Does the Presence of Short Sellers Affect Insider Selling?

Massimo Massa is Professor of Finance at INSEAD. This post is based on an article authored by Professor Massa; Wenlan Qian, Assistant Profess of Finance at National University of Singapore; Weibiao Xu of the Department of Finance at National University of Singapore; and Hong Zhang, Associate Professor of Finance at Tsingua University.

A large body of literature shows that insiders trade on private information. Less attention, however, has been devoted to how the trading activity of other types of “informed” investors affects insiders’ trading activity. In our study, we address this issue by exploring how the presence of a particular type of informed investors—i.e., the short sellers—could alter insiders’ incentives to trade on their private (negative) information.

We know that short sellers are able to identify overvalued stocks. In addition, short sellers intermediate a considerable amount of trade. Collectively, these characteristics make short sellers an important class of “informed” investors whose trading activity may directly and significantly affect insiders.

In our paper, Competition of the Informed: Does the Presence of Short Sellers Affect Insider Selling?, forthcoming in the Journal of Financial Economics, we propose a channel through which short selling can affect insiders: trading competition. More specifically, we argue that the presence of short sellers changes the strategic behavior of insiders by introducing potential competition in private information trading. In the absence of short sellers, insiders with access to information about a value-destroying event not yet disclosed to the market will strategically sell their shares before the information is known to the public. However, in the presence of short sellers, insiders will fear that short sellers may obtain access to the same information and therefore compete with the insiders in trading on the information. The presence (fear) of such trading competition increases the rate at which private information is revealed to the market, drives down the price at which insiders can sell their shares, and jeopardizes the profitability of insider sales. Insiders, such as senior managers and board directors, having access to superior corporate information before the outsiders, will accelerate their information processing and trading activities in order to preempt short sellers. As a result, the potential of effective short selling ex ante increases the scope and speed of insider sales. By contrast, with no credible short-selling competition, insiders should sell at low volumes and over a long period of time to reduce the price impact of their trades.

We test this focusing on US stocks over the 2006-2011 period. We use lendable sharesthe fraction of shares available for borrowing (by short sellers)—as a proxy for the potential severity of short selling (hereinafter, short-selling potential). We first show that the occurrence (i.e., likelihood) of open market sales by insiders (directors and officers) is strongly positively associated with the availability of lendable shares in the previous month. In other words, insiders tend to trade more aggressively in the presence of short sellers when their trading is motivated by private information.

Then we focus on the modality of the insider sales. More specifically, we examine the amount and time span of insider trades. We document that, conditional on their decision to participate in open market sales, the amount that insiders sell as a fraction of their existing stakes is significantly positively associated with short-selling potential. By contrast, the time span of insider sales is significantly reduced by the potential presence of short selling. This suggests that insiders also speed up their trades to potentially pre-empt short sellers.

We show that our results are causal exploiting an experiment: the SHO experiment. The Regulation SHO PILOT program, announced in 2004, randomly selected one-third of the stocks on the Russell 3000 Index to be exempt from uptick rules and other price restrictions. The relaxation of short-selling restrictions induced an exogenous change in short selling cost. We show that, in line with our full sample results, the announcement that the short-selling restrictions were being lifted increased the propensity for insider selling among the pilot firms relative to the firms in the control group.

Furthermore, we focus on the number of negative public news events concerning the firm and the level of realized shorting activity among industry peers to proxy for short sellers’ potential attention. We find that insiders sell more of their ownership stake and do so more rapidly when both lendable shares and short sellers’ potential attention are high.

We then explore the market implications of short selling with respect to information dissemination. We document that the predictability of (opportunistic) insider sales is concentrated in stocks with high short-selling potential. In other words, in the presence of short sellers, insiders are more likely to sell when they have information of particularly high quality. By urging insiders to release new negative information into the market, short selling indirectly accelerates information dissemination for firms. This finding confirms our initial intuition that the impact of other types of informed traders on insiders will significantly affect the general process of information dissemination in the market.

These results extend this literature by revealing a specific channel through which short sellers expedite information discovery—by incentivizing insiders who have private information to trade. They are important as they document that “informed” professional investors (e.g., shortsellers) improve market efficiency not only by directly trading, but also (and possibly more importantly) by speeding up the trades of the insiders. To our knowledge, this is the first study that addresses such an important issue with a detailed empirical analysis that links shortselling and sales by insiders. This provides new insights for regulators and policy makers in terms of the interaction between insider trading rules and restrictions on short selling activity.

We also contribute to the literature on the informativeness of stock prices. Existing studies in this literature focus on the institutional environment faced by firms to explain the informativeness of stock prices. Our unique contribution is to propose and test an explicit economic channel through which short selling can (indirectly) improve the price efficiency of the economy. This indirect channel complements the direct channel of trading in affecting efficiency.

Overall, our results have important normative and policy implications, illustrating that regulations aimed at reducing short selling will also affect the informativeness of the market by reducing insider selling. Therefore, the subjects of different policies may need to be considered jointly: policies that affect shorting are likely to also affect insider trading. Moreover, our findings suggest that the effect of short selling could have been largely underestimated to date, because regulators and academic researchers have till now ignored its impact on prices through insider trades that precede the shorting trades.

The full paper is available for download here.

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