Short Sellers and Financial Misconduct
Jonathan M. Karpoff, University of Washington
Xiaoxia Lou, University of Delaware

We examine whether short sellers detect firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors. Abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe. Short selling is associated with a faster time-to-discovery, and it dampens the share price inflation that occurs when firms misstate their earnings. These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values.

Although theory suggests that short selling should make prices more efficent, few empirical studies have been undertake to provide support for this proposition. The current public policy debate on short selling thus is often based on emotional and political issues rather than on hard facts. This study help fill this void. The result will interest active investment managers who employ short selling strategies and passive investment managers whose performance depend on fairly priced securities.