Does Short Selling Discipline Earnings Manipulation?

The experience of the recent financial crisis has brought to the attention the role of short selling. Short selling has been identified as a factor that contributes to market informational efficiency. At the same time, however, short selling has been regarded as “dangerous” to the stability of the financial markets and has been banned in many countries. Interestingly, these two seemingly conflicting views are based on the same traditional wisdom that short selling affects only the way in which information is incorporated into market prices by making the market reaction either more effective or overly sensitive to existing information but does not affect the behavior of firm managers, who may shape, if not generate, information in the first place.

This is not the case! Short selling, being part of the “invisible hand” of the market, may directly influence the behavior of firm managers. There are two potential effects. To understand them, consider a manager who can manipulate a firm’s earnings to reap some private benefits but who faces reputational or pecuniary losses if the public uncovers this manipulation. The manager will be confronted with a trade-off between the potential benefits and losses. The presence of short sellers affects this trade-off. On the one hand, given that short sellers increase price informativeness and attack the misconduct of firms, their presence, by increasing the probability and speed with which the market uncovers earnings management, reduces managers’ incentives to manipulate earnings. We call this view the disciplining hypothesis.

On the other hand, the downward price pressure of short selling may increase the negative impact of failing to meet market expectations. Therefore, any additional downward price pressure arising from short selling may incentivize firms to manipulate earnings. In other words, the threat of potential bear raids may drive managers to manipulate earnings to avoid the attention of short sellers and thus the confounding impact associated with the downward price pressure of their trades. We call this view the price pressure hypothesis.

These considerations, together with the aforementioned traditional wisdom that managers may simply ignore the existence of short sellers suggest that short selling may have conflicting effects in the real economy. Distinguishing among these competing hypotheses is critical to identify the real impact of short selling, which is the aim of our paper, The Invisible Hand of Short-Selling, Does Short-Selling Discipline Earnings Manipulation?, forthcoming in the Review of Financial Studies

To detect the potential impact of short selling, we focus on the ex ante “short-selling potential” (SSP)—that is, the maximum potential impact that short sellers may have on firm behavior or stock prices—as opposed to the ex post actions taken by short sellers in response to observed firm manipulation. The main proxy for SSP is the total supply of shares that are available to be lent for short sales. We explore the impact of SSP by using a worldwide sample of short selling covering thirty-three countries over the 2002–2009 period. We find strong evidence that SSP of a stock is negatively associated with the extent of the firm’s earnings management.

Moreover, we show that this is not mere correlation, but causality—i.e., the presence of short sellers reduces earning manipulation! To achieve such causal interpretation, we conduct two endogeneity tests—these tests also have important nominal implications as we will discuss shortly. First, since more and more exchange-traded funds (ETFs) supply lendable shares to the short-selling market, we use the ownership of ETFs that fully replicate benchmarks as an instrument variable to capture exogenous variations in SSP. Second, we explore two regulatory experiments that enhance SSP for some stocks within a market: the SEC Regulation SHO in the United States and the gradual introduction of (regulated) short selling on the Hong Kong Stock Exchange. In both tests, increases in SSP reduce earnings management, supporting the disciplining hypothesis as opposed to the alternative hypotheses/interpretations.

The disciplining effect applies to a wide spectrum of earnings management measures, including not only discretionary accruals but also a list of target-beating, earnings persistence, and earnings misstatement measures. In addition, we also show that, worldwide, regulations that restrict short selling (such as country-wide short-selling bans) are typically associated with greater earnings management. Interestingly, we observe that the disciplining impact of short selling on earnings management increases over time when short-selling activity grew. Finally, we not only confirm a positive relationship between short selling and stock price informativeness, but also find that this positive relationship is more pronounced when the potential impact of short selling on earnings management is high, suggesting that short selling may increase price efficiency by reducing the incentives for firms to manage their earnings.

Overall, we find compelling evidence that short selling disciplines managers. Unlike traditional governance mechanisms, the disciplining force of the short-selling channel identified in our paper arises from outside the firm (i.e., from the external market) as opposed to inside the firm (i.e., from existing shareholders; more discussions on the relationship between short selling and internal governance can be found here). Hence, the “invisible hand” of the market, through mechanisms such as short selling, not only allocates resources but also affects and disciplines managers.

Our findings have important normative implications. We provide extensive analyses related to lendable shares and their passive suppliers—ETFs. In particular, we document that ETFs, while unrelated to information and shareholder activism, play a key role in disciplining managers by providing ammunition to the short-sellers. This finding not only allows us to measure the disciplining impact of short selling using a concrete proxy, but also enables us to identify a pivotal economic channel—that is, ETFs—that affects the prosperity and efficiency of the short selling market. Moreover, our focus is broad, considering the impact of short selling on the global market, not merely the U.S. market. Jointly, therefore, our results provide both concrete channels and unique international experience that policy makers, especially those in emerging markets, can rely on to improve firm efficiency through both the adoption of better short-selling-related regulations and the development of passive (ETF-alike) and long-term investors.

The full paper is available for download here.