Short selling as a disciplinary mechanism?

Short Selling as a Disciplinary Mechanism?

Student Name Frans Putker

Student Number 10486313

Supervisor Dr. J. Ligterink – Associate Professor of Finance, University of Amsterdam

Final Thesis - Executive Master of Finance and Control Amsterdam Business School – University of Amsterdam

1.3 Main Research Question and related questions ... 5

1.4 Relevance for the CFO and the Controller ... 6

2. Theoretical Framework ... 7

2.1 Agency Theory ... 7

2.2 Empirical Studies on Corporate Governance and Stockholder Returns ... 8

2.3 Shareholder Activism and Corporate Governance ... 9

2.4 Empirical Studies on Short Selling ... 9

2.4.1 Theory on Short Selling ... 9

2.4.2 Empirical Studies on Short Selling Constraints ... 10

2.4.3 Empirical Studies on Short Selling and its (Disciplinary) Implications ... 10

2.5 Analysis of the Interviews with Hedge Fund Managers ... 12

2.6 Hypotheses ... 13

3. Research Methodology ... 15

3.1 Research Methodology ... 15

3.2 Survey with Hedge Fund Managers and Company’s Executives ... 15

3.2.1 Survey with Hedge Fund Managers ... 16

3.2.2 Survey with Management/Board of Firms confronted with short positions ... 21

3.3 Empirical Analysis of US Companies ... 26

3.3.1 Research Framework ... 26 3.3.2 Data Collection ... 27 3.3.3 Definition of Variables ... 27 3.3.4 Statistical Analysis ... 30 3.3.4.1 Net Dataset ... 30 3.3.4.2 Descriptive Statistics ... 30

3.3.5 Results of Statistics - Part I: Model 2009 and 2010 Results ... 31

3.3.5.1 Correlation Matrix ... 31

3.3.5.2 Regression Formula Models 2009 and 2010 ... 32

3.3.5.3 Description Results Regression Models 2009 and 2010 ... 33

3.3.5.4 Collinearity ... 35

3.3.6 Results - Part II: Effects of a Short Position ... 35

3.3.6.1 Correlation Matrix - Delta Corporate Governance ... 35

3.3.6.2 Correlation Matrix - Delta Accruals ... 36

3.3.6.3 Correlation Matrix - Delta Price to Book Value ... 36

3.3.6.4 Regression Formula ... 37

3.3.6.5 Description Results Regression Model Delta Corporate Governance ... 37

3.3.6.6 Description Results Regression Model Delta Accruals ... 38

3.3.6.7 Description Results Regressions Model Delta Price-to-book-value ... 38

4. Conclusion ... 39

4.1 Conclusion Surveys ... 39

4.2 Conclusion Empirical Study US Firms ... 39

4.3 Insights developed for the Controller profession ... 39

4.4 Limitations and suggestions for further research ... 40

5. Bibliography ... 41

APPENDIX I – Answers to Open Questions in Survey ... 43

APPENDIX II – Histograms LN Short Position and LN Net Sales (1 of 2) ... 45

APPENDIX II – Histograms LN Short Position and LN Net Sales (2 of 2) ... 46

Executive Summary

Purpose of the research is to explore whether short selling contributes to decreasing the agency gap between management and owners of a firm. The relation between corporate governance and short selling is explored and between two financial indicators and short selling. The research is two-fold: i) a survey with hedge fund managers and with company executives and ii) an empirical study of US firms. We find that companies with strong corporate governance (or few antitakeover provisions) have lower short positions than companies with medium corporate governance. Direct effects of a short position resulting in a change in corporate governance were not found.

1. Introduction

1.1 Introduction

The theory on corporate governance addresses the issue of the agency problem resulting from the separation of owners and managers of the firm. This agency problem results in agency costs for the firm. In the finance literature a number of mechanisms for corporate governance are identified that reduce the agency problem (ownership concentration, structure of the Board of Directors, corporate debt and the market for corporate control and takeovers, amongst others (Shleifer, A. and R.W. Vishny (1997)).

Shareholder activism is regarded as another potential corrective mechanism. Over the years activist shareholders have evoked mixed reactions. In The Netherlands activist shareholder TCI triggered a takeover battle for ABN AMRO that ended with a hostile takeover by RBS, Santander and Fortis. The takeover was beneficial to ABN AMRO’s shareholders but resulted in ABN AMRO being split up in parts. In another example activist shareholders hedge funds Centaurus and Paulson targeted Stork. By forcing the company to split into two business units and sell one of them they realized substantial shareholder value. Public opinion is often skeptical on activist shareholders. Recent literature however shows that activist hedge funds "attain success or partial success in two-thirds of the cases" (Brav, A., W. Jiang, F. Partnoy and R. Thomas (2008) (page1729)).

In this paper the focus is not on activist shareholders taking a long position to trigger change and/or to discipline management. This paper intends to investigate if short selling by hedge funds has as disciplinary role and if short selling contributes to better corporate governance. Short selling or "going short on a stock" is commonly used to describe the situation where an investor commits to deliver a share that he or she does not own. The investor will do this in case he or she is anticipating a decrease in the share price. The short seller closes a deal with a broker, borrows the shares (directly from the broker but usually via the broker from an institution) for a lending fee and sells the shares. The proceeds are placed in his account. Subsequently, the short seller can decide to close its position by buying shares in the market and delivering them back to the broker. The short seller will do this when the market price is lower than the original purchase price. The short seller can also be forced to close its position by the broker risking a purchase in the market at a higher price.

Supporters of short sellers (which are mostly hedge funds) will take the view that the hedge funds have done a thorough financial and strategic analysis of the company and its management resulting in the conclusion that the stock is overvalued and a drop in share price is to be expected. Skeptical people, who mistrust hedge funds, will state that hedge funds just speculate and take advantage of short-term price movements of the stock that have nothing to do with the underlying company, its management nor its long-term performance. The skeptical opinion is that short selling puts too much pressure on companies and their management. At worst, according to this view, the company could be threatened by bankruptcy. At best management is distracted and spends its time addressing the actions of a short seller. During the financial crisis regulators have put regulation in place curbing the practice of short selling of financial institutions during a limited time period and in particular the practice of naked short selling (naked short selling is the practice of short-selling a stock without first borrowing the stock, as is normally done in a short sale).

