Short Selling and Earnings Management: A Controlled Experiment

Abstract

During 2005 to 2007, the SEC ordered a pilot program in which one-third of the Russell 3000 index were arbitrarily chosen as pilot stocks and exempted from shortsale price tests. Pilot firms' discretionary accruals and likelihood of marginally beating earnings targets decrease during this period, and revert to pre-experiment levels when the program ends. After the program starts, pilot firms are more likely to be caught for fraud initiated before the program, and their stock returns better incorporate earnings information. These results indicate that short selling, or its prospect, curbs earnings management, helps detect fraud, and improves price efficiency. PREVIOUS RESEARCH SHOWS that short sellers can identify earnings manipulation and fraud before they are publicly revealed. 1 But this is for earnings manipulation that has already taken place. Might short selling also constrain firms' incentives to manipulate or misrepresent earnings in the first place? That is, does the prospect of short selling help improve the quality of firms' financial reporting?In this paper we exploit a randomized experiment that allows us to address this question. In July 2004, the Securities and Exchange Commission (SEC) adopted a new regulation governing short-selling activities in the U.S. equity markets-Regulation SHO. Regulation SHO contained a Rule 202T pilot program in which stocks in the Russell 3000 index were ranked by trading volume * Fang is with the University of Minnesota. Huang is with the Hong Kong University of Science and Technology. Karpoff is with the University of Washington. We are grateful for helpful comments from two anonymous referees, an anonymous Associate Editor, Kenneth Singleton (the Editor), Vikas pilot stocks were exempted from shortsale price tests, including the tick test for exchange-listed stocks and the bid test for NASDAQ National Market (NASDAQ-NM) stocks. 2 The pilot program creates an ideal setting to examine the effect of short selling on corporate financial reporting decisions, for three reasons. First, the exemption from short-sale price tests decreased the cost of short selling in the pilot stocks relative to the nonpilot stocks (SEC (2007), Diether, Lee, and Werner (2009)). The pilot program thus eliminates the need to directly estimate short-selling costs, a notoriously difficult task (Lamont (2012)). Rather, we use the fact that the prospect of short selling increased for pilot firms relative to nonpilot firms during the program. Second, the pilot program represents a truly exogenous shock to the cost of selling short in the affected firms. We identify no evidence that the firms themselves lobbied for the pilot program, or that any individual firm could know it would be in the pilot group until the program was announced. Third, the pilot program had specific beginning and ending dates, facilitating difference-in-differences (hereafter, DiD) analysis of the impact of short-selling costs on firms' financial reporting. In particular, the anticipated ending date allows us to investigate w...

Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment

“…Finally, our study provides additional evidence on the effect of short selling regulation. Recent research examines the effect of Reg SHO on short selling activities and market quality (Diether, Lee, and Werner [2009]), corporate financing and investment decisions (Grullon, Michenaud, and Weston [2012]), the design of CEO compensation contracts (Angelis, Grullon, and Michenaud [2013]), and earnings management (Fang, Huang, and Karpoff [2013]). Our study contributes to this line of research by examining the effect of Reg SHO on corporate voluntary disclosure decisions.…”

“…According to a 2008 NYSE survey, managers appear to be aware of and sensitive to the impact of eliminating price tests on the amount of short-selling in their firms(Grullon, Michenaud, and Weston [2012],Fang, Huang, and Karpoff [2013]). They also should have known whether their firms were selected for the experiment given the public disclosure of the list of pilot securities on the SEC's Web site several months before implementation of Reg SHO and the extensive financial media coverage of the experiment.…”

Short Selling and Executive Pay-for-Performance Sensitivity

“…Karpoff et al (2010) [4], Hirshleifer et al (2011) [5] found that short selling can restrain the financial fraud. Chen et al (2015) [12], Fang et al (2016) [13] found that short selling can restrain earnings management and improve the reliability of financial information. Li (2017) [14] found that the introduction of short selling significantly improved the quality of the target company's information disclosure.…”

Short‐selling constraints and corporate payout policy

“…Following Fang et al (2016), we use a DiD approach in the following regression models (Eqns 1 and 2) to identify a causal relationship between short-selling constraints and corporate payouts.…”

“…the 2004 Regulation SHO pilot program (see next paragraph)) to investigate whether relaxing short-sale constraints affects corporate decisions, such as investment and financing (Grullon et al, 2015), earnings management (Fang et al, 2016) and design of compensation contracts (De Angelis et al, 2017). A strand of studies examines the relationship between short selling and corporate decisions using conventional fixed-effects regression analysis.…”