Can Short Sellers Detect the Risk of Financial Misreporting?

Abstract

We examine whether short sellers are interested in, and capable of, identifying firms with corporate governance deficiencies. Using a novel setting – short selling prior to the revelation of Internal Control Weaknesses (ICW), we show that short sellers accumulate positions in firms that are about to disclose ICW under Section 404 of the Sarbanes-Oxley Act for the first time when ICW problems are severe. We find that the short interest build-up is more likely due to the use of private rather than of public information, which suggests that their trades contain incremental prediction power of upcoming corporate governance failure. Furthermore, the ability of short sellers to predict ICW is more pronounced in firms with poor information environments. Overall, we present evidence of short sellers’ ability to predict and trade on corporate governance deficiencies, and establish a path through which ICW impacts equity investors.