Recent literature provides evidence of short selling as a disciplinary mechanism. Massa, M., B. Zhang and H. Zhang (2012) have tested the disciplinary role of short selling by its impact

or found that the stock returns of companies with short positions are below market returns (Gerritsen, D. and R. Verdoorn, 2014).

This paper aims to explore the potential role of short selling as a disciplinary mechanism. Short positions do also occur when investors consider a convertible bond issued by a company undervalued. Short selling is further used to hedge positions (hedging a sold put on a stock, to hedge a long position in a stock or to combine an investment strategy for instance long in Toyota and short in Volkswagen). Not all short positions therefore will have a potential signaling and disciplining effect.

1.2 Research Objective

The objective of this research is i) to provide insight in the considerations for hedge funds to take a short position and ii) to provide insight to what extent short selling has a disciplinary effect. More specific the relation between short selling and corporate governance will be investigated to determine whether short selling is addressing the agency problem between shareholders and managers of the firm.

The topic is relevant in the light of the measures taken by Regulators regarding the banning of certain types of short selling after the financial crisis, that assumed that short selling has negative effects on the capital markets. On the other hand in a number of cases short sellers had an early warning effect for instance for companies that gave a false impression to the outside world while in financial trouble (short sellers studied for instance Sino-Forest Corp. and found dubious financials and published their findings; Sino-Forest Corp. was delisted from the Toronto Stock Exchange (TSX:TRE) and later forced into bankruptcy). A. Baker, in his article "Why short selling is good for capital markets" (Financial Times February 20, 2011) quotes Iosco (the International Organization of Securities Commissions): "Short selling plays

an important role in capital markets for a variety of reasons, including more efficient price discovery, mitigating price bubbles, increasing market liquidity, facilitating hedging and other risk management activities." Karpoff, J.M. and X. Lou (2010) study found that short sellers are

good at identifying overvalued firms and that especially with firms with severe misstatements of their earnings, short sale positions increase abnormally in the 19 month period before the misstatement is widely known by the public (Abstract). Saffi P. and K. Sigurdsson (2011) observe that short selling has a positive effect on price efficiency (see for more literature in paragraph 2.4).

1.3 Main Research Question and related questions

To obtain insight in the research objective the following research question is formulated as central question in this research paper is:

Does short selling contribute to decreasing the agency gap as a disciplinary mechanism?

This research paper builds on the existing theories on activist shareholders and their influence on addressing the agency problem between managers and shareholders. In addition more recent literature on the role of short selling is being taken into account. The research is split into the potential characteristics of companies that are targets and the potential corrective effect of short selling.

The sub questions are: Part I of the Research

• Are companies with bad or weak corporate governance (that is: with a substantial number of antitakeover provisions in place1) targets for short sellers?

• Are companies that have indications of earnings manipulation targets for short selling?

• Are companies that show a discrepancy between market value and book value targets for short selling?

Part II of the Research

• Do companies improve their corporate governance after being confronted with a short position?

• Does a company decease its accrual position following a short position?

• Does a company improve the discrepancy between market- and book value following a short position?

In the literature there is quite some research done on the effectiveness of activist

shareholders (see 2.3), on short selling constraints (see 2.4.2) and on the disciplining effects of short selling (see 2.4.3). This research aims to contribute to the discussion on potentially benefiting effects of short selling in decreasing the gap between shareholders and managers. This research focuses on the effects of short selling on corporate governance. The research is split into a part I that explores the potential characteristics of companies that are targets and a part II that explores the potential corrective effects of short selling.

The knowledge basis on which the research is built consists of a study of academic literature and on three interviews with active hedge fund managers.

The approach taken in the research is twofold. The first approach is a survey among relevant players such as i) hedge fund managers, who take the decisions on shorting a stock or not, and ii) managers and board members of listed companies, who are confronted with such actions. The second approach is an empirical study on financial data of the US S&P 1500 companies to explore potential causes of short selling and to explore any potentially disciplining effects.

1.4 Relevance for the CFO and the Controller

Listed companies can be confronted with hedge funds (or other market players) taking short positions in the stock of the company, where the CFO/Controller is employed. In such a situation the CFO/controller can contribute to the decision making process by presenting an objective analysis. The CFO/Controller can support management by providing a background analysis and an overview of the pros and cons of certain strategic choices. Especially in emotional situations where short sellers put pressure on management an independent and objective view that a CFO/Controller can deliver is supporting management.

More fundamentally a CFO/Controller, with knowledge of modern corporate finance theory and aware of the practice of activist shareholders and short sellers, is able to contribute to the strategic decision making of the company by providing analysis of investment decisions and the company’s dividend and/or share buy back policy. By continuously supporting management with advice, the CFO/Controller has a value added role and may be able to prevent that the company will be a target of short sellers. Excellent performing companies seem to have a lower chance to attract short sellers or activist shareholders as studied by Dechow, P.M., A.P. Hutton, L. Meulbroek, R.G. Sloan (2001). They found that short sellers target firms with poor fundamental (financial) ratios (such as book values and earnings).

2. Theoretical Framework

The theory available can be split into a number of different angles. The basic framework is the theory on the agency theory addressing the fundamental issues of splitting the ownership from the management. Also Empirical Studies on Corporate Governance and Stockholder Returns are a fundamental source of empirical findings providing insights in the research topic. Academic literature on Hedge Fund Activism and Corporate Governance will be addressed before focusing on the theory regarding short selling (from paragraph 2.4 onwards).

2.1 Agency Theory

Berle, A.A. and G.C. Means (1932) in their book "The modern cooperation and private property" (reviewed by McCraw, Th. K. (1990)) were among the first to address the issues of the separation between ownership and control. They noted the impact of the growth of firms to the point where they considered that neither owners nor managers could possess so much wealth that they would able to own a significant stake of a company. As a result ownership and control would separate more and more and in their view threaten the traditional economic order. Bebchuck L.A. and M.S. Weisbach in their article The State of Corporate Governance Research" (2010) give an overview of the research on corporate governance since Berle and Means (1932). Key contributions since Berle and Means include the following authors.

