Short Seller Trading in Companies with a Severe Accounting Irregularity

Abstract

We find that shorts establish significant positions more than a year before the average restatement announcement, those positions increase as the announcement month approaches, and the largest positions are held in companies that will announce an accounting irregularity that attracts class action litigation. Shorts are thereby well positioned to profit from the lengthy string of negative returns that precede the announcement of a severe accounting irregularity. Afterward, we find average short interest is sticky, and shorts retain positions in firms that experience a further price decline. In the six months after an announcement, positions in heavily shorted restating firms (i.e., short interest exceeding 2.5 percent before the announcement) earn an additional 24 percent (31 percent with class action litigation). We conclude that shorts have the skill to play an important private-sector role in identifying and disciplining companies with accounting irregularities.