Short sellers have been known to uncover companies that engage in financial. Indeed, several activist short sellers like Muddy Waters Research and Citron Research make a name for themselves by proactively targeting fraudsters, bringing their misconducts to light, and profiting from their price decline. Not surprisingly, managers should consider the cost and benefits of frauds and incorporate them in decision making. Hence, managers who are tempted to use frauds to advance their personal interests, e.g., receive higher bonuses, selling their stocks at a higher price, should be more constrained when it is easier for short sellers to target their company. This idea is precisely what we show in our paper.

We exploit an experiment by the SEC that randomly assign one third of the stocks as pilot stocks. Short sellers can more easily short sell this group of stocks during a pilot period between 2005 and 2007. What we find is that once the experiment begins, managers in pilot firms engage in less financial frauds compared to nonpilot firms, and that this difference disappears after the pilot program ends.

Although short selling remains a controversial activity, with politicians and media using short sellers as scapegoats for market decline and claiming that they only care about their own profit, we point out that short sellers do provide benefits to other investors. They act as police alongside market regulators to keep managers in line, to improve financial reporting quality and stock price efficiency.