La Porta, R., F. Lopez-Silanes and A. Shleifer (1999) have done research on corporate ownership around the world to test the Berle and Means (1932) assumption that there are no large shareholdings at the larger listed firms. They observe that "in larger firms most companies observe the one-share-one-vote mechanism but that pyramid structures of ownership are more common in countries with lesser shareholder protection" (page 500). They found that in an average country families control ca. 25% of the value of the top 20% firms and that ca. 69% of family controlled companies have representatives in management (page 500). La Porta et al (1999) observe potential issues for the protection of minority shareholders for which they propose to address these issues by improving the legal environment. They note that legal enforcement of the one-share-one-vote principle will have little effect as they found in their research that pyramid structures remain an important strategy.

Shleifer A., and R.W. Vishny (1997) describe the agency problem and corporate governance mechanism. They show that the agency problem is a serious one and that there are many well-documented examples of managers not taking care of shareholder funds. They quote Jensen (1986) who found that oil companies in the eighties spent some $20/barrel instead of buying proven reserves for some $6/barrel. Shleifer and Vishny (1997) research focuses on the different legal systems in the world on shareholder protection and conclude that both legal protection and large shareholdings contribute to better governance. They note that there is done quite some research in the US on the impact of legal measures but less so in other countries.

Holderness, C.G, R.S. Kroszner, and D.P. Sheehan (1999) have researched the managerial ownership levels and found higher levels in 1995 (21%) compared to 1935 (13%). They found a linear pattern between firm performance (as measured by Tobin’s Q) and managerial ownership. More managerial ownership has evolved in the US over time, which as the authors indicate, could provide insights for guidelines on corporate governance.

2.2 Empirical Studies on Corporate Governance and Stockholder Returns

Gompers, P., J. L. Ishii and A. Metrick (2003) examine whether there is a relation between corporate governance (shareholder rights) and returns of shareholders (corporate performance). They form a portfolio of firms with the best corporate governance standards, which they denote as the "democracy portfolio", where management has little power and shareholders are able to replace management, and the "dictatorship model", where management has extensive power (and where governance is poor). They use 24 provisions followed by the Investor Responsibility Research Center for 1500 firms since 1990 as basis for their research. Based on these provisions they create a "Governance Index" as a proxy for the balance of power between managers and shareholders (each additional provision is another point on the index). Based on the number of points (provisions) they create a "Dictatorship Portfolio" (strong management power) and a "Democracy Portfolio" (strong shareholder power). They find empirical relationships between firm performance and corporate governance: the Democracy Portfolio outperformed the Dictatorship Portfolio significantly.

Bebchuk, L., A. Cohen and A. Ferrel (2009) refine the Gompers study. They investigated the 24 provisions followed by the Investor Responsibility Research Center. Aim of their research was, given growing empirical evidence on shareholder value being affected by obstacles to governance, to find which provisions were most influential in the link between corporate governance and firm value.

Based on the findings of their research they propose a so-called "Entrenchment Index" based on a subset of six of these provisions:

1. Classified Board: A board in which directors are divided into separate classes (typically three) with each class being elected to overlapping terms.

2. Vote % Required to Amend Charter: A provision limiting shareholders’ ability through majority vote to amend the corporate bylaws.

3. Vote % Required to Amend Charter: A provision limiting shareholders’ ability through majority vote to amend the corporate charter

4. Supermajority to Approve a Merger: A requirement that requires more than a majority of shareholders to approve a merger

5. Golden Parachute: A severance agreement that provides benefits to management/board members in the event of firing, demotion or resignation following a change in control

6. Poison Pill: A shareholder right that is triggered in the event of an unauthorized change in control that typically renders the target company financially unattractive or dilutes the voting power of the acquirer.

They have chosen these six provisions for their index because they found that increases in this index level had a positive relation with reductions in firm value. They further found large negative abnormal returns during a 1990-2003 survey period and that the six provisions have a negative correlation with firm value. The researchers analyzed trading strategies consisting of a long portfolio of stocks with a certain entrenchment score and, simultaneously shorting another portfolio of stock with a higher entrenchment score. They found abnormal returns for this strategy. Since the publication of their study more than 75 papers have used this index as we will do in this paper as well.

2.3 Shareholder Activism and Corporate Governance

Gillan, S.L. and L.T. Starks (2007) describe the evolution of shareholders activism in the United States. They note the rise of hedge funds and private equity funds as important activists, while earlier during the 1980s corporate raiders were the prominent activist shareholders. They describe that dissatisfied shareholders can sell their shares ("vote with their feet") or take other actions such as initiating a takeover or a buy-out. They quote previous empirical studies (Admati and Pfleiderer (2006) and Parriro, Sias and Starks (2003)) that concluded that (larger) selling-off of shares can result in changes in corporate governance and thus have a disciplinary effect.. Gillian and Stark (2007) conclude that shareholder activism addresses the agency conflict. They also note that although short-term positive effects of activism are found in some studies, the effect on the long term is unknown. Activist shareholders are mostly hedge funds. Activism can take different forms. Brav A, W. Jiang, F. Partnoy (2008) give some examples as follows:

1. a non-confrontational approach convincing management that executed upon the suggestions done by the hedge funds;

2. an initially hostile approach followed by management agreeing with the proposal(s) and

3. hostile approaches that remain confronted by management and board of the target company.

In their research they found that activist hedge funds are successful in two-thirds of the cases. Kahan M. and E.B. Rock (2007) argue that hedge funds are different to other active shareholders in the sense that they pursue significant and strategic changes at a company (compared to changes pursued gradually and/or incidental by other activists). Zhu (2013) has done research on the effect of the threat of activists and found that there is a positive relation between the likelihood of an activist action and shareholders returns and a positive relation between the likelihood of an activist action and a decrease in management remuneration. The question that arises from these studies is whether more specific short selling achieves similar abnormal positive returns (as activist hedge funds taking long positions) and has a similar disciplining effect on corporate governance. Several research related to this topic has been done as summarized hereunder.

2.4 Empirical Studies on Short Selling

The Empirical Studies on short selling can be distinguished in i) studies on the impact of short sale constraints and ii) studies on the characteristics of firms being targeted and the implications of short selling for firms and their stocks

We will focus on the second source of literature for our research. However, the studies on short sale constraints provide insights that are relevant for our research as well. These short sale constraints studies add to the knowledge and understanding of the effects of short selling.

