In Short, Investors Can Help Keep Firms Honest
"We should by no means deny that short selling comes with external positive benefits. That benefit includes restraining firms' optimistic reporting behavior."
For years, it’s been held that stock markets are simply a side show, absorbing and trading off the decisions companies make and the information they disclose. Assistant Professor Vivian Fang says that this viewpoint doesn’t capture the entire story. According to her research, firms also pay attention to the trading of their stocks and this often can affect the decisions they make.
Fang was presented with a unique way to study and demonstrate this effect when the SEC adopted changes to the regulations governing short selling. As part of the Regulation SHO, the SEC conducted a nearly two-year pilot program that allowed one third of the firms on the Russell 3000 index to be traded free of short sale price tests. This randomized experiment reduced the costs of short selling these firms and produced some rather interesting findings.
"Our research shows short sellers can have a disciplinary effect on managers and during this pilot program that helped constrain optimistic reporting behavior," says Fang.
She says capital market pressure can create an incentive for firms to manage their earnings by manipulating accruals to just beat expectations such as those set by analysts. When Fang and her colleagues looked at firms’ discretionary accruals, those who were in the pilot (and thus easier to short) saw their discretional accruals decrease during the SEC’s program before reverting to pre-experiment levels when it ended.
"The SEC implemented this experiment to evaluate market quality," she explains. "So they were definitely surprised that the price tests had such a strong impact on a firms’ reporting behavior."
Fang and colleagues also discovered that among those firms who had engaged in financial misconduct before the program began, those who were in the pilot (and thus less costly to short) were more likely to get caught than non-pilot firms after the program began.
Watch Fang further describe her findings:
“Short Selling and Earnings Management: A Controlled Experiment”
Fang, V., et al, Journal of Finance (forthcoming)