Short Sellers and Financial Misconduct Jonathan Karpoff University of Washington Xiaoxia Lou University of Delaware The Q Group April 5, 2011 Short sellers - April 5, 2011
Xerox’s cumulated market-adjusted returns January 1997 – December 2006 10/8/99: Xerox warns 3rd qtr 1999 Public revelation earnings will be short of projections 10/8/99: Xerox warns 3rd qtr 1999 1/1/97: Violation earnings will be short of projections period begins 6/16/00: Xerox announces 2nd qtr 2000 earnings will not meet expectations Violation to revelation 7/3/00: SEC starts formal investigation 3/26/07: SEC enforcement 4/10-12/02: Wells Notice; action concluded SEC files civil complaint Short sellers - April 5, 2011
Our questions 1. Do short sellers anticipate financial misrepresentation? 2. How do they affect markets and social welfare? Short sellers - April 5, 2011
Short selling is in the news… � A pernicious strategy of “short and distort … Market integrity is threatened.” � Former SEC Chairman Christopher Cox � “Financial Terrorism” � CNBC’s Jim Cramer, on short selling � “Financial Jihad” � Infidel Blogger’s Alliance, on short selling Short sellers - April 5, 2011
Defenders and detractors � Academics: Short selling facilitates information flow and the price discovery process � Detractors: Short selling facilitates market manipulation Was Shamu actually ill? � � Might short sellers be heroes? Jim Chanos helped expose Enron � David Einhorn and Allied Capital � Short sellers - April 5, 2011
These views affect policy SEC actions during the crisis (September 2008): � Banned naked short selling � Temporarily banned all short selling in 799 “financial companies” � New short selling reporting rules for institutional money managers � Dodd-Frank bill (2010) � Mandates new SEC study of short selling (to “protect” investor � confidence) Short sellers - April 5, 2011
Our data All 632 SEC/DOJ enforcement actions initiated from 1988-2005 for � financial misrepresentation � 13(b)(2)(A) - requires accurate books and records � 13(b)(2)(B) - requires internal controls Monthly short interest data available for 474 firms � CRSP data available for 454 firms � Short sellers - April 5, 2011
Timeline of a typical enforcement action Enforcement Period Violation Period Regulatory Period * Proceedings Events Public Violation Violation Inquiry Investigation Wells Initial Concluding revelation Begins Ends Event Event Notice Regulatory Regulatory (“trigger Proceeding Proceeding event”) Violation to Revelation Enforcement Events We focus on the time before public revelation Short sellers - April 5, 2011
Num ber of enforcem ent actions and m onths to public revelation # of Cases Violation beginning to revelation (months) 80 70 Median time to revelation = 26 months 60 50 40 30 20 10 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Short sellers - April 5, 2011
The Xerox example is typical… Public revelation is bad news (Table II) Initial Revelation Regulatory Inquiry or Initial revelation Violation proceedings investigation Period Down 3% Down Down 10% 18% Short sellers - April 5, 2011
Question #1: Do short sellers anticipate financial misconduct? � Raw short interest = # shares short in month t ÷ # outstanding shares � Averages 1.65% over all firm-months � Abnormal short interest: ABSI(j) it = raw SI it − expected SI it Short sellers - April 5, 2011
Table III: Three measures of ABSI(j) , j=1,2,3 Included in ABSI(2) Short sellers - April 5, 2011
Table III: Three measures of ABSI(j) , j=1,2,3 Included in ABSI(3) Short sellers - April 5, 2011
Raw and abnormal short interest during months [-19, +20] (Table IV and Figure 2) Raw short interest Abnormal short interest ABSI(1) Short sellers - April 5, 2011
Is short selling related to the severity of the misconduct? ABSI(1) i,-1 = 1.25 – 0.038 AR i + controls (p=0.03) Abnormal short Abnormal interest in return upon month -1 revelation � But this could indicate merely that short sellers anticipate a large price drop, not that they sell more when the misconduct is severe. Short sellers - April 5, 2011
Three measures of misconduct severity � Fraud charges � Insider trading charges � Total accruals during misrepresentation period Short sellers - April 5, 2011