2.4.1 Theory on Short Selling

Diamond, D.W. R.E. Verrecchia (1987) analyzed the effects of short sales constraints on "the distribution and speed of adjustment of security prices" (page 278). The implications of their model are as follows (amongst others):

- short selling constraints reduce the efficiency of information especially with regard to bad news (or the other way round: reducing costs for short selling increases the price efficiency)

They observe that short sellers only trade when expected return compensates for costs and risks of shorting a stock and that short sellers are better informed than long investors.

2.4.2 Empirical Studies on Short Selling Constraints

Ali, A and M.A. Trombley (2003) analyzed the relation between momentum stock returns (that is the difference in return between winner stock and loser stocks in prior six months) and short sale constraints. They found a positive relationship between the probability of a high loan fee (for borrowing the shares) (as the proxy for the short sale constraint) and momentum returns. They concluded that when there are short selling constraints this prevents arbitrage of the momentum stock returns.

Asquith, P, P.A. Pathak J. Ritter (2005) did research on the effect of constraints on short selling. They investigated institutional ownership (the supply) and the short interest (the demand). They found that short-sale constrained stocks (with little institutional ownership and relatively high short positions) underperform compared to unconstrained stocks. Based on these findings they conclude, "an investor should avoid long positions in stocks that are short-sale constrained" (page 273).

Beneish, M.D., C.M.C. Lee and D.C. Nichols (2015) research shows that when there are indicators of over-valuation of a stock, the lenders of shares tend to reduce the supply of the lendable shares although such stock would be of most interest for short sellers. This observed phenomenon shows that there is not an optimal pricing efficiency because short sellers would want to profit from observed overvalued firms but are hindered by limited supply.

Boehmer, E, C.M. Jones and X. Zhang (2008) examined the effects of a short selling ban by the U.S. Securities and Exchange Commission ("SEC") in September 2008. They found that "–except for the smaller stocks in the smallest size quartile- the stocks suffer a severe degradation in market quality (measured by quoted and effective spreads, price impacts and realized spreads)" (page 1364). Boehmer et al (2007) conclude that from the results of their study (showing deteriorating market efficiency) it is not clear whether the SEC achieved its objectives.

Bris, A, W. N. Goetzmann and N. Zhu (2007) analyzed short sales restrictions and whether this affects the efficiency of markets. They found some evidence supporting the view that restrictions on short sales "inhibit downward price discovery" and strong evidence that "in markets where short selling is either prohibited or not practiced, market returns display significantly less negative skewness" (page 1029). In other words: in markets with more short sale restrictions there are more negative market returns than in markets with less short sale restrictions.

Saffi P. and K. Sigurdsson (2011) observe that short selling has a positive effect on price efficiency. Their main findings are that:

i) more supply of lendable stock results in faster incorporation of information in stock prices and therefore improves price efficiency;

ii) the regulator assumption that short sale constraints stabilizes prices is not supported by their research and

proxy) and firm value (with Tobin’s Q as proxy). Their research shows that a short selling threat has a disciplining effect on M&A decisions by management

Dechow, P.M., A.P. Hutton, L. Meulbroek, R.G. Sloan (2001) examined in which companies short sellers take positions. They found that short sellers target firms with low fundamental to price ratios (such as cash-flow-to-price and earnings-to-price). Short sellers analyze companies’ fundamentals thoroughly before taking a short position. They observed that short sellers cover their positions when the stock price has declined and became more in line with fundamental ratios. They further showed that short sellers avoid relatively high transaction costs for short selling.

This is consistent with earlier research that has found abnormal returns associated with net stock issues, accruals and momentum (Fama and French, 2008). Such factors explain certain deviations in stock prices over a period of time from the Capital Asset Pricing Model. Fama and French (2008) did further research on the observed causes in earlier research of abnormal average returns. They found further additional evidence that accruals provide information about average returns and that the accrual anomaly is an important indicator for over valuation.

Francis, J., M. Venkatachalam, Y. Zhang (2005) have done research on unexpected levels of short position and subsequent effects on revisions by analysts regarding fundamentals and/or risk. As measure for short interest Francis et al use: number of shares shorted / total number of shares outstanding. They found that analysts revise their earnings forecasts downward to a greater extent for firms with unexpected high short positions than for firms with a low unexpected short position. They indicate that this implies that short sellers target stocks that are over-priced compared with their fundamental financials.

Gerritsen, D. and R. Verdoorn, (2014) examined the hypothesis whether short sellers generate abnormal returns and whether a short selling position in a company is relevant information for long investors. Their research in the Dutch market provided evidence that indeed companies with a short position showed a lower stock price performance compared to the market.

Hirshleifer, D., S.H.Teoh and J.J. Yu (2011) research intended to provide further insights in the opposing views that i) short sellers cause downward distortion on prices and ii) short selling helps to correct overpricing. They investigated whether there is a relation between short positions and accruals and whether this is a positive one. The evidence they found shows that short sellers do take positions in stocks with high accruals.

Karpoff, J.M. and X. Lou (2010) find that short sellers are good at identifying overvalued firms and that especially with firms that have severe misstatements of their earnings, short sale positions increase abnormally in the 19 month period before the misstatement is widely known by the public (Abstract).

Lu, J. (2015) studied the relation between the ex-ante role of short selling and earnings management (that is managers misreporting the earnings which is a creating an agency gap problem). The study shows that short selling decreases earnings management ex-ante and that informed short sellers identify earnings management ex-post.

Pownall, G. and P.J. Simko (2005) studied how the market reacts to significant increases in short positions and what explanations there could be for such market responds. They analyzed whether earnings expectations and alternative information sources could explain such market reaction (page 941). They found that investors consider short positions as providing information about the company. Pownall and Simko (2005) describe short sellers as being instrumental in mitigating temporary mispricing of a stock

Massa, M., B. Zhang and H. Zhang (2012) have tested the disciplinary role of short selling by its impact on earnings manipulation. They aim to contribute to the discussion on hedge fund

activism that short selling may have a disciplining effect as well. Their research shows a positive role of the short-sellers. In particular they find a negative correlation between accruals and short selling potential, which, as they conclude, suggests a disciplinary effect of short selling on earnings manipulation (accruals is widely examined as an indicator for earnings manipulation).

