Short-Sale Constraints and Firm Investment Efficiency: Evidence from a Natural Experiment

Abstract

We examine the causal effect of relaxing short-sale constraints on firm investment efficiency using the experiment of the SEC Regulation SHO pilot program. Using a difference-in-differences approach, we find significant treatment effects of the pilot program on mitigating both underinvestment and overinvestment during the pilot period. These treatment effects disappear after the end of the pilot program. The effect on mitigating underinvestment is stronger for firms with severe financial constraints before the pilot period. The pilot program mitigates underinvestment and alleviates financing constraints more for pilot firms that experienced greater improvement in price efficiency after the pilot program began. The effect of the pilot program on mitigating overinvestment is more pronounced for firms with weaker governance and firms with more severe agency problems before the pilot period. These results suggest that relaxing short-sale constraints mitigates underinvestment through the external financing channel by improving price efficiency that alleviate financial constraints; and mitigates overinvestment through the managerial incentive channel by strengthening the disciplinary role of short sellers that enhances managers’ incentives to take correct actions.

Keywords: short-sale constraints, Regulation SHO, investment efficiency, underinvestment, overinvestment

JEL Classification: G14, G31, M41, M48