Short Selling and Firms’ Disclosure of Bad News: Evidence from Regulation SHO

Abstract

This study provides evidence that short selling influences the disclosure of bad news by firms. Managers have incentives to withhold or delay the release of bad news. As informed traders, short sellers enhance the informativeness of stock prices, especially related to bad news, potentially reducing the benefits and increasing the litigation and reputational costs of withholding bad news. We exploit a quasi-natural experimental setting provided by the introduction of SEC regulation SHO (Reg-SHO), which significantly reduced the constraints faced by short sellers for an effectively randomly selected subsample of U.S. firms (pilot firms). Relative to control firms, we find a significant increase in the likelihood of voluntary bad news management forecasts by the pilot firms, and firms provide these forecasts in a more timely manner. We also find that firms accelerate the release of quarterly bad earnings news. Each of these effects is stronger for subsamples of moderate (compared with extreme) bad news, firms facing high (compared with low) litigation risks, and firms that had a high likelihood of forecasting in the pre-Regulation SHO period. Similar effects are not observed for voluntary good news management earnings forecasts. A range of robustness tests reinforce our results.

Keywords: Short selling, Voluntary disclosure, Litigation risk

JEL Classification: G14, D22, K22, K41, M40