The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?

The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?

The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?

Massimo Massa

INSEAD – Finance

Bohui Zhang

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University of New South Wales (UNSW) – School of Banking and Finance; Financial Research Network (FIRN)

Hong Zhang

Tsinghua University – PBC School of Finance; INSEAD – Finance

Review of Financial Studies, Forthcoming

INSEAD Working Paper No. 2012/93/FIN

Asian Finance Association (AsFA) 2013 Conference


We hypothesize that short selling has a disciplining role vis-à-vis firm managers that forces them to reduce earnings management. Using firm-level short-selling data for 33 countries collected over a sample period from 2002 to 2009, we document a significantly negative relationship between the threat of short selling and earnings management. Tests based on instrumental variable and exogenous regulatory experiments offer evidence of a causal link between short selling and earnings management. Our findings suggest that short selling functions as an external governance mechanism to discipline managers.

The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management? – Introduction

Short selling has traditionally been identified as a factor that contributes to market informational efficiency.1 However, short selling has also been regarded as “dangerous” to the stability of financial markets and has even been banned in many countries during financial crises.2 Notably, 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.

However, short selling may also directly influence the behavior of firm managers. To understand the intuition, 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. As short sellers increase price informativeness and attack the misconduct of firms (e.g., Hirshleifer, Teoh, and Yu, 2011, Karpoff and Lou, 2010), 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 implying that managers may simply ignore the existence of short sellers (which can thus be labeled the ignorance hypothesis), suggest that short selling may have conflicting effects in the real economy. Distinguishing among these competing hypotheses is critical to elucidate the real impact of short selling, which is the aim of this paper.

To detect the potential impact of short selling, we focus on the ex ante “short-selling potential” (SSP)—i.e., the maximum potential impact that short sellers may have on firm behavior or stock prices 3—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 (hereafter, Lendable). This variable is directly related to the theory on the ex ante impact of short selling. Diamond and Verrecchia (1987), for instance, demonstrate that short-sale constraints reduce informative trades and the speed of adjustment to private information. A limited supply of lendable shares imposes precisely this type of constraint (Saffi and Sigurdsson, 2011). Thus, a high fraction of shares lendable to short sellers implies a high degree of SSP that may either discipline managers or exert price pressure. Moreover, more active shareholders are also less likely to lend shares to short sellers on a large scale (e.g., Prado, Saffi, and Sturgess, 2013).4 This unique property will also help us to identify the passive supplies of lendable shares as an instrument to control for the spurious impact of internal monitoring.

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