Short Sellers and Financial Misconduct

¶ … role of short sellers in discovering firms guilty of financial misrepresentation. The article opens by recounting the criticisms of short selling, beginning with the charge that short sellers subvert investor's confidence in financial markets and that short selling results in diminished liquidity. Short sellers have been known to spread false rumors about a firm in which they had taken a short position, then subsequently profit from the resulting drop in the stock price. Proponents of short selling argue, on the other hand, that the activity actually promotes market efficiency and the price discovery process.

Karpoff and Lou researched the question of whether short sellers identify firms that are overpriced, and whether they consequently convey benefit or harm to other investors. The study authors investigated the premise by analyzing a sample of firms that were disciplined by the SEC for financial misrepresentation. Their research included three tests with results showing short sellers' expertise in uncovering financial misrepresentation before it is publicly disclosed. In the 19 months preceding the misrepresentation becoming public, short interest increased significantly. The researchers also found that there was a positive correlation between the amount of short selling and the degree of financial misconduct. This correlation existed because short sellers took larger positions in firms with the more flagrant SEC violations. Study findings also showed that indicators of short interest were significantly related to the actual occurrence of financial misrepresentation which was later revealed in SEC documents.

Related Research

The study authors researched the available literature on previous studies looking for evidence that short sellers anticipate and help to disclose financial misconduct. The studies revealed mixed results. Karpoff and Lou found three prior studies that were closely related to theirs. With these studies in mind, Karpoff and Lou designed their study to control for the severity of the misconduct, to examine whether short selling was concentrated in misconduct firms, and to estimate the external effects on uninformed investors.

Data and Short Interest Measures

Karpoff and Lou discussed the measures they took to avoid data problems that were associated with other studies. Their investigation revealed information about when the misrepresentation occurred and about the nature of the trigger event, a circumstance which defined the initial public revelation of firm misconduct. They gave examples of the types of trigger events that attract SEC scrutiny: self-disclosures of malfeasance, restatements, auditor departures, and unusual trading.

One of the more interesting pieces of data to come out of the authors' study was the timeline for a typical SEC enforcement action. The median length of the violation period combined with the enforcement period was just under 6 years. Their study also revealed a trend showing that this combined violation and enforcement period generally increased from 1988 to 2005.

Do Short Sellers Identify Misrepresenting Firms?

Karpoff and Lou's research would indicate that the answer to this question is yes. Another point of interest that the study highlights is that abnormal short interest took several months to decline after the misconduct was publicly revealed. This finding would seem to indicate that new short sellers were taking new positions in the stock, and that short sellers were continuing to profit even after the initial revelation of misconduct.

The study also offered evidence that short sellers detect financial misrepresentation in advance of its revelation to the public. Given that short sellers seemed to be expert at uncovering information about overvaluation of the affected firms, the study authors expected that the amount of short selling would be directly related to the severity of the misrepresentation. Their analysis did indeed show that short sellers anticipated not only the existence of financial misrepresentation, but also its severity.

Short Seller's External Effects on Other Investors

This study had a number of fascinating aspects, findings that ran counter to some generally held beliefs about the consequences of short seller activities. While many would assume that short sellers contribute to downward price pressure that happens when misconduct is publicly revealed, the study authors found no evidence to show that short selling caused an overreaction. What they found instead was evidence that short sellers helped to expose financial misrepresentation.

Other study findings showed how short selling affected share prices and the number of shares held by other investors. Uninformed investors realized benefits from short selling when it kept prices nearer to their full-information values. At the same time however, uninformed investors were harmed due to short sellers' profits.

Conclusions

Karpoff and Lou's study demonstrated the effect of short sellers on markets. They showed evidence that short sellers improve informational efficiency. Study results show evidence of short sellers' ability to successfully identify financial misrepresentation before it becomes generally known to the investing public. Although the explanation that the study authors provide, that short sellers react to specific triggers that indicate the likelihood of misconduct, their performance is still impressive. If knowledge of firm characteristics that are known to correlate with short selling, such as firm size, book-to-market ratio, momentum, share turnover, institutional ownership and total accruals, do not account for short seller success at identifying financial misrepresentation, then that leaves superior abilities to explain their success. It is worth noting that the study authors do not rule out insider information as an explanation for their superior insights.

The fact that short interest is so clearly a predictor of financial misrepresentation is fascinating. It would seem that a logical extension of this observation is the fact that anyone who wanted to profit from short selling needs only follow the lead of the short sellers. This observation applies to SEC enforcers or anyone else with an interest in identifying firms that misrepresent their financial condition.