THE INVISIBLE HAND OF SHORT-SELLING
by Massimo Massa, Bohui Zhang and Hong Zhang.
The experience of the recent financial crisis has brought attention to the role of short-selling. Short-selling has, in general, been identified as a factor that contributes to market informational efficiency. At the same time, however, short-selling has been regarded as “dangerous” to the stability of the financial markets and has been banned in many countries. Interestingly, the two seemingly conflicting views start from the same belief that short-selling only affects the way information is incorporated in the prices of the stocks, but not the behavior of the managers of the companies. That is, short-selling amplifies the reaction to existing information, making the market either more effective or overly sensitive, but does not affect managerial actions.
This is not the case! Indeed, it turns out that short-selling does affect the way managers behave by acting as a disciplinary mechanism for them. The disciplinary role of short-selling arises in two ways: First, short-sellers amplify the effect of shareholders walking the “Wall Street Rule” and selling the company shares. This negatively affects the stock price, effectively punishing the managers. In other words, short-selling can be seen as a “vote of confidence” on managerial behavior, which, by itself, provides information to the market about the firm. The fact that shorting demand can be levered or potentially coordinated implies that its impact on stock price could be even more effective to discipline the manager than the Wall Street Walk of any individual shareholder.
For instance, managers may have incentives to manipulate accounting information. Short-selling directly reduces such incentives by punishing firms with dubious accounting, and therefore indirectly improving the quality of information revealed to the market. As an example, in July 2011, short-sellers targeted Sino-Forest, a Toronto-listed Chinese forestry company. The alleged problems of the company ranged from reporting excellent results from one of its early joint ventures that never went into operation, to massively exaggerating the income and assets on its accounting books. The attack was so devastating that the firm filed for bankruptcy in the March 2012. This example illustrates the power of short-selling in punishing firms with suspicious reporting.
Second, given that short-selling improves price efficiency and that more information facilitates the use of more effective incentive-based contracts for the managers, the practice should be generally related to more efficient contracts. Overall, through enhanced oversight, improved price efficiency, and more efficient contracts, short-selling should be associated with better-aligned managerial incentives and better quality of information revealed by the firms.
Indeed, there is now evidence that the presence of short-sellers may affect stock value if news hits the market that doesn’t meet expectations. The short-sellers’ potential threat disciplines managers by acting as a multiplier of the sensitivity of the stock to bad or unexpected accounting news. As a result, companies in which there is more short-selling pressure manipulate the earnings less and display better accounting and transparency standards.
What about alternative oversight channels, such as the set of contractual arrangements designed to make the managers more responsible to the shareholders, including disclosure rules, high-powered incentives (e.g., equity-based compensation), specific configurations of the board set-up, and formal governance rules (e.g., anti-takeover provisions)? Is short-selling a substitute?
This is not the case. In fact, the presence of short-selling does improve the quality of such more “internal” governance. Indeed, the presence of short-selling makes it more costly for the existing shareholders to experience bad governance, and therefore increases the pressure on them to improve internal governance. In other words, the very fact that short-sellers discipline the managers by punishing them via the market price also punishes the uninformed shareholders of the firm. Therefore, the existing shareholders have an incentive to acquire information on the managers in order to preempt the short-sellers; i.e., selling before them. Alternatively, if such information acquisition is very expensive or they plan in any case to stay invested in the company for the long run, but still suffer from its short-term fluctuations, such shareholders do resort to putting in place a framework that better controls the managers by preventing them from triggering short-selling (i.e., improving internal governance.) The higher the loss that the existing shareholders suffer from short-selling, the more money they will be willing to pay for monitoring/governance.
This implies that threat of short-selling also increases the incentives to have a better quality of internal governance. And indeed, there is now evidence of a direct relation between the presence of short-selling and the quality of internal governance. Higher short-selling potential implies better formal governance, better structure and quality of the board, and more effective equity-based executive compensation.
An interesting related question is this: Who provides shares to short-sellers in order to exercise such a disciplining effect? The answer is institutional investors, and among them, ETFs. In the past decade, from 2001 to 2010, the ETF industry experienced an astonishing 40 percent annual growth rate, compared to the 5 percent annual growth rate of both global mutual funds and equity markets. This suggests that ETFs, while unrelated to information and shareholder activism, play a key role in disciplining managers by providing ammunition to the short-sellers.
Overall, this implies that short-selling—in general considered to be a source of the problem—does, in fact, contribute to its solution. The disciplinary force of the shortselling channel comes from the outside (i.e., the external market) as opposed to the inside (i.e., existing shareholders). This depicts one approach through which the “invisible hand” of the market affects and disciplines firm behavior.