way," Block said, reiterating that "if we're out there trying to expose and remove the economic incentives for a small number of people to take advantage of naiveté, that's American."

The volatile action in GameStop and the role social media played in attracting retail investors to the heavily bet-against stock has raised questions about how short sellers will approach positions in the future. Plotkin, for example, told Congress he believes hedge funds will adapt their strategies to avoid being caught in such dramatic short squeezes again.

One firm, Citron Research, has already said it's pivoting away from publishing short-selling research in favor of seeking out long positions.

While Block said he thinks GameStop may have changed the dynamics in some ways, he said he first observed a noticeable change last year. One company Muddy Waters shorted "ripped on us, and that was new," Block said.

"That told us there's a lot going on in the market that has nothing to do with fundamentals, and it's really technicals," he said. "Coming into this year before GameStop, we were thinking a lot about flows and how passive [management] and ETFs are really warping markets, so when we saw GameStop, I think that's just the five-alarm fire saying that these markets are really divorced, in many cases, from the fundamentals of the underlying asset."