Carson Block was on a Delta flight to New York when he felt blood pooling on his seat.

It’s a tale the famous, filter-free founder of trading firm Muddy Waters Capital launches into to make a point about misdoings among short sellers, the subject of a vast probe by the US Justice Department. It describes a trip to unveil a big trade when the whole thing goes sideways because of a suspected information leak. And it gets darker as he goes. “Graphic story time,” he warns at the outset.

A few years ago, Block was heading to a conference to pitch his bet against Tal Education Group. As the jet cruised toward New York, he watched as someone else in the market rapidly stacked up bearish trades to profit on the presentation. Block tensed up and felt his blood pressure rising.

His firm had quietly set up the short position by borrowing shares and selling them. If his research sent Tal’s price tumbling, his staff could snap up the stock cheaply, repay loans and book a profit. But the mysterious interloper’s clumsy moves risked ruining everything.

Block told a colleague to unwind the trade immediately -- because if both Muddy Waters and the other investor tried to do so simultaneously, the price could surge and inflict losses. Indeed, that’s exactly what started happening.

“The stock’s rocketing, I’m just physically ill, I want to vomit, and I’ve got a million things racing through my mind,” Block recalled.

It was at that moment, he said, he felt a hemorrhoid burst. After the jet touched down he bought a sweatshirt from an airport gift shop to cover the stain. Then he bought a box of Depends. He soon walked on stage and improvised a speech about Chinese accounting, wearing adult diapers. 

In the staid world of Wall Street, perhaps no other money manager but the infamously brash Block would reel off such an episode in the middle of an interview to discuss the US investigation that’s upending life on the short-selling scene.

But Block, punctuating his remarks with expletives and chewing through a bowl of lifesavers on a conference room table at his office in Texas, argues it proves his case: The short-selling realm is chaotic, cutthroat and filled with people who try to profit from your ideas, but he can deal with it. He doesn’t need the feds trying to sort things out for him. Nor does he believe that the person who tried to piggyback on his trade broke the law. 

Yet a flurry of subpoenas the Justice Department has sent short sellers and their allies hint at serious concerns. The inquiries have sought information on trading in Tal, among numerous other companies, according to people familiar with the matter. Prosecutors and the Securities and Exchange Commission are examining whether short sellers are improperly teaming up to attack public companies -- part of a series of US inquiries into suspected market abuses. In this case, authorities are examining why bearish firms sometimes appear to move in sync, spurring concerns about potential market manipulation or insider trading.

"There’s a gun pointed at us, and it's really uncomfortable."

While prosecutors have gathered information on dozens of names in the industry, they've shown heightened interest in a few, including Block and his roughly US$200 million firm.

In October, federal agents wearing blue windbreakers approached Block as he was putting one of his kids into his car. They showed him a nine-page subpoena and seized his phones.

Block’s view is that the universe has flipped upside down. In the past, the authorities used his research as a starting point for their own inquiries, delisting companies or leveling regulatory or criminal charges. Now, they’re examining him.

Last year, he notes, Muddy Waters and other short sellers were mercilessly squeezed while betting against Chinese online-education company GSX Techedu Inc. Prosecutors have since accused Bill Hwang of market manipulation for driving up prices of that stock and others with a series of highly leveraged wagers that ultimately collapsed and took down his Archegos Capital Management. Hwang is fighting the charges.

During a day of interviews at his office, Block expressed confidence that he’s done nothing illegal. Yet at moments, he also questioned whether it’s worth the trouble anymore. More recently, he has sounded upbeat, expanding his operation and preparing new reports. He unveiled another trade just this week — pressing on while waiting to see whether the government takes any further action.

The notion that prosecutors might go after Muddy Waters reminds Block of the time he was mugged at gunpoint, initially shrugging it off but later realizing he could have died.

“Anytime somebody points a gun at you, there’s a non-zero chance something goes wrong even if that’s not their original intention,” he said. “That’s the case with being the subject of a DOJ investigation. There’s a gun pointed at us, and it’s really uncomfortable.”

A spokesperson for the Justice Department declined to comment. Authorities haven’t accused Block of wrongdoing, and an inquiry doesn’t necessarily mean charges will be filed.

Visitors to Muddy Waters’ new headquarters in Austin are greeted by a sparkling gold tuxedo jacket commemorating Jho Low, the fugitive financier accused of masterminding Malaysia’s multibillion-dollar 1MDB fraud. The garment is part of a costume used in the firm’s raunchy sendup of awards shows, “The Fidouchies,” with guests including adult film actress Stormy Daniels celebrating corporate conmen. Along the walls are numerous other mementos of Muddy Waters’ skirmishes with public companies.

It’s a reminder of how short selling has been a lot more colorful since Block splashed onto the scene more than a decade ago. 

When Muddy Waters opened in 2010, activist short sellers were a looser constellation of misfits, including some who spent lonely hours in their basements poring over company disclosures and other evidence to spot malfeasance. Even those who achieved fame, such as Block, recount how they struggled to fit into meticulously tailored Wall Street.

“Most of us were in some way outsiders for a long f---ing time,” Block said. “It’s really hard for us to hold our tongues and not make people feel uncomfortable.” 

But when his 2011 report on Sino-Forest Corp. sent the Chinese company’s shares down more than 70 per cent in a few days, Wall Street and retail investors began taking him very seriously. The research, accusing the tree-planting venture of exaggerating its assets, sparked probes and sanctions. Sino-Forest’s removal from the Toronto Stock Exchange is one of eight delistings for which Block claims credit. He soon turned his attention to other Chinese companies and their auditors.

Muddy Waters’ evolution since then illustrates how short selling is made up of ever-changing alliances between researchers and money managers -- relationships that US investigators are now said to be mapping out.

