Short selling and corporate financial fraud: Empirical evidence from China

Abstract

This study employs a difference-in-differences model to examine the impact of short selling on corporate financial fraud by utilizing China's relaxation of short selling regulation as a quasi-natural experiment. The results suggest that short selling can restrain the tendency of companies to commit financial fraud and reduce the severity of such fraud. This effect is more pronounced in privately-owned enterprises. Moreover, short selling can exert regulatory influence on corporate financial fraud through two distinct mechanisms: by elevating the litigation risk faced by auditors and by bolstering the vigilance of external shareholders. Furthermore, our extended investigation reveals that a favorable external corporate governance environment is more conducive to the effectiveness of short selling in regulating corporate financial fraud. However, the regulatory impact of short selling on corporate financial fraud remains unaffected by the quality of the internal corporate governance environment. Our study contributes to the theoretical research on the economic consequences of relaxing short-selling regulations and provides empirical insights into the governance of financial fraud in Chinese companies.