Short Sellers and Financial Misconduct

TLDR

The study investigates whether short sellers can detect financial misrepresentation and whether their trading imposes external costs or benefits on other investors. Abnormal short interest rises steadily in the 19 months before misconduct is publicly disclosed, especially for severe cases, and short selling accelerates discovery, dampens share‑price inflation, and helps keep prices closer to fundamentals.

Abstract

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 when firms provide incorrect financial information.