I've noted many times over the years that short selling has many pro-social aspects, while being unfairly blamed for problems whose root causes lie elsewhere. A new paper brings to our attention an important additional prosocial benefit of short selling:
We hypothesize that short-selling has a disciplining role vis-à-vis the managers forcing them to reduce earning manipulation. Using firm-level short-selling data over the sample period of 2002 to 2009 across 33 countries, we document a significantly negative relationship between lending supply and activism in the short sell market and earnings manipulation. Additional tests using ETF ownership as an instrument or based on market-wide short-selling restrictions further confirm that short selling potential strongly discourages earnings manipulation. Meanwhile, the impact is more pronounced for firms with weaker corporate governance. Collectively, our findings suggest that short selling provides an external governance mechanism to discipline managerial incentives.Massa, Massimo, Zhang, Bohui and Zhang, Hong, The Invisible Hand of Short-Selling: Does Short-Selling Discipline Earnings Manipulation? (August 5, 2012). Available at SSRN: http://ssrn.com/abstract=2124464
Earnings manipulation is an important source of agency costs in public corporations. By constraining management's ability to do so, short selling thus provides an important market check on potentially destructive misconduct. Which, once again, calls into question the wisdom of restricting it.