In a new paper, we explore the often-misunderstood role of short sellers in corporate misconduct and securities class actions. Short sellers are investors who bet on a future decline in a company’s stock price. While their actions are sometimes criticized as detrimental to companies, our research shows that they actually serve two important functions: helping to prevent corporate wrongdoing before it occurs and uncovering hidden problems once misconduct has taken place.
How Short Sellers Prevent Corporate Misconduct
Before any misconduct occurs, the mere potential for short sellers to target a firm acts as a powerful deterrent. We refer to this as “ex ante short-selling potential.” As short sellers must borrow shares in a firm to complete the short-sale transaction, we measure a firm’s short-selling potential by the proportion of its shares available for lending to short-sellers on the secondary securities-lending markets. When managers are aware that their actions might attract the attention of short sellers, they are more likely to act prudently and avoid misbehavior that could jeopardize shareholder interests and attract lawsuits.
Our study finds that companies with high short-selling potential — those with relatively large numbers of shares available for lending to short sellers — are less likely to face lawsuits arising from corporate misconduct. This is particularly evident for companies that have less independent boards, lower levels of institutional ownership, or other indicators of weak internal oversight. In such situations, short sellers may act as external watchdogs, helping to hold management accountable. As a result, managers of these companies tend to avoid actions such as manipulating earnings or insider trading.
Detecting Problems After They Occurred: The Role of Short Sellers
Our study also examines what happens after corporate misconduct has taken place, focusing on the role of short sellers in uncovering these issues. This phase is referred to as “ex post short interest.” When short sellers increase their bets against a company, this often signals that they have identified something problematic that the wider market has not yet recognized. Such heightened short-selling activity can serve as a warning sign, suggesting that legal or financial troubles are on the horizon.
We found that a spike in short-selling activity often occurs just before a lawsuit is filed, indicating that short sellers have detected serious issues within a company. This ability to recognize red flags can help bring hidden misconduct to light faster, prompting legal actions and ensuring that problems do not remain concealed. By taking these actions, short sellers play a key role in ensuring that misconduct is revealed and addressed.
Balancing Prevention and Discovery in Litigation
Our research presents a nuanced view of how short sellers influence the lifecycle of securities litigation. On one hand, the potential for short selling can deter companies from engaging in misconduct, fostering a more transparent and accountable environment. On the other hand, when misconduct does occur, short sellers help uncover it by increasing their activity and signaling to the market that something is amiss.
This dual role places short sellers in a key position at different stages of the legal process. Initially, they act as a deterrent, helping to prevent problems from arising. Subsequently, they serve as detectives, illuminating issues that require legal attention.
The Impact on Legal Outcomes
Short sellers also play a significant role in how lawsuits unfold. Our study finds that lawsuits accompanied by higher levels of short-selling activity are more likely to result in settlements. When short sellers increase their positions against a firm, it signals to the market and legal stakeholders that the alleged misconduct is serious and likely to have a significant impact on the company. As a result, companies involved in these cases face greater pressure to settle the claims to avoid prolonged court battles. Additionally, the presence of short sellers can affect a company’s stock price, creating further incentives for management to resolve legal disputes quickly and minimize financial damage. Our findings suggest that short sellers’ insights into the severity of misconduct can significantly predict the outcomes of the litigation for the sued companies.
Broader Implications for Policy and Governance
Our study’s insights have important implications for regulators, corporate managers, and investors. Policymakers should recognize that restricting short selling could unintentionally undermine its role in deterring corporate misconduct. Moreover, understanding the role of short sellers in the phase of misconduct detection can help companies better prepare for and manage legal risks. Managers, particularly in firms with weaker governance, should be aware of the heightened scrutiny they may face in markets where short selling is more prevalent. Being transparent and maintaining robust internal controls can help reduce the risks that attract the attention of short sellers.
For lawyers and investors, our research highlights the value of monitoring short-selling activity as a potential indicator of impending legal challenges. The correlation between increased short interest and imminent lawsuits suggests that short sellers’ actions can reveal critical information about a firm’s vulnerabilities before these issues become widely known. Investors can use this information to better assess risks, while legal professionals can recognize the role of short sellers as part of a broader system of market oversight.
Policy Considerations: Balancing Market Stability and Oversight
Our study also contributes to debates about regulating short selling, especially during periods of market downturns or distress. Critics of short selling argue that it can deepen declines in stock prices during crises, potentially destabilizing markets. However, our findings show that short sellers play a valuable role in promoting transparency and reducing corporate wrongdoing. Optimal policy solutions require striking a balance between maintaining market stability and allowing short sellers to perform their watchdog function.
Rather than imposing outright bans on short selling, policymakers could consider measures that enhance transparency around short-selling activities. Requiring more detailed disclosure from short sellers could help regulators and investors understand the motivations behind their actions without curbing their role in detecting misconduct. This approach would ensure transparency while preserving the benefits that short sellers bring to market oversight.
A More Accountable Market
Our research offers a comprehensive view of the dual roles of short sellers throughout the lifecycle of securities litigation. By examining the impacts of both the potential for short selling before misconduct occurs and the actual short-selling activity after problems arise, we provide new insights into how short sellers contribute to both the prevention and discovery of corporate misconduct. While short sellers are often criticized for driving down stock prices, our findings suggest that their presence can enhance transparency, discipline corporate managers, and create a more accountable market environment.
This post comes to us from Chelsea Liu at the University of Adelaide and Lily H.G. Nguyen and Kelvin Jui Keng Tan at the University of Queensland. It is based on their recent paper, “The Dual Role of Short Sellers in the Lifecycle of Securities Litigation,” available here.