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
1/1/97: Violation
period begins
Violation to revelation
10/8/99:
warns 3rd qtr 1999
Public Xerox
revelation
earnings will be short of projections
10/8/99: Xerox warns 3rd qtr 1999
earnings will be short of projections
6/16/00: Xerox announces 2nd qtr 2000
earnings will not meet expectations
7/3/00: SEC starts formal investigation
4/10-12/02: Wells Notice;
SEC files civil complaint
Short sellers - April 5, 2011
3/26/07: SEC enforcement
action concluded
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.”
„
„
“Financial Terrorism”
„
„
Former SEC Chairman Christopher Cox
CNBC’s Jim Cramer, on short selling
“Financial Jihad”
„
Infidel Blogger’s Alliance, on short selling
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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
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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
Violation
Begins
Regulatory Period
*
Public
Violation revelation Inquiry
Ends
Event
(“trigger
event”)
Investigation
Event
Wells
Notice
Proceedings Events
Initial
Concluding
Regulatory
Regulatory
Proceeding
Proceeding
Enforcement Events
Violation to Revelation
We focus on the time before public revelation
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Number of enforcement actions and months 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
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1998
1999
2000
2001
2002
2003
2004
2005
The Xerox example is typical…
Public revelation is bad news (Table II)
Initial
Revelation
Violation
Period
Initial revelation
Inquiry or
investigation
Regulatory
proceedings
Down 3%
Down
18%
Down
10%
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
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Table III:
Three measures of ABSI(j), j=1,2,3
Included in
ABSI(2)
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Table III:
Three measures of ABSI(j), j=1,2,3
Included in
ABSI(3)
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Raw and abnormal short interest during months [-19, +20]
(Table IV and Figure 2)
Raw short
interest
Abnormal short
interest ABSI(1)
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Is short selling related to the severity of the
misconduct?
ABSI(1)i,-1 = 1.25 – 0.038 ARi + controls
(p=0.03)
Abnormal
short
interest in
month -1
„
Abnormal
return upon
revelation
But this could indicate merely that short sellers
anticipate a large price drop, not that they sell
more when the misconduct is severe.
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Three measures of misconduct severity
„
Fraud charges
„
Insider trading charges
„
Total accruals during misrepresentation period
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From Table V
ABSI( j )i ,−1 = λ0 + λ1 Severityi ,−1 + λ2 Controlsi ,−1 + ε i ,
1
Panel A: ABSI(1)
2
3
j = 1,2,3
4
Severity measures:
Fraud charges
5.151
1.328
(0.13)
1.299
(0.12)
4.47
(0.00)
(0.00)
1.65
(0.03)
Insider trading charges
2.034
(0.01)
Total accruals
Inference: Abnormal short interest at
month -1 is positively related to the
severity of the misrepresentation – that
is not yet public.
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The severity measures are economically
meaningful
Change in
Implied change
severity measure in ABSI(1), in %
Fraud
1.65
Insider trading
2.03
Total accruals:
10th to 90th
percentile
3.02
Fraud charges
nearly double ABSI
Insider trading
charges more than
double ABSI
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
Begins
Violation
Ends
Violation to Revelation
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Public
Revelation
Is this affected by
short selling?
Table IX: Time-to-discovery logistic survival model
log(M i ) = β ' X i + ε i .
Difference between
75th and 25th
percentiles = 8
months
Models
X(t)
Abnormal short interest
Fraud
1
2
3
4
5
-0.028
-0.025
-0.028
-0.026
-0.023
(<0.0001)
(<0.0001)
(<0.0001)
(<0.0001)
(<0.0001)
-0.323
-0.480
(<0.0001)
(<0.0001)
Insider Trading
Total accruals
The amount of prior short
selling is negatively related
to the time until the
misconduct is publicly
revealed.
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-0.008
0.122
(0.91)
(0.13)
-0.228
-0.197
(0.05)
(0.07)
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
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Short sellers’ external effects on share prices and
quantity, for a given month t
How we estimate Phigh
Step 1: Cross-sectional model for each month t:
K
retit = β 0 + β1Sizei,t −1 + β 2 BTM i,t −1 + β 3 Momi,t −1 + ∑ Indik,t −1 + β 4 ABSI ( j)i,t −1 + ε i
k =1
Step 2: Hypothetical return in month t if abnormal short interest were zero:
retithyp = rit Ğβö4 ABSI( j )i ,t −1
Step 3: Hypothetical cumulative return from the beginning of violation:
t
cumretit = ∑ retihigh
τ
τ =1
Step 4: Phigh is the starting price * hypothetical cumulative return:
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External effects, mean estimates
Data
Net benefit to
uninformed
investors = 1.09%
of mkt cap.
