The Impact of Financial Markets on Payout Policy: Evidence from Short Selling

Abstract

We investigate the impact of the stock-price formation process on payout policy using the Regulation SHO pilot program which removed short selling constraints and increased the prospect of short selling for a random sample of pilot firms. We find that pilot firms are more likely to increase dividends during this program. Subsequent to the ending of the program, these firms are less likely to increase dividends but continue to pay dividends and the propensity to repurchase shares increases too. Consistent with signaling and agency-based models, our results are more pronounced for firms with higher information asymmetry and weaker governance. We also provide evidence of a substitution effect between dividend increases and repurchases. Importantly we find that pilot firms are less likely to smooth dividends and that dividends are more likely to be financed through debt when the prospect of short selling increases. Overall, this study shows that stock price dynamics within the secondary financial market have a significant and long-lasting impact on firms’ payout policy.