Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision

The following post comes to us from Yinghua Li of the School of Accountancy at Arizona State University and Liandong Zhang at City University of Hong Kong.

Corporate executives pay considerable attention to secondary market prices and they have strong incentives to maintain or increase the level of their firms’ stock prices. The accounting literature has long recognized that managers can make strategic financial reporting or disclosure choices to influence stock prices. A large body of empirical research examines whether and how corporate disclosures affect stock prices. The literature, however, provides little directional evidence on whether the behavior of stock prices has a causal effect on managerial strategic disclosure decisions. The difficulty in establishing causality stems largely from the endogenous nature of stock prices. In the paper, Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment, which is forthcoming in Journal of Accounting Research, we use a randomized experiment, the Regulation SHO pilot program, to examine the causal effect of stock price behavior on managers’ voluntary disclosure choices.

On September 7, 2004, the SEC passed Reg SHO, which mandated temporary suspension of short-sale price tests for a set of randomly selected pilot stocks during the period May 2, 2005 to August 6, 2007. The pilot stocks comprise every third stock of the Russell 3000 Index ranked by average daily trading volume. The suspension of short-sale price tests (i.e., the uptick test for the NYSE and the bid test for the NASDAQ) represents an exogenous decrease in short-sale constraints, leading to an increase in short selling activities for the pilot stocks. Increased trading activities of pessimistic investors make prices of the pilot stocks more sensitive to negative news. We predicts that managers of pilot firms, in response to the positive shock to price sensitivity to bad news, reduce the precision of bad news earnings forecasts to maintain the current level of stock prices. This prediction is based on the theory and evidence that the magnitude of price reaction to a disclosed signal is positively related to its precision (e.g., Kim and Verrecchia, 1991).

Using a difference-in-differences regression approach, we find that the pilot firms significantly reduce their bad news forecast precision by about 17% relative to the control group upon adoption of Reg SHO, consistent with our prediction. This result is robust to controlling for a battery of other determinants of forecast precision as well as firm and time fixed effects. Moreover, we find no significant differences in changes in good news forecast precision between the treatment and control groups. This null result for good news forecasts essentially lends additional credence to the causal effect of short selling pressure and consequent price behavior on management disclosure choices. In addition, the finding on management forecasts appears to be generalizable to other corporate disclosures. We find that pilot firms with bad earnings news also reduce the readability (or increase the textual complexity) of their annual reports around implementation of Reg SHO. This result is consistent with the conjecture of Bloomfield (2002) that managers can reduce the market response to bad news by making bad news more costly to analyze.

Overall, our study represents one of the first efforts to investigate the causal effect of stock price behavior on managers’ disclosure choices. Our evidence is consistent with the assumption maintained in the accounting literature that maximizing stock prices is one of the most important factors determining managers’ strategic disclosure choices. Corporate managers, in response to increased sensitivity of stock price to bad news, tend to obscure disclosure of negative information. In addition, our empirical results support the general idea of Bond, Edmans, and Goldstein (2012) that secondary market prices have a causal effect on the decisions of corporate managers, and are not simply a sideshow.

The full paper is available for download here.

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