2.5 Analysis of the Interviews with Hedge Fund Managers

To complement the knowledge base upon which the hypotheses will be drawn three interviews were held with hedge fund managers in The Netherlands on an anonymous basis. The main findings of the interviews are that hedge funds base their decisions taking a short position on:

- Fundamental financial analysis including sector- and peer group analysis (by applying filters). Fundamentals include cash flow to total debt, EBITDA, details undisclosed) - Discussions with Management/Management presentations (quality of Management,

strategy of the company)

- After initial selection detailed analysis of annual accounts - Analysts opinions (but rather as contra indicator)

- Events (News, Insider Trading)

- Market position (declining business models, competitive threats, changing technological environment)

- Trading Volume of the stock

- Ownership structure (corporate governance is considered on a qualitative basis but not as a key indicator)

- Technical analysis is not widely used

The risk and costs experienced by the hedge fund managers are consistent with the literature (Asquith et al (2005) page 272):

- The lending costs are relatively minor (15bp to 20bp mostly)

- Risk that shares are sold at the beginning of the day but that the execution of the order to lend the shares takes hours to settle (price difference)

- Risk that the order to lend the shares cannot be executed by the broker

- Risk that the shares are called back at a moment that is causing a loss for the short seller (short squeeze risk or margin calls)

- Timing of the market to "share" the views of the short sellers (the position of the short sellers may continue to deteriorate when the stock rises despite fundamental analysis showing over-valuation of the stock)

Short selling is used as an instrument to gain an economic benefit from stocks that are perceived to be over-valued, for a number of reasons:

• Price: short selling is cheaper than put options • Availability: there are not always put options available • Below a threshold: anonymity

The short sellers are professional investors doing extensive research before taking a short position. The risks involved are significant for short sellers. The hedge fund managers consider that management/board should pay attention to short positions. However, they are hardly ever requested to discuss the reasons of taking a short position. On the other hand the hedge funds inform management that they consider a position in the company’s stock but do not disclose in their discussions with management which type of position (long or short).

2.6 Hypotheses

The central question in this research paper is:

Does short selling contribute to decreasing the agency gap as a disciplinary mechanism?

From the literature we derived the following variables for which we will explore the relationship with short positions.

Corporate Governance as this is the main research item. Given the observed effect of the Entrenchment Index by Gompers at al (2003) and the fact that 75 papers have used this index since the publication we will use this index as proxy for corporate governance for the empirical study on US Firms, as described below. The Entrenchment Index is useful for the US context. Each country has different "entrenchments" dependent on the local country’s Company and Civil Law. In the Netherlands for instance an anti-takeover measure such as the Stichting Preferente Aandelen is a strong "entrenchment" enabling Management and Board of a company to prevent (or at least delay) a takeover by a (hostile) bidder.

Accruals will be used as proxy for earnings manipulation. Accruals are widely considered as indicator for earnings manipulation. With that knowledge Accruals can be considered as a measure for misalignment between owners and managers. Forced by law the managers publish financials to (amongst others) the owners of the firm. Manipulating such financials cannot be considered in the best interest of the owners. Accruals are chosen following empirical findings by Hirschleifer et al (2011), who found "a positive association between accruals and short selling" (page 2429) and following research by Massa et al (2012), who also use accruals as proxy for earnings manipulation. The definition for Accruals that will be used is the one that Massa et al (2012) have used: Accruals = ((ΔCurrent Assets - ΔCash) – (ΔCurrent Liabilities - ΔShort Term Debt - ΔIncome Tax Payable)- (Depreciation and amortization))/Total Assets previous year.

We will use Price-to-Book-Value as proxy for a discrepancy between book value and market value. Dechow et al (2001) use Tobin’s Q (a similar variable; Tobin’s Q = Total Market Value of Firm / Total Asset Value of Firm). Dechow et al (2001) found that short sellers target firms with low fundamental ratios. We explore the relationship between short selling and price-to-book-value to learn if short selling is triggered by a discrepancy of fundamentals and market prices.

Based on our findings from the literature and the insights from the interviews with the three Hedge Fund Managers we formulate the following hypotheses:

Part I

Hypothesis I: There is a negative relation between good Corporate Governance (that is with a low number of antitakeover provisions) and short positions

Hypothesis II: There is a positive relation between earnings manipulation (as indicated by the proxy Accruals) and short positions

Hypothesis III: There is a positive relation between a high discrepancy of book- and market value (as indicated by the proxy Price-to-Book-Value) and short positions

We will use the data for the two preceding years 2009 and 2010 (t = -2 and t = -1) respectively and the year that a short position occurs (t = 0 per March 31, 2011).

Part II

Hypothesis IV: short selling has a disciplining effect and contributes to an improvement of the corporate governance of the companies that are targeted

Hypothesis V: short selling has a disciplining effect and contributes to an improvement of the accrual position of the companies that are targeted

Hypothesis VI: short selling has a disciplining effect and contributes to a decrease in the discrepancy between market- and book value of the companies that are targeted.

3. Research Methodology

3.1 Research Methodology

In order to get insight in the research questions and test the hypotheses, two researches were done:

- a survey with hedge fund managers and with company’s executives and - an empirical analysis of data from 1500 US firms

3.2 Survey with Hedge Fund Managers and Company’s Executives

A survey was held with i) Hedge Fund Managers and ii) with Executive- and Non-Executive Board Members of listed companies. For the survey Qualtrics was used, an online tool for surveys (https://az1.qualtrics.com/ControlPanel/?T=7JHYGnBe7BvpuNcB1sIvm8). The research objectives in the survey follow the findings from the theory and the insights obtained from the interviews and intend to test the main hypothesis of this thesis. Main research objective is to explore a potential relationship between corporate governance and short positions: is bad corporate governance resulting in hedge funds taking a short position and do these short positions have a (disciplining) effect on companies?

The questions testing the hypotheses give the respondents five potential answers on a Likert scale. For the questions testing Hypothesis I to III the potential answers range from "Not all at important" to "Extremely important" (5 choices). Hypothesis IV to VI were tested by a number of questions to be answered on a Likert scale "Strongly Disagree" to "Strongly Agree" (5 choices). To obtain further insights the survey included a number of open questions to get the personal opinion of the respondents on the effects of short selling.

