Can Short Sellers Detect Internal Control Material Weaknesses? Evidence From Section 404 of the Sarbanes–Oxley Act

Abstract

We examine whether short sellers are interested in, and capable of, identifying firms with an upcoming revelation of internal control material weaknesses (ICMW). We show that short sellers accumulate positions in firms that are about to disclose ICMW under Section 404 of the Sarbanes–Oxley Act for the first time when internal control problems are severe. We find that the short-interest buildup is mainly due to the use of private rather than public information, which suggests that their trades contain incremental prediction power of the upcoming internal control failure. Furthermore, the ability of short sellers to predict ICMW is more pronounced in firms operating in poor information environment. Finally, we find no evidence that trades by short sellers prior to the ICMW disclosure create a cascade of selling that leads to an overreaction of ICMW. Overall, we present evidence that corporate governance information in the form of ICMW is part of the short sellers’ information set, and we establish a path through which ICMW impacts equity investors.

The Impact of Short-selling Institutions on Chinese Stock Companies and MarketFrom the Case of Luckin Coffee

“…Disclosure will not cause companies to overreact before the report is released [8], nor will it exacerbate price declines during short-selling declines on days of extreme negative returns [9], which indicated that impact of short-selling institution is rational even effective. However, it is not clear enough that the tendency of company's stock price and the possible changes of the whole market.…”

Short selling and firm investment efficiency

“…First, although short-sellers can identify firms with significant internal control weaknesses, the evidence primarily focuses on material internal governance failures (Singer et al 2022). Considering the large sample size in this paper, the relationship should not be driven solely by these rare instances of material internal governance failure.…”

Research on the External Governance Effects of Short Selling Mechanism on Technological Innovation and Enterprise Performance

“…Related to the impact of short selling on corporate information transparency, The findings of Singer, Wang, and Zhang [13] also indicate that short selling traders could have private information of the internal control status of the companies because they found a sudden large short interest before the announcement of significant internal control deficiency by studying the short selling and internal control data from 2004 to 2010.…”