Regulatory Trading Restrictions, Overvaluation, and Insider Selling

Abstract

A contentious debate is emerging over the regulatory response to the financial crisis. This paper takes advantage of a rare opportunity to empirically test sweeping short sale constraints. Specifically, I analyze 2008 trading restrictions which prohibited short selling in all U.S. financial stocks. It is not clear whether restrictions keep negative sentiment off the market, sending prices up, or discourage ownership by stock lenders, sending prices down. It is also debatable how coincident events such as TARP affect prices, since avoiding bankruptcy is beneficial, but equity issuance and poor capitalization is not. The findings in this paper have three important implications for market participants. First, positive abnormal return and increased insider selling are consistent with an overvaluation hypothesis. The possibility of overvaluation due to TARP is ruled out since only a small percentage of restricted firms receive TARP funding and prices react negatively when they do. The overvaluation finding is consistent with prior studies of trading restrictions, such as IPO lockups. Second, additional evidence is provided on the documented relationship between institutional ownership and short sale constraints. Firms with low institutional ownership, low short interest, small market cap, and firms traded on the NASDAQ were least affected by the ban. This is relevant since 95% of stocks are not constrained by institutional ownership levels. Finally, short selling is known to facilitate information revelation and I find large declines in short interest result in less market efficiency.

Keywords: SEC Regulation, TARP, short sale constraints, market efficiency, institutional ownership, insider trading

JEL Classification: G14, G18, K22, K23