The survey was sent to Hedge Fund Managers in The Netherlands, the UK and the US in author’s network, to Hedge Funds mentioned in the AFM’s short selling register and to a number of Hedge Funds obtained from DataStream. In total 250 surveys were sent to Hedge Funds. There was a limited number of Hedge Fund respondents (13) that started the survey with only 6 filling in responses, therefore a response rate of 2,4%. Eight Hedge Funds gave a reason for not participating: they were not able to participate; in a number of cases Hedge Funds indicated that their internal compliance did not allow participating in these kind of surveys.

The survey was also sent to a number of Non-Executive and Executive Board members in author’s network and to companies listed on the AEX, AMX and AScX. Surveys were sent to 61 Executive Board Members and 78 Non-Executive Board Members. Please note that in both numbers we count a survey sent to a listed company on Euronext as one. The reason to do this is that from the responses we learnt that most companies do not participate in such surveys. In total 9 Executive and 3 Non-Executive Board Members answered the survey resulting in response rates of 14,8% for Executives and 3,8% for Non Executives. If we assume 5 Executive Board Members and 5 Non Executive Board Members per listed company the numbers are 293 and 310 respectively and the response rates 3,1% and 1,0%. Six listed companies indicated that they could not participate in these kinds of surveys. One referred to the website as source of published information, which is understandable given the strict rules for disclosing information. One Non-Executive Board Member did not want to participate because he dislikes short selling.

The samples are too small to be able to accept the hypotheses/reject the null hypotheses and are mainly intuitive. However, the results give some interesting insights.

3.2.1 Survey with Hedge Fund Managers

The survey consists of a number of questions to test the hypotheses that we also test in the second part of our research:

Hypothesis I There is a negative relation between good Corporate Governance (that is with a low number of antitakeover provisions) and short positions

Hypothesis II There is a positive relation between earnings manipulation (as indicated by the proxy Accruals) and short positions

Hypothesis III There is a positive relation between a high discrepancy of book- and market value (as indicated by the proxy Price-to-Book-Value) and short positions e Hypothesis IV Short selling has a disciplining effect and contributes to an improvement of

the corporate governance of the companies that are targeted

Hypothesis V: Short selling has a disciplining effect and contributes to an improvement of the accrual position of the companies that are targeted

Hypothesis VI: Short selling has a disciplining effect and contributes to a decrease in the discrepancy between market- and book value of the companies that are targeted.

Research objective is to get insight:

i) if corporate governance and two other potential indicators of a misalignment of owners and managers are causing a short position (Hypothesis I, II and III) and ii) if a short position does have a disciplining effect (Hypothesis IV, V and VI)

Hypothesis I There is a negative relation between good Corporate Governance (that is with a low number of antitakeover provisions) and short positions To test this hypothesis the following question was put to Hedge Fund Managers: What are reasons for you to take a short position in a company?

The questions include a general question on the misalignment of owners and managers and three questions regarding antitakeover provisions of which two items of the Entrenchment Index by Gompers et al (2003) (one share is not one vote and golden parachutes in place). The results are shown below in Table 2.1. Interestingly, respondents consider a misalignment of owner and manager an important reason to take a short position with a mean of 4.00 (a neutral answer would be a 3.00 score). If we look at the other questions specifically focusing on antitakeover provisions, which are an indicator for misalignment as described by Gompers et al (2003), the respondents consider these less important. An explanation could be that one anti-takeover measure itself is not a sufficient reason to take a short position while several antitakeover provisions combined are. Gompers et al (2003) had found that companies with less antitakeover measure earned abnormal returns compared to companies with more antitakeover provisions. Respondents perceive weak corporate governance as a potential reason for taking a short position. The answers by the respondents are in line with Gompers et al (2003) observation. Hedge Fund Managers respond that they are more often taking a short position when the interests of managers and shareholders are not aligned.

Table 2.1: What are reasons for you to take a short position in a company (1)?

Statistic

Management and shareholders interests not aligned

One share is not

one vote Provisions in place Antitakeover

Company has golden parachutes in place Min Value 1 1 1 1 Max Value 5 4 5 5 Mean 4.00 2.57 2.86 2.71 Variance 2.00 1.29 2.14 2.24 Standard Deviation 1.41 1.13 1.46 1.50 Total Responses 7 7 7 7

Hypothesis II There is a positive relation between earnings manipulation (as indicated by the proxy Accruals) and short positions

Accruals are considered a measure for earnings manipulation following the literature (by Massa, Zhang and Zhang (2012) amongst others. For this reasons this indicator is chosen to test if short positions are caused by abnormal high accruals.

This hypothesis was put to the Hedge Fund managers in a question form. The respondents indicated that they do consider Abnormal high Accruals/Total Assets an important consideration to take a short position (mean = 3.71). Five respondents answered this to be a very important reason (scale 4) while two respondents answered neutral (scale 3). The results are as follows:

Table 2.2: What are reasons for you to take a short position in a company (2)?

Statistic Abnormal high Accruals *) divided by Total Assets _{compared to Peer Group}

Min Value 3 Max Value 4 Mean 3.71 Variance 0.24 Standard Deviation 0.49 Total Responses 7

*) (Accruals = (Δ Current Assets - Δ Cash) - (Δ Current Liabilities - Δ Short Term Debt - Δ Income Tax Payable) - (Depreciation and amortization)

The results indicate that respondents consider Accruals/Total Assets as an indicator that short positions are more likely to be taken at companies with abnormal Accruals/Total Assets. This would indicate that firms that manipulate earnings would be overvalued and attract short sellers. If that would be a well-known phenomenon, short selling would have a disciplining effect. This is in line with findings by Fama and French (2008), who found that accrual anomaly is an important factor for over valuation.

Hypothesis III There is a positive relation between a high discrepancy of book- and market value (as indicated by the proxy Price-to-Book-Value) and short positions

To obtain further insight in the considerations of hedge fund managers they were asked if a number of potential financial indicators are a reason to take a short position. The results show that respondents consider the following factors to be important to take short positions:

• Cash Flow to Price ratio low compared to peers

• High Enterprise Value/EBITDA ratio compared to peer group • High Market Cap/earnings ratio compared to peer group

• Abnormal high Off Balance Sheet Obligations compared to peer group • Decreasing growth/contraction

• Events causing an over-reaction • Insider stock sales and

• Liquidity

Table 2.3: What are reasons for you to take a short position in a company (3)?

