Illustration by Christoph Niemann

In November, 2013, Whitney Tilson, who runs a small hedge fund called Kase Capital Management, gave a presentation to a group of money managers. Tilson’s talk was about a flooring company called Lumber Liquidators. In the previous two years, its profits had more than doubled and its stock had risen sevenfold. But Tilson made a case for selling the company short—betting on its stock to fall. He thought that its profit margins were unsustainably high and suspected that it had driven down costs by buying wood illegally harvested in Siberia. (The company denies buying illegally logged wood but says that it may face criminal charges relating to this issue.) Months later, a whistle-blower contacted him. “He said the story was much bigger than the sourcing of illegal hardwood,” Tilson told me. The contact alleged that the company was saving money by buying laminates made of wood soaked in formaldehyde (a carcinogen) from Chinese factories, and that the resins these factories used also contained the substance. Tilson hired a lab to test the laminates, and it found formaldehyde levels two to seven times the limit established as safe by California, on which forthcoming federal standards are based. A small investor named Xuhua Zhou had already published a detailed report alleging similar problems.

Shorting Lumber Liquidators turned out to be a good call. On March 1st, “60 Minutes” aired a blistering exposé on the company. The segment included tests showing high formaldehyde levels and hidden-camera interviews in which workers in China admitted lying about quality. The next day, Lumber Liquidators’ stock fell twenty-five per cent. It then recovered a bit as the company mounted a P.R. offensive—insisting that its products were safe and that “60 Minutes” had used “improper” testing procedures. But the stock is still down more than forty per cent in the past three weeks.

Short selling—borrowing an asset in order to sell it, in the hope of buying it back after the price has fallen—has been a part of markets at least since the seventeenth century. But Lumber Liquidators’ tumble is the result of something new: the rise of the activist short. Traditionally, shorting has been seen as unsavory, even corrupt. Many people blamed it for the Great Crash of 1929, and the practice is illegal in some countries. During the financial crisis of 2008, many countries, including the U.S., banned the short selling of financial stocks. Regulators have generally been skeptical of shorts. When the hedge-fund manager Bill Ackman shorted the mortgage insurer MBIA, alleging accounting problems, he was investigated by the New York State Attorney General’s office. Short sellers, not surprisingly, tended to keep their heads down.

But in recent years they have been going public. In 2011 and 2012, a small short-selling firm called Muddy Waters made a name for itself by exposing fraud at a series of Chinese companies that were listed on North American exchanges. Last summer, a short-selling outfit called Gotham City Research published a report excoriating the financial accounting of Gowex, a Spanish telecom company. Within days, the company’s C.E.O. had resigned and Gowex had filed for bankruptcy. Battles between shorts and the companies they attack have even become front-page news, as with Ackman’s billion-dollar bet (so far unsuccessful) against Herbalife.

Many investors are unhappy about activist shorts and argue that they have an incentive to drive down a company’s stock price with false allegations and then cash out at the bottom—a practice known as “short and distort.” This is Lumber Liquidators’ current defense: it says that it is the victim of “a small group of short-selling investors who are working together.” Shorting and distorting does happen, and is illegal. But the rise of activist shorts has been, on the whole, a good thing. All kinds of forces conspire to push stocks higher: investor overconfidence, corporate puffery, and Wall Street’s inherent bullish bias. Shorting helps counterbalance this, and it contributes to the diversity of opinion that healthy markets require. In 2007, a comprehensive study of markets around the world found that ones where short selling was legal and common were more efficient than ones where it was not. And a 2012 study concluded simply, “Stock prices are more accurate when short sellers are more active.”

Short sellers can also play a vital role in uncovering malfeasance. Stock exchanges do almost no vetting of companies, as long as they meet financial requirements. Wall Street analysts run the risk of alienating clients if they’re too bearish. And regulators don’t have the resources to look closely at thousands of companies. In that environment, short sellers—precisely because they get rich from bad news—help keep the market honest. The most famous example is the Enron scandal: it was a short seller, James Chanos, who suggested that the emperor had no clothes. A recent study of markets in thirty-three countries concluded that shorting helps “discipline” executives and reduces the likelihood of earnings manipulation.

Of course, short sellers are often wrong, and that may yet prove to be the case with Lumber Liquidators. But the fact that the company’s response to the charges was to attack short sellers should give investors pause. In a 2004 study, Owen Lamont, a business-school professor, looked at more than two hundred and fifty companies that had gone after short sellers—filing lawsuits, calling for S.E.C. investigations, and so on. Their long-term performance was dismal: over three years, their average stock-market return was negative forty-two per cent. That suggests that, if you react to bad news by shooting the messenger, it may be because you know the message is true. ♦