The Informational Role of Internet-Based Short Sellers

The following post comes to us from Lei Chen of the Department of Accounting at the London School of Economics and Political Science.

Despite serious concerns about the quality of auditing and financial reporting of U.S.-listed Chinese firms, the SEC and the PCAOB have been unable to provide sufficient or timely information to U.S. investors due to resource constraints, the confidentiality rules underlying the PCAOB disciplinary proceedings, and no access to relevant work papers of Chinese auditors. In the paper, The Informational Role of Internet-Based Short Sellers, which was recently made publicly available on SSRN, I focus on a new breed of information intermediary, i.e. Internet-based short sellers that have emerged in response to such regulatory loopholes and severe information asymmetry. Based on hand-collected Internet reports released during the 2009-2012 period by short sellers that target U.S.-listed Chinese firms, I find that these short sellers provide substantial information both directly and indirectly to investors.

Short sellers’ reports have an immediate effect on stock prices of targeted firms, and the magnitude of such an effect can be explained by the timeliness and quality of the information contained in the reports. Non-targeted firms experience negative spillover upon short sellers’ coverage, especially when they have shared the same non-Big 4 auditors as targeted firms. In the long run, the stock prices of most targeted firms do not recover, and the realized stock returns are highly correlated to short sellers’ implied stock returns. Short sellers’ coverage is likely to be followed by class action lawsuit and SEC enforcement. I also find that short sellers are more likely to cover the firms that show impressive operating and stock performances, and that have already displayed red flags in financial reporting quality. Overall, by exploiting the unique setting of U.S.-listed Chinese firms, I show that Internet- based short sellers overcome the limitations of regulators. This paper contributes to both the literature on the role of media as an information intermediary and the literature on short selling. Last, my research also adds to current discussion of more intensive, mandated disclosure of short interest.

This paper focuses on U.S.-listed firms and covers the reports from 2009-2012, which limit the generalizability of my findings. To enhance our standing of Internet-based short sellers, broader samples need to be adopted. For instance, in response to recent accounting debacles at Chinese firms, the PCAOB has intensified its dialogue with both the China Securities Regulatory Commission and the Ministry of Finance. Further research might examine whether the role of short sellers targeting Chinese firms has weakened due to such regulatory initiatives. Moreover, Internet-based short sellers certainly extend their coverage to other firms and have become more active after establishing the reputation with successful bearish calls on Chinese companies. It will be interesting to examine their impact on non-Chinese firms and their selection of targets, given less severe information asymmetry in other settings.

A voluminous literature has examined the effects of the tone or sentiment expressed in a variety of information outlets such as annual reports, analyst reports, media news, and the Internet. So far, this line of research is based on an analysis of texts, and has ignored non-text elements such as pictures, audio, and video. Short sellers’ reports contain considerable non-text information. For example, when exposing the fraud of Sino Clean Energy, short sellers present dozens of photos and hours of surveillance videos of its plants that show no meaningful production. As I documented, reports that present first-hand evidence, which is normally in the form of pictures, audio or video, cause the most drastic market reactions. However, any dictionary or linguistic algorithm used in this literature would fail to capture the sentiment in such a report. Therefore, a fruitful area for future research could be the role of non-text information conveyed by information intermediaries in financial markets.

The full paper is available for download here.

Both comments and trackbacks are currently closed.