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External effects: Some details (Table X)
On average, short sellers
convey substantial benefits
to uninformed investors
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But for the median
firm, these benefits are
negligible (and the net
benefit is slightly negative)
Summary:
The overall pattern of (abnormal) short selling
Public
revelation
Major build-up
Early build-up
Wind-down
positions
The build-up is
positively related to
the severity of the
misrepresentation
Short sellers - April 5, 2011
How do short sellers affect
markets and social welfare?
Short interest does not
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
Early build-up
Wind-down
positions
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
Appendix: Other issues examined
„
„
„
„
Do short sellers get it right in general? (Table VII)
Does short selling exacerbate the price decline when
bad news hits the market (Table VIII)
Why does short selling tick up before the violation
period begins?
Other measures of severity (sizes of penalties
imposed)
Short sellers - April 5, 2011
The Xerox example is typical…
Public revelation is bad news (Table II)
Short sellers - April 5, 2011
Do short sellers focus on misrepresenting
firms? (Table VII)
But 4.18% of the
“High shortinterest” firmmonths are in
violation months
Only 1.78% of all
firm-months are
violation months
Short sellers - April 5, 2011
Question #2(a): Do short sellers exacerbate price declines when
bad news hits the market?
Is this price drop larger when
short interest is high?
1/1/97: Violation
period begins
Or this drop?
Public revelation
10/8/99: Xerox warns 3rd qtr 1999
earnings will be short of projections
4/10-12/02: Wells Notice;
SEC files civil complaint
Short sellers - April 5, 2011
3/26/07: SEC enforcement
action concluded
Table VIII:
ARi = a + f1 ABSI(1)i,-1 + f2 Severityi + f3 Controlsi + ei
Models
Variables
Abnormal
short interest
1
2
3
4
5
-0.314
-0.231
-0.185
-0.191
-0.052
(0.10)
(0.23)
(0.33)
(0.34)
(0.79)
Fraud
-9.610
-8.528
(0.00)
(0.00)
Insider
trading
Controlling for the severity of
the misconduct, short interest
does not exacerbate the price
Total accruals drop.
N
Adj-R2
-11.72
-10.52
(0.00)
(0.00)
-5.963
-2.810
(0.07)
(0.37)
339
339
339
273
273
0.036
0.073
0.094
0.027
0.119
Short sellers - April 5, 2011
Additional evidence:
When does the short selling begin?
Build-up before violation officially starts
- Does the violation start earlier than the SEC states?
Short sellers - April 5, 2011
Accruals and short interest at the violation start date
High accruals at month
before violation start date
Low accruals at month
before violation start date
…Implying that short sellers
use accruals to help predict
misrepresentation
Short sellers - April 5, 2011
Table IX, Panel B: Instrumental variable tests
ABSI( j)it = δ 0 + δ1Optionsit + ε i ,
Short sellers - April 5, 2011
j = 1, 2, 3.
Five ways to construct a sample of financial misconduct
„
Our approach: All SEC/DOJ enforcement actions initiated from 1988-2004 for
financial misrepresentation
„
„
„
Key word news (e.g., Lexis-Nexis) search
„
„
46% of our sample events have corresponding 10b-5 lawsuits
Accounting and auditing enforcement release (AAER)
„
„
„
„
Karpoff-Lott (JLE 1993); Murphy, Shrieves, Tibbs (JFQA 2009)
Securities class action (10b-5) lawsuits (e.g., Gande-Lewis, JFQA 2009; FichShivdasani JFE 2007)
„
„
15 U.S.C. §§ 78m(b)(2)(A) - requires accurate books and records
15 U.S.C. §§ 78m(b)(2)(B) - requires internal controls
AAER is a secondary designation assigned when the enforcement release names an
accountant or auditor
Created in 1982
May or may not have anything to do with financial misrepresentation
GAO (2002, 2003) restatement database (e.g., Burns-Kedia JFE 2006)
„
Currently popular
Short sellers - April 5, 2011
Universe of financial misrepresentations
Our sample
•
•
Type I error (miss events in which
misrepresentation occurred) may be high
Type II error (events include innocent firms or
individuals) is essentially zero
AAER samples
• AAERs miss 18% of enforcement actions, and
29% of all Administrative and Litigation
Releases - so Type I error is higher
• AAERS include many instances in which there
is no financial misrepresentation (e.g., Boston
Scientific – Securities Exchange Act Release
34-43183, also assigned AAER-1295) - so Type
II error is non-trivial.
GAO restatement sample
• 1997–June 2002 (total = 919)
• Supposed to be cases of “fraud”, but SEC now says that
many are not misrepresentations or violations (implying
that Type I and Type II error rates are very large)
Short sellers - April 5, 2011