When Block set up shop, he had to rely on a so-called balance sheet provider, an outside money manager that could set up trades to profit on his reports. Block would get a cut. As Muddy Waters saw its clout grow, it began managing outside capital from funds-of-funds, as well as universities and foundations. Now Muddy Waters conducts its own research, handles trades and also teams up with outsiders who need its balance sheet. That last part of its business is managed by Freddy Brick, whom Block brought over from Oasis Management in 2014.

Block said he takes a variety of steps to prevent leaks before his trades. He requires researchers to sign contracts barring them from sharing information, capping their trading volume or even forbidding them from placing their own bets. Research partners let Muddy Waters look over their draft reports for quality control and are obligated to tell the firm publication is coming, he said, so that it can ensure its trades are set up. Still, specific trading plans aren’t shared, Block said. He also monitors his staff’s trading.

From the beginning, Block said he figured he would be sued, or even investigated, from time to time, but that such things were the cost of doing business. All he needs are three or four big, successful shorts a year to make ends meet -- or as he put it,  “feed the mouths of the research team and at the end of the day make it worth the bulls--- and the death threats and the dealing with litigation and all of the hatred on social media.”

'SMASH AND GRAB'

That hatred has been growing. Some of it comes from retail investors outraged over attacks on hot stocks. But there are also suggestions by academics and even some money managers that activist short selling may have devolved into a scheme of its own for making a quick buck. 

Marc Cohodes, a former hedge fund boss who now manages his own money from a chicken ranch in California, calls it “smash and grab.” It works like this: A prominent short seller stands on a stage and unveils research on a target company. The stock plunges 10 per cent, 20 per cent or 30 per cent before anyone has time to digest the report. By the time the public can debate the merits, the short seller has already closed out positions and is tallying gains.

Cohodes has become outspoken in the short-selling community about his disdain of such practices. He and Block have seen their once-cordial relationship sour into a deeply personal Twitter feud.

“There’s no place in the investment landscape for people who encourage others to trade one way and then take the other side of that position,” Cohodes said by phone. “When the government is done looking at this, people will know the proper rules on what you can and can’t do.”

Block doesn’t hide that he takes money off the table quickly. “What he calls ‘smash and grab,’ we call risk management,” he said of Cohodes.

In the interview, Block said he builds a position slowly over time, hoping to avoid attention as he shorts a mountain of stock equal to about 50 per cent to 100 per cent of its average daily trading volume. If his research causes the price to plunge, Block quickly locks in his gains, reduces his risk over the next few days and maintains a small bearish position from there on out.

The short-selling model had to change after the financial crisis, he said, because it spurred years of loose monetary policy that distorted markets and put a number of bearish investors out of business.

Waiting any longer, he said, also leaves the short seller exposed to other forces in the market. Retail traders might spot a short position, rally together and drive up the stock. Or algorithmic trading systems might exacerbate a rebound in a stock’s price by snapping up shares, erasing a short seller’s gains and even turning them into losses.

Block said that happened when one of his researchers published a bearish report in 2018 and watched the price climb. He also worried about setting off algorithms when unwinding his bets against Tal on the flight to New York.

It’s frustrating, he said, that short squeezes and computer-driven trading ignore the content of his reports. 

Like others embroiled in the US investigation, he’s trying to determine what prosecutors are actually after. 

Block saw the first sign that something might be up in late summer 2019 when one of Muddy Waters’ web hosts forwarded an email from a contractor for the Postal Inspector requesting an email trap be placed on one of the firm’s domains -- meaning that copies of messages sent to his firm would also go to the feds. He said this happened right after he published a report questioning the finances of Burford Capital, which funds litigation. Burford didn’t respond to messages seeking comment.

Then, last year, federal officers approached Block, Brick and Muddy Waters Chief Financial Officer Scott Devinsky.

Ever since, Block said his attention has been absorbed by the investigation. While he and his staff continue to grind out research and plan for the next report, Block said it’s no longer as much fun. He describes the probe as a dark cloud hanging over everything, including time with his family. And the legal fees are painful.

Some of Block’s anger is aimed at Columbia University law professor Josh Mitts, who he believes helped spur the probe with what Block sees as flawed research, taking issue, for example, with his sampling of bearish reports. Mitts has found that in many cases, such reports only temporarily depressed a stock’s value, raising concerns about potential market manipulation. He and about a dozen other securities-law professors urged the SEC to enact stricter rules on short sellers, forcing them to divulge more information on their trades. Block went so far as to send a letter to Columbia asking the school to conduct an ethics investigation into Mitts over his work for companies including Burford that have been targeted by short sellers.

Columbia didn’t respond to requests for comment. Mitts addressed the issue in a recorded speech to a conference this month, noting that when he initially published his research he didn’t have a consulting business. “I fully complied with Columbia's conflict of interest disclosure rules,” he said. “In fact, I've gone above and beyond those rules.”

'NO LIGHT'

Block suspects the Tal Education incident was caused by one of his outside researchers who got greedy, traded on it and leaked it. He suggests those trades may have, in turn, been detected and amplified by algorithms. Block ended up releasing his report on the Chinese tutoring firm about a week after his ill-fated Delta flight to New York, and the stock fell more than 40 per cent over the ensuing four months. 

Block rattled off several other instances when he suspected someone involved in the research either traded or spread word of an upcoming report, despite confidentiality agreements. He could try to sue confidantes for breaking promises but even then he doesn’t see how their actions could trigger a federal probe. 

With US investigators rummaging through bank records and personnel files, Block questioned his old analysis that an occasional inquiry would be a cost of doing business. It now seems more existential. He wonders aloud how long he’ll stick with the business.

“The guys who’ve been making cases for years based on our s---, if they think we’re a f----ing problem, there’s no end,” Block said of the Justice Department. “There’s no light at the end of the tunnel.”