59 Pages Posted: 7 Aug 2009 Last revised: 9 Feb 2010
Date Written: 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.
Keywords: Short selling, fraud, financial misconduct
JEL Classification: G38, G34, K42, K22
Suggested Citation: Suggested Citation