Corporate fraud poses a significant agency cost for stock ownership. Activist short sellers, who conduct and publicize investigative research, play a crucial role in exposing such fraud, in contrast with most short sellers who quietly await price catalysts without public dissemination. These activists publish their findings and engage with market participants to prompt a swift share price drop by encouraging mass stockholder sales. Prior research has shown that companies targeted by these activists tend to experience negative stock returns following campaign disclosures, implying that the information revealed is, on average, credible. However, there is significant variation in the post-disclosure return performance among activist short campaigns, even within those disclosed by the same activist.

In a new paper, we develop a framework delineating the roles of campaign-specific private information quality and short-selling dynamics in shaping voluntary disclosure incentives. Based on this framework, we argue that the decision to disclose fraud allegations combined with observable short selling quantity and the magnitude of short selling costs and risks are informative about the precision and severity of a disclosing short seller’s private information. Since we can observe short selling activity leading up to the activist’s disclosure, our setting provides insights into the information advantage of short sellers by analyzing stock-lending market dynamics associated with the activist’s private information and decision to publicly disclose.

We model the disclosure decision as a threshold strategy, where the return implications of a short seller’s private signal must be large enough to exceed a disclosure threshold that increases in short-selling costs and risks. A privately informed short seller voluntarily discloses if the assessed short selling benefits of the disclosure surpass the threshold

 Our disclosure model produces two predictions. First, we predict that following the disclosure of fraud allegations, the severity of negative consequences for target firms is increasing in the quantity of shares shorted in the pre-disclosure period. Second, we predict that higher short-selling costs will magnify the association between pre-disclosure shorting quantity and post-disclosure underperformance of the target.

We test these predictions using data from Activist Insight Shorts. Our focus is on short campaigns that accuse corporations of engaging in various forms of corporate fraud, such as accounting fraud, major business fraud, deceptive accounting practices, pyramid schemes, and fraudulent stock promotion schemes.

We begin with an analysis of short selling dynamics surrounding the public disclosure of fraud allegations. We document substantial variation in pre-disclosure shorting intensity across activist short campaigns. Consistent with our first prediction, we find that higher pre-disclosure shorting intensity is associated with more severe post-disclosure returns. The difference in stock return performance between high and low shorting intensity campaigns is -25 percent one-year out. This spread is estimated after controlling for the credibility of the prior track record of the disclosing activist, which allows us to isolate the quality of private information that is idiosyncratic to a specific campaign.

To test our second prediction, we interact pre-disclosure shorting intensity with explicit shorting fees and key determinants of shorting risk. Consistent with our disclosure framework, we find that the link between pre-disclosure shorting intensity and post-disclosure stock returns is amplified when activist short sellers face higher and more volatile stock loan fees, rising stock prices, greater idiosyncratic volatility, and elevated short-squeeze risk leading to the public disclosure of their fraud allegations.

Fraud allegations are often complex and challenging to analyze, which means that price discovery for more serious accusations can extend over long periods as market participants assess the economic and legal implications of the allegations. The business press can play a key role in the price discovery process by validating, synthesizing, and disseminating information. For activist fraud campaigns based on more consequential private information, we expect more prolonged flows of negative media reports. Consistent with this, we find that the post-disclosure flow of negative business press coverage is significantly increasing in the intensity of pre-disclosure short selling, which is consistent with more severe private information fueling a more sustained and intensive price discovery process.

Furthermore, we expect that activist fraud campaigns, characterized by a higher quality of private information, are more likely to result in negative corporate outcomes that are closely monitored by the activist community. Supporting this, we find that the likelihood of (a) auditor turnover, (b) material accounting restatements, (c) class-action lawsuits, and (d) performance-related delistings all significantly increase with the intensity of pre-disclosure short selling. Controlling for immediate campaign disclosure effects, our evidence further shows that pre-disclosure short selling activity embeds material information for anticipating long-term negative corporate outcomes beyond immediate announcement price drops and subsequent stock-drop lawsuits.

On October 13, 2023, the SEC, in a 3-2 vote, adopted rules requiring traders holding significant short positions to report their daily positions in detail, aiming to boost transparency and combat manipulative “short-and-distort” schemes. A short and distort scheme involves taking a short position in a stock and then driving its price down by spreading false or misleading information to profit from buying it back at the lowered price. This manipulative tactic is essentially the opposite of a “pump and dump” scheme, where the price is artificially inflated through false or exaggerated positive information before the stock is sold at a higher price.

The SEC rules have raised concerns over their impact on price discovery and fraud detection. These concerns are echoed in the dissenting opinions of commissioners Peirce and Uyeda, who expressed skepticism regarding the effectiveness of the rules and the potential for unintended consequences. Against this backdrop, the U.S. Department of Justice has launched an investigation into prominent activist short sellers for possible manipulative practices.

Considering the growing scrutiny of short activism, we investigate the extent to which activist short sellers systematically engage in short-and-distort schemes. Short-and-distort schemes would lead to “V-shaped” patterns where returns fall and then quickly reverse immediately following the campaign disclosure. We find that one-third of activist fraud campaigns exhibit a V-shaped reversal in the five-day disclosure window. However, extending the return window reveals that V-shaped reversals are transient and that long-term performance does not systematically differ with or without a V-shaped reversal. Furthermore, we find no systematic evidence of rapid short covering after activist fraud campaign disclosures to front-run the rebound of stock prices.

Contrary to the view that activist short sellers undermine capital markets by maliciously spreading unverified bad news to earn quick profits, we conclude that short activism can enhance the integrity of capital markets and price discovery by taking on the difficult task of uncovering corporate fraud.

This post comes to us from Byung Hyun Ahn at Dimensional Fund Advisors and professors Robert M. Bushman at UNC Kenan-Flagler Business School and Pano Patatoukas at U.C. Berkeley, Haas School of Business. It is based on their recent article, “Under the Hood of Activist Fraud Campaigns: Private Information Quality, Disclosure Incentives, and Stock Lending Dynamics,” forthcoming in The Accounting Review and available here.