If one is an incident, two is a coincidence, and three is a trend, the freedom to sell short is in danger. The lawsuit filed by Overstock.com was the first recent case in which a company tried to sue short sellers for market manipulation. At the time, the suit seemed like a quirk, the product of an eccentric executive’s paranoid imagination. The public started paying attention only when, in a related investigation, the Securities and Exchange Commission’s enforcement division overstepped its bounds and tried to subpoena journalists. Now that another company, pharmaceuticals firm Biovail, has filed suit against hedge funds that sold its stock short, and has gotten a sympathetic segment on “60 Minutes” to boot, it’s time to pay real attention.

Short sellers borrow stock to sell on the market and then buy the shares back later to repay the loan. They make money if the stock price falls between when they sell the share and when they repurchase it, meaning that, for a short seller, the only good news is bad news. In these cases, Overstock.com and Biovail charge that various hedge funds – each company names a different set – conspired with a single analyst, Gradient Analytics, to manufacture some bad news.

Not that the defendants would have had to try very hard even if they were issuing slanted research. Biovail had a bad year in 2003, the time during which it claims these doings were afoot. It faced dispatches in the Wall Street Journal about allegedly dubious marketing practices. It missed earnings targets by miles. It disclosed that it was under investigation by the SEC for its accounting practices, for which it was also facing a shareholder lawsuit by the end of the year. A rival company got approval for a drug to compete with one of Biovail’s products. You can’t blame anyone for selling the stock short, Gradient report or no.

Yet that is precisely what Biovail is trying to do with its $4.6 billion lawsuit, to which one can add a separate $4 billion suit filed by Biovail’s shareholders earlier this week. Worse, if these suits are allowed to proceed they could spark even more. The plaintiffs’ bar goes where the money is, and hedge funds have a lot of money. The funds also engage in a lot of short selling because the trades offer them a way to hedge their portfolios – and fulfill their fiduciary responsibilities. Ambitious trial lawyers need only find any company that experienced a dramatic drop in stock price amid negative analyst reports – and there are plenty of these in the wake of the tech boom and bust – and head to court. It’s a way to spin straw into gold.

The effects, if this is legitimized by the courts, could be profound. Short selling is extremely important to functional financial markets, an expert on litigation reform at the Manhattan Institute’s Center for Legal Policy, James Copland, told us yesterday. “In the aggregate, if these suits are allowed to proliferate, it will put a damper on hedge funds’ ability to sell short,” Mr. Copland said. A member of the Manhattan Institute’s board, Mark Gerson, is chief executive of the Gerson Lehrman Group, a firm named as a defendant in the Biovail suit.

It may not come to that. If either, or better yet both, of these cases fail, the lawyers, not to mention disgruntled executives, will have to find other outlets for their energy. The risks make the cases worth watching. If nothing else, they point to the dangers of over-litigation in securities markets, as plaintiffs’ lawyers have increasingly been encroaching on territory that traditionally belonged to regulators like the SEC. In this case, that encroachment could seriously damage America’s financial markets.