Electronic copy available at: http://ssrn.com/abstract=1443361
Short Sellers and Financial MisconductI. Introduction
Short selling is a controversial activity. Opponents argue that short sellers engage inunscrupulous activities that undermine investors’ confidence in financial markets and decreasemarket liquidity. For example, a short seller can spread false rumors about a firm in which hehas a short position and profit from the resulting decline in the stock price.
Former SECChairman Christopher Cox calls this strategy “distort and short,” and argues that because of such false rumors, “market integrity is threatened” (Cox 2008). Advocates, in contrast, arguethat short selling facilitates market efficiency and the price discovery process. Investors whouncover unfavorable information about a firm can sell short, thereby allowing the unfavorableinformation to be quickly incorporated into market prices. In his account of short selling inAllied Capital, Inc., hedge fund manager David Einhorn argues that short sellers even helpuncover corporate misdeeds and financial reporting violations (Einhorn 2008).
In this paper we investigate whether short sellers do in fact identify overpriced firms,and whether in the process they convey external benefits or harms on other investors. We doso by measuring the short selling activity in a set of firms that,
, clearly were overpriced:those that are disciplined by the SEC for financial misrepresentation. In our sample of 454firms from 1988 through 2005, 96% have negative abnormal returns on the days their
In 2000, for example, investor Mark Jakob turned a $241,000 profit by shorting Emulex stock and spreading aninternet rumor that Emulex’ CEO was stepping down amid an SEC investigation (seehttp://www.sec.gov/litigation/litreleases/lr16747.htmand http://www.sec.gov/litigation/litreleases/lr16857.htm).Leinweber and Madhavan (2000) report a case in which investors shorted Sea World stock and spread falserumors that Shamu, Sea World’s main attraction, was ill. For other examples, see Barr (2006).
Lamont (2004) and Jones and Lamont (2002) discuss the sometimes heated language that characterizes thedebate over short selling, and whether it fosters market efficiency or facilitates harmful manipulation. See alsoWilchins (2008).