Does Board Independence Reduce Informed Short Selling Prior to Earnings Announcements? Evidence from Quasi-Natural Experiment

Courtesy of Suchismita Mishra, Anisur Rahman, and Arun Upadhyay

In a new paper, we argue that the transparency created by independent boards prevents informed short sellers from taking advantage of nonpublic information, and thus results in a lower likelihood of surprise predictions of informed short selling prior to upcoming earnings announcements.

Short sellers—those who sell borrowed shares in the hope that the shares will decline in value before they are returned—are considered sophisticated investors. Financial theory suggests that short positions should bear a negative relation with stock returns. Prior literature provides ample evidence that short sellers are generally successful in identifying securities that are overpriced in the market. Some studies suggest that short sellers’ ability to identify stocks that will underperform in the future can be partially attributed to their possession of private information. For example, Christophe et al. (2004) examined short selling prior to Nasdaq-listed firms’ earnings announcements and found that pre-announcement short selling appears to be mostly driven by information specific to the upcoming announcements of the individual firms. Anderson et al. (2012) investigated the relationship between organizational structure and the information content of short sales and found that informed trading via short sales occurs more readily in family firms than in nonfamily firms. They hypothesized that family-firm owners may have a variety of linkages with other stakeholders which could facilitate the leakage of material nonpublic information, leading to informed trading prior to earnings announcements.

In light of the evidence that short sellers may use privately acquired information in selling short prior to earnings announcement events, an obvious question arises about information asymmetry among various groups of shareholders and the role of governance mechanisms in reducing the adverse effects of such asymmetry on shareholders. For example, by establishing transparency between insiders and outsiders, effective boards can reduce the benefits that short sellers could potentially earn at the expense of other shareholders.

As more and more directors are outsiders, it is important to understand the channels through which they could affect corporate outcomes. Because boards are responsible for supervising the information production process, independent boards could impact the quality of information produced by a firm. The evidence for an association between board structure and information environment quality, however, is mixed. By examining the impact of independent boards on the behavior of informed traders we can shed some light on the effectiveness of independent boards.

Sarbanes-Oxley As a Natural Experiment

The Sarbanes-Oxley Act of 2002 (SOX) provides a natural experiment to assess the impact of board structure on information quality. SOX introduced an exogenous shock to the representation of independent directors on corporate boards. We use this shock to determine whether our results are concentrated in firms that were forced to have a majority of independent directors due to SOX and subsequent listing rules.

To run this analysis, we first identify firms that, in the pre-SOX period, did not meet the mandates of SOX and subsequent stock exchange listing rules to have a majority of independent members. These firms were forced, post-SOX, to have a majority of independent directors.; these firms are therefore our Treatment Firms. Our analysis shows that although informed short selling was higher in the Treatment Firms than in firms with independent boards during the pre-SOX period, informed short selling decreased in the Treatment Firms after their boards became independent. These results suggest that although short sellers were successful in predicting the stock price movement of Treatment Firms in the pre-SOX period, they lost this predictive ability after the boards of those firms became independent in the post-SOX period.

How Do Independent Directors Reduce The Predictive Ability of Short Sellers?

There are at least two ways that independent directors may reduce short sellers’ predictive ability: (1) independent directors reduce information asymmetry in the market or (2) independent directors reduce the leakage of nonpublic information.

The first possibility suggests that if independent directors reduce information asymmetry in the market, then there are fewer opportunities for short sellers to engage in a thorough analysis of market information and unearth nonpublic adverse information. Therefore, with analysts’ forecast dispersion proxying for information asymmetry, we expect the ability of short sellers to successfully predict the direction of unexpected quarterly earnings to be statistically insignificant or decline in firms with low dispersion. Our results suggest that at least part of the beneficial effect of board independence in reducing successful informed short selling comes through a reduction in information asymmetry in the market.

The second possibility suggests that the ability of short sellers for correct prediction declines because independent directors reduce the leakage of nonpublic information. To evaluate this possibility, we draw on existing studies suggesting that sophisticated investors, including short sellers, better predict the outcomes of upcoming earnings of companies with more connected directors. Our results suggest that director connections in independent boards reduce the ability of short sellers to correctly predict the direction of unexpected quarterly earnings.

Board Independence and CEO Duality

Assigning the titles of both CEO and the Chairman of the Board to the same individual is commonly referred to as CEO duality. We argue that the effectiveness of board independence in limiting informed short selling based on superior information is more pronounced in firms with CEO duality. To evaluate this hypothesis, we divide our sample into two subsamples; one subsample includes the observations with CEO duality; the other includes the observations without CEO duality. Our results show that Independent Boards is significantly negatively correlated with Prediction where CEO duality is present and insignificant where CEO duality is absent, providing support for our hypothesis.

Board Independence and Board Size

We also hypothesize that the effectiveness of board independence in limiting informed short selling varies with board size. To evaluate this hypothesis, as before, we divide our sample into two subsamples. One subsample includes the observations where the board size is small; the other subsample includes the observations where the board size is large. We define board size as small if the size of a board is less than the cross-sectional median board size and as large otherwise. The results show that the coefficient estimate of Independent Boards is negative and significant in firms with large boards and insignificant in firms with small boards, suggesting that board independence is more effective in firms with large boards than with small boards at limiting informed short selling based on nonpublic information prior to earnings announcements.


Our study contributes to the literature on both governance and short selling by examining one of the most important aspects of internal corporate governance—board independence—within the context of short selling. Firms often argue that short-selling activities hurt shareholders by increasing the cost of capital. Prior research shows that short selling has a depressing (pessimistic) impact or a “disposition effect” on shareholders These findings suggest that shorting activity weighs down future stock prices — asymmetrically — after both negative and positive surprises. Thus, in cases of negative news, the downward trend can continue for a while and could force firms affected by short selling to alter their plans for raising capital. Regulators actively try to restrict trading based on private information, and the ban on short selling during the financial crisis of 2008 was a result of this effort.

If firms could limit short sales by improving its internal governance structure, there should be no need for short-sale and insider trading–related regulations. Our study contributes to this ongoing debate by demonstrating that independent boards limit the ability of short sellers to engage in informed trading. The results of our study have significant implications for policymakers in their attempt to maintain a transparent financial market.

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