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Short Sellers and Financial Misconduct

Xiaoxia Lou

University of Delaware - Alfred Lerner College of Business and Economics

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business

August 5, 2009

We examine whether short sellers identify firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors. Abnormal short interest increases steadily in the 19 months before the initial public revelation of financial misrepresentation that subsequently triggers SEC sanctions. Short interest is positively related to the severity of the misrepresentation, and it is higher in misrepresenting firms than in other firms. There is no evidence that short selling exacerbates a downward price spiral when the misconduct is publicly revealed. Short selling is, however, associated with a faster time-to-discovery of the misconduct, and it dampens the share price inflation that occurs when firms overstate their earnings. Our point estimates of the net external benefits to uninformed investors who trade during the average firm’s violation period range from 0.19% to 1.53% of the firm’s equity value. Overall, this evidence indicates that short sellers anticipate the eventual discovery and severity of financial misconduct. Short selling also conveys external benefits to uninformed investors, by helping to uncover financial misconduct and by keeping prices closer to fundamental values when firms provide incorrect financial information.

Number of Pages in PDF File: 59

Keywords: Short selling, fraud, financial misconduct

JEL Classification: G38, G34, K42, K22

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Date posted: August 7, 2009 ; Last revised: February 9, 2010

Suggested Citation

Lou, Xiaoxia and Karpoff, Jonathan M., Short Sellers and Financial Misconduct (August 5, 2009). Available at SSRN: http://ssrn.com/abstract=1443361 or http://dx.doi.org/10.2139/ssrn.1443361

Contact Information

Xiaoxia Lou
University of Delaware - Alfred Lerner College of Business and Economics ( email )
Newark, DE 19716
United States
Jonathan M. Karpoff (Contact Author)
University of Washington - Michael G. Foster School of Business ( email )
Box 353200
Seattle, WA 98195-3200
United States
206-685-4954 (Phone)
206-221-6856 (Fax)
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