The Informational Role of Internet-based Short Sellers

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Lei Chen examines the informational role of short sellers that publish negative Internet reports, using the setting of U.S.-listed Chinese firms, in a working paper series provided on SSRN.

During 2011, many China-based companies listed in the United States found themselves under attack from Internet-based short-sellers and online analysts dedicated to publishing negative reports and exposing instances of alleged fraud and financial mismanagement.” –Bloomberg (2011)

“In the absence of stricter regulation on companies and auditors, it is left to independent investors like Andrew Left or Carson Block to ferret out suspicious activity.” –Reuters (2011)

Although U.S.-listed Chinese firms were once Wall Street’s favorites, many of them have been embroiled in accounting scandals in the last few years. Behind the tumble of Chinese stocks was a new breed of information intermediary, i.e. short sellers who publish negative reports on the Internet, exposing incidences of alleged financial misconduct committed by Chinese firms (hereafter Internet-based short sellers). For instance, on June 28, 2010, Muddy Waters released a report on Oriental Paper, which rated the stock as a “strong sell” and questioned the veracity of the information contained in the company’s financial statements and press releases. On January 30, 2011, Citron Research issued a report on China MediaExpress Holdings Inc (OTCBB:CCME), showing evidence of this stock being “too good to be true”. On February 3, 2011, LM Research claimed that China Agritech Inc. (OTCMKTS:CAGC)’s financial statements for the fiscal year 2009 filed with the Security and Exchange Commission (SEC) were materially overstated compared to its subsidiaries’ financial statements filed with Chinese authorities. The rise of Internet-based short sellers soon attracts considerable attention of the mainstream media.

According to Reuters, these short sellers were the catalyst that wiped more than $21 billion off the market value of Chinese companies listed in North America, and the sell-off led to big losses for some very prominent investors, including hedge fund manager John Paulson and former American International Group Inc (NYSE:AIG) CEO Maurice “Hank” Greenberg.

Why do Internet-based short sellers expose the alleged financial misconduct of Chinese firms in particular? Why would they emerge, despite the oversight by regulators such as the SEC and the Public Company Accounting Oversight Board (PCAOB)? In a nutshell, the number of U.S.-listed firms that have the majority, or even all, of their operations in China, has soared during the past few years. Although such a trend is not inherently problematic, U.S. regulators have been increasingly concerned about these firms’ disclosure quality. Unfortunately, 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 the lack of access to relevant work papers of Chinese auditors. In response to the regulatory loopholes and severe information asymmetry, Internet-based short sellers emerge as a new breed of information intermediary, who conduct their own due diligence and publish negative reports on targeted firms where they allege corporate disclosures to be untrue or even fraudulent.

Against this backdrop, this paper examines the informational role of Internet-based short sellers. Using 360 hand-collected Internet reports, which target 74 distinct U.S.-listed Chinese firms from 2009 to 2012, I find an average three-day cumulative abnormal return (CAR) of -6.4%, centered on the report release day, and -13.8% for initial coverage of the firm. CARs are more negative when short sellers’ reports present first-hand evidence that is not available to the public, such as corporate filings by local unlisted subsidiaries, photos from unannounced factory tours and camera surveillance. The stock returns of targeted firms are also lower when short sellers provide extremely pessimistic stock price forecasts, which proxy for more severe alleged financial misconduct.

Full study via SSRN  

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