Statistic Book Value / Market Value ratio below Peer Group's average Cash Flow *) to Price relatively low compared to Peer Group Enterprise Value / EBITDA ratio high compared to Peer Group Market Cap / Earnings Ratio high compared to Peer Group Off Balance Sheet Obligations / Equity high compared to Peer Group Min Value 1 3 3 3 4 Max Value 4 4 5 5 5 Mean 2.57 3.83 4.33 4.17 4.17 Variance 0.95 0.17 0.67 0.57 0.17 Standard Deviation 0.98 0.41 0.82 0.75 0.41 Total Responses 7 6 6 6 6

*) (Cash Flow = operating income after depreciation -/- accruals; Price = # of shares x price of stock)

The results indicate that overvalued firms are considered a target for short sellers (means of 3.83, 4.33 and 4.17). Interestingly, respondents consider companies with cash flow (or EBITDA (a proxy for cash flow) or earnings) compared to market value (or price or enterprise value) a clear indicator for over valuation; more so than market value compared to book value. This is consistent with the findings by Dechow, Hutton Meulbroek and Sloan (2001), who found that short sellers target firms with low fundamental-to-price ratios. Also abnormal high off balance sheet obligations were also considered a reason to take short positions and therefore a signal that a company may be overvalued.

To explore other considerations for taking a short position respondents were asked which factors were reasons for a short position. The results are below in Table 2.4.

Table 2.4: What are reasons for you to take a short position in a company (4)?

Statistic Decreasing growth/ contraction expected An Event causing an over-reaction in upward valuation Sale of Stock by insiders Majority of Analysts giving a "Buy" recommendation Ease of Borrowing the stock Market liquidity *) Min Value 4 3 3 2 3 3 Max Value 5 5 5 4 4 5 Mean 4.67 3.67 3.83 3.17 3.50 4.00 Variance 0.27 0.67 0.97 0.57 0.30 0.80 Standard Deviation 0.52 0.82 0.98 0.75 0.55 0.89 Total Responses 6 6 6 6 6 6

*) trading volume per day sufficient to be able to buy back the shares relatively quickly

Other factors respondents mentioned in an open question were: i) low return and declining operating conditions and ii) quality of management.

From the other conditions leading to short positions in a company’s stock, contraction is considered an important indicator. Also insider sales of stock are considered a signal for over valuation. At last liquidity is a condition for short selling as shown by the answers on the importance of the ease of borrowing and the market liquidity. This is in line with findings from Dechow, Hutton Meulbroek and Sloan (2001), who found that short sellers avoid relatively high transactions costs.

From the above results the Hedge Fund managers participating consider multiple factors important before assuming a short position. Financial ratios indicating an overvaluation compared to a company’s peer group are a clear indication that a short position might be taken by a Hedge Fund according to the group of respondents. Also companies with abnormal financial ratios, such as abnormal high accruals/total assets and high off balance sheet obligations, indicating earnings manipulation, attract short sellers. Other factors indicating a downfall in the company’s value such as contraction and sale of stock by insiders are considered important indicators.

Hypothesis IV to VI Short Selling has a disciplining effect

The Hedge Fund Managers were asked their opinion on the potential disciplining effect of short selling. The questions test if:

• Short selling improves corporate governance (Hypothesis IV)

• Companies decrease abnormal high Accruals/total Assets positions after a short position (Hypothesis V)

• Companies improve their book-to-market value after a short position (Hypothesis VI) The results are as follows summarized in Table 2.5:

Table 2.5: Effects of Short Selling: please give your opinion

The answers indicate that respondents agree that short selling could have a disciplinary effect by its potential rather than by its actual happening. Respondents do not think that companies improve their corporate governance or work to achieve better financials, but they do think that short selling contributes to disciplining management and better governance. The last observation is consistent with findings that Massa, Zhang and Zhang (2012) summarize in their introduction of their paper: "short sellers may amplify the effect of shareholders walking the Wall Street Rule" and selling the company’s shares (e.g. Maug (1998), Kahn and Winton (1998), Admati and Pfeiderer (2009), Edmans (2009) and Edmans and Manso (2011) (page 1)). Saffi and Sigurdson (2011) found that short selling improves price efficiency and therefore conveys information about a company’s stock to the market. This should then have a disciplining effect on the behavior of managers, since they cannot ignore the market in a structural manner. Massa, Zhang and Zhang (2012) found in their study a strong negative correlation between short-selling potential and earnings manipulation: the more potential for short selling the less manipulation by managers.

Hedge Fund Managers were further asked to give their opinion on a number of statements with the following results (see Table 2.6 below):

Statistic Short Selling contributes to disciplining management Short Selling contributes to better governance Short selling has a disciplinary effect by putting pressure on management to avoid earnings manipulation Companies improve their Corporate Governance after a short position has been taken Companies decrease their Accrual/ Total Assets ratio after a short position has been taken Company's book to market value increases after a short position has been taken A perceived over valuation as expressed by a Company's Enterprise Value/EBITDA ratio decreases after a short position has been taken Cash Flow to price ratio increases after a short position has been taken (Cash Flow = operating income after depreciation -/- accruals) Market Cap/ earnings ratio decreases after a short position has been taken Min Value 3 2 3 2 2 2 2 2 2 Max Value 5 5 4 4 3 3 4 4 4 Mean 3.67 3.50 3.50 2.83 2.67 2.83 3.17 3.00 3.17 Variance 0.67 1.10 0.30 0.57 0.27 0.17 0.57 0.40 0.57 Standard Deviation 0.82 1.05 0.55 0.75 0.52 0.41 0.75 0.63 0.75 Total Responses 6 6 6 6 6 6 6 6 6

Table 2.6: Please give your opinion on the following Statements

Statistic Investors being long should pay attention to short positions Executive Board Members should evaluate the information that a short position conveys Non-Executive Board Members should evaluate the information that a short position conveys Executive Board Members should meet the short sellers in their stock and learn

from their considerations

Non-Executive Board Members should meet the short sellers in their stock and learn from their considerations Min Value 4 3 4 2 2 Max Value 5 5 5 5 5 Mean 4.33 4.17 4.33 3.67 3.67 Variance 0.27 0.57 0.27 1.07 1.07 Standard Deviation 0.52 0.75 0.52 1.03 1.03 Total Responses 6 6 6 6 6

Respondents indicated that short positions convey important information to investors and (Non) Executive Board Members (mean 4.33 and 4.17 respectively). The respondents clearly indicate that short selling conveys important information on a company’s stock and Managers should pay attention to these signals. This is consistent with the literature mentioned above. Regarding the statements that Board Members should meet short sellers the respondents confirmed the statements (means of 3.67 on two questions) albeit less strong than the first two questions.

