Don’t Silence Short Sellers, They Play an Important Role

Former Lehman CEO Richard Fuld’s recent public emergence was accompanied with the complaint of many a corporate leader: Don’t blame me, blame the short sellers.

During the financial crisis, his was not a lone voice calling for a ban on short selling. The Securities and Exchange Commission ultimately delivered on such due to extensive Wall Street lobbying.

The evidence, however, is overwhelming — short sellers regularly identify corporate misbehavior and often do so long before financial regulators like the SEC.

Of course, this should not be a surprise; shorts have very strong incentives to do so. Unlike our financial regulators, who keep their jobs regardless of their performance, short sellers put huge amounts of their own money on the line.

As an economist, I’m generally quick to remind others that all policies have both costs and benefits. The same is true for short selling. There have been abuses and frauds.

I have far more confidence in short sellers weeding out corporate misbehavior than I do in the SEC.

Shorts can and have profited by spreading false rumors. At least one went so far as to short Sea World and then spread false rumors that the killer whale Shamu was ill. Such rumors can momentarily increase funding costs and divert corporate resources.

The same could be said of unflattering press coverage, but we would never think of silencing the press as an avenue of lessening these real costs.

Short sellers have at times also attempted to leverage the powers of Washington to help cover their bets. Some have contributed to individual members of Congress in the hope that a hearing appears in relation to the object of their short.

Regulators have been urged to open investigations. In cases where there is sufficient evidence, investigations may be merited. One need only recall the years-long efforts to get the SEC to investigate Bernie Madoff.

The SEC and other regulators following up on allegations is part of their jobs, but that should be done quietly until some evidence of guilt is established. As a former Senate committee staffer, I could never imagine organizing a hearing with the purpose of helping a hedge fund cover its bets. The ethics are questionable, to say the least.

So yes, shorting has its costs and its ugly side. But given the perverse and weak incentives of our financial regulators, I have far more confidence in short sellers weeding out corporate misbehavior than I do in the SEC.

My confidence is not based simply on some theoretical model, but on the facts. A 2010 study in the leading finance journal investigated empirically who blows the whistle on corporate fraud. Under a variety of tests, the researchers find that short sellers were consistently one of the primary sources of identifying corporate fraud.

Perhaps more shocking is that short sellers did so at rates far higher than does the SEC. In fact, over the time frame studied, 1996 to 2004, short sellers exposed more than twice the level of corporate fraud exposed by the SEC.

Another 2010 study found that when short sellers discover corporate fraud they cause that fraud to be ultimately discovered sooner, as well as dampening the extent to which stock prices are inflated by corporate misreporting of financial statements.

These findings mean that short sellers not only benefit themselves but also help protect regular retail investors by reducing the amount of time that retail investors are vulnerable to financial misreporting.

The price dampening impact of shorts also reduces the ultimate loss that retail investors would suffer when financial misreporting is eventually revealed. This study, also published in the leading finance journal, estimates that retail investors actually receive more of the benefits of shorting than do the shorts themselves.

One might argue that even a broken clock is correct twice a day. Short enough companies and you will eventually find some guilty of fraud. The evidence here is also conclusive. Shorts are not random. Nor are they riding off the work of others. Short interest is overwhelmingly concentrated in firms that are later revealed to misrepresent their financials.

Short interest also is found to begin long before any initial investigation by regulators or the press. Successful shorting is the result of intensive investigation into financial statements and industry data.

Whether short sellers were “responsible” for the failure of Lehman Bros. is something I will leave for others to debate. What is clear from the academic evidence is that short sellers play an outsize role in weeding out corporate fraud.

Do they get it wrong sometimes? Sure. Do they occasionally push the envelope on ethical behavior? No doubt about it. But do they also protect retail investors from financial fraud and do so at no cost to the taxpayer? You can bet on it.

Mark Calabria is director of financial regulation studies at the Cato Institute.