From Table V i , − 1 = λ 0 + λ i , − 1 + λ i , − 1 + ε j = 1,2,3 ABSI( j ) 1 Severity 2 Controls i , Panel A: ABSI(1) 1 2 3 4 Severity measures: 1.328 Fraud charges 1.65 (0.03) (0.13) 2.034 1.299 Insider trading charges (0.01) (0.12) 5.151 4.47 Total accruals (0.00) (0.00) Inference: Abnormal short interest at month -1 is positively related to the severity of the misrepresentation – that is not yet public . Short sellers - April 5, 2011
The severity measures are economically meaningful Change in Implied change severity measure in ABSI(1), in % Fraud charges nearly double ABSI Fraud 1.65 Insider trading Insider trading 2.03 charges more than double ABSI Total accruals: 3.02 10 th to 90 th percentile Overall average level of short interest = 1.65% Average abnormal SI in month -1 = 1.9% Short sellers - April 5, 2011
Question #2: How do short sellers affect markets and social welfare? E.g., do they help uncover financial misconduct? Violation Period Violation Public Violation Begins Revelation Ends Is this affected by Violation to Revelation short selling? Short sellers - April 5, 2011
Table IX: Time-to-discovery logistic survival model log( M i ) = β ' X i + ε i . Difference between 75 th and 25 th percentiles = 8 months Models X(t) 1 2 3 4 5 Abnormal short interest -0.028 -0.025 -0.028 -0.026 -0.023 (<0.0001) (<0.0001) (<0.0001) (<0.0001) (<0.0001) Fraud -0.323 -0.480 (<0.0001) (<0.0001) Insider Trading -0.008 0.122 (0.91) (0.13) The amount of prior short selling is negatively related Total accruals -0.228 -0.197 to the time until the (0.05) (0.07) misconduct is publicly revealed. Short sellers - April 5, 2011
Do short sellers affect the price inflation during the violation period? Would the price have been even higher without short selling? Actual price path Violation to revelation Price after public revelation Short sellers - April 5, 2011
Short sellers’ external effects on share prices and quantity, for a given month t
How we estimate P high Step 1: Cross-sectional model for each month t: K ∑ ret it = β 0 + β 1 Size i , t − 1 + β 2 BTM i , t − 1 + β 3 Mom i , t − 1 + + β 4 ABSI ( j ) i , t − 1 + ε i Ind ik , t − 1 k = 1 Step 2: Hypothetical return in month t if abnormal short interest were zero: hyp = r it Ğ ö β 4 ABSI( j ) ret it i,t − 1 Step 3: Hypothetical cumulative return from the beginning of violation: t ∑ cumret it = high ret i τ τ = 1 Step 4: P high is the starting price * hypothetical cumulative return: Short sellers - April 5, 2011
External effects, mean estimates Data Net benefit to uninformed investors = 1.09% of mkt cap. Short sellers - April 5, 2011
External effects: Some details (Table X) On average, short sellers But for the median convey substantial benefits firm, these benefits are to uninformed investors negligible (and the net benefit is slightly negative) Short sellers - April 5, 2011
Summary: The overall pattern of (abnormal) short selling Public revelation Major build-up Wind-down positions The build-up is Early build-up positively related to the severity of the misrepresentation Short sellers - April 5, 2011
How do short sellers affect Short interest does not markets and social welfare? exacerbate the price decline when the misconduct is revealed Public revelation Major build-up Wind-down positions Early build-up Short sellers - April 5, 2011
How do short sellers affect markets and social welfare? Public revelation Major build-up Wind-down positions Early build-up Short interest decreases the time to public discovery of the misconduct Short sellers - April 5, 2011
How do short sellers affect markets and social welfare? Public revelation Major build-up Wind-down positions Early build-up … And it dampens the price inflation during the violation period. Short sellers - April 5, 2011
Our questions answers 1. Do short sellers anticipate financial misrepresentation? Yes. a) They anticipate the severity of the misconduct. b) They get it right, on average (low rate of false positives) Short sellers - April 5, 2011
Our questions answers 1. How do short sellers affect markets and social welfare (at least with regard to this set of events)? Positively. a) They do not exacerbate price declines on bad news. b) They accelerate the discovery of the misrepresentation. c) They help keep prices in check while the books are in error. Short sellers - April 5, 2011
Short sellers - April 5, 2011
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