Hedge Fund Managers were asked an open question "What other effects does short selling have in your view?"

The responses are in Appendix I. The difference in answers from the respondent group indicates that short selling could indeed have a disciplinary effect and increase market efficiency. The respondents indicate that short selling could also result in market disruption in case short sellers exploit effects of their actions without a company’s fundamental mispricing. At last the respondents were asked to describe in a few words their opinion on short selling The reactions by the respondents are similar to the generally observed opinions on short selling. Massa, Zhang and Zhang (2012) describe these conflicting views of on the one hand "short selling contributing to market information" and "short selling being dangerous to the stability of financial markets" (page 1) (resulting in bans on short selling). The literature (such as Saffi and Sigurdson (2011) indicates that short selling contributes to price efficiency. Actions by Regulators banning forms of short selling and public opinion tend to assume there is a negative effect on the stability of financial markets. The respondents show support for both views.

3.2.2 Survey with Management/Board of Firms confronted with short positions

The main hypotheses are tested with the following outcome.

Hypothesis I There is a negative relation between good Corporate Governance (that is with a low number of antitakeover provisions) and short positions To test this hypothesis the following question was put to Company’s Board Members: What are in your view reasons for Hedge Fund Managers to take a short position in a company? The questions include a general question on the misalignment of owners and managers and three specific questions regarding anti takeover provisions.

Like the Hedge Fund Managers the Board Members also indicated that a misalignment of management and shareholders is an important reason to take a short position (mean of 3.60 on a 1 to 5 scale). This is consistent with the findings by Gompers, Ishii and Metrick (2003), who found a strong correlation between corporate governance and stock returns. The Board Members showed a different opinion in answering the related questions such as if a one share is not one vote would be an important consideration (mean of 2.80 on a 1 to 5 scale). Apparently they do not consider one specific antitakeover measure to result in hedge funds taking a short position. Especially golden parachutes were not considered an important factor (mean of 1.80) compared to the opinion of hedge fund managers (mean of 2.71). This sounds like a case of cognitive dissonance by the Executives. Gompers Ishii and Metrick (2003) treat golden parachutes as a restriction to shareholder rights and include them in their Index. Table 2.7: What are in your view the reasons for Hedge Funds to take a short position in a

company’s stock (1)?

Statistic

Management and shareholders not

aligned

One share is not one vote Antitakeover measure(s) in place Company has Golden Parachutes Min Value 1 1 1 1 Max Value 5 5 3 3 Mean 3.60 2.80 2.20 1.80 Variance 2.30 2.70 1.20 0.70 Standard Deviation 1.52 1.64 1.10 0.84 Total Responses 5 5 5 5

Hypothesis II There is a positive relation between earnings manipulation (as indicated by the proxy Accruals) and short positions

This hypothesis was put to the Board Members in a question form: "What are reasons for Hedge Fund Managers to take a short position in a company?" The respondents indicated that they do not consider Abnormal high Accruals/Total Assets an important consideration to take a short position (mean of 2.40). Interestingly the answer is very different from the answers by Hedge Fund Managers and deviates from findings in the finance literature (see also above; Accruals/Total Assets are considered a measure for earnings manipulation following the literature). The responding Board Members seem to underestimate the information that is conveyed to the market regarding the level of accruals/total assets.

Table 2.8: What are in your view the reasons for Hedge Funds to take a short position in a company’s stock (2)?

Statistic

Abnormal high Accruals divided by Total Assets compared to Peer Group (Accruals = (Δ Current Assets - Δ Cash) - (Δ Current Liabilities - Δ Short Term Debt - Δ Income Tax Payable) - (Depreciation

and amortization))

Min Value 1

Max Value 4

Hypothesis III There is a positive relation between a high discrepancy of book- and market value (as indicated by the proxy Price-to-Book-Value) and short positions

Again this hypothesis was put to the Board Members in the same question: "What are in your view reasons for Hedge Fund Managers to take a short position in a company?".

Board Members considered that Price to Book Value was not an important consideration for Hedge Fund Managers to take a short position. This is an identical result as obtained from the survey held with the Hedge Fund Managers. The survey further explored a potential effect of related financial indicators. Factors that Board Members consider important are:

• Low cash flow to price compared to peers

• Relatively high Enterprise Value/EBITDA compared to peers • Relatively high valuation/earnings multiple compared to peers The results are presented in Table 2.9 below.

Table 2.9: What are in your view the reasons for Hedge Funds to take a short position in a company’s stock (3)? Statistic Book Value/ Market Value ratio below Peer Group's average Cash Flow to Price relatively low compared to Peer Group (Cash Flow = operating income after depreciation -/- accruals) Enterprise Value/EBITDA ratio high compared to Peer Group Market Cap/ Earnings Ratio high compared to Peer Group Off Balance Sheet Obligations/ Equity high compared to Peer Group Min Value 2 3 4 4 3 Max Value 3 4 5 5 4 Mean 2.80 3.60 4.40 4.40 3.20 Variance 0.20 0.30 0.30 0.30 0.20 Standard Deviation 0.45 0.55 0.55 0.55 0.45 Total Responses 5 5 5 5 5

The answers to these questions are similar to the findings from the survey with Hedge Fund Managers. These findings are consistent with the findings by Dechow, Hutton, Meulbroek and Sloan (2001), who found that short sellers target firms with low fundamental-to-price ratios. Also abnormal high off balance sheet obligations were also considered by Board Members to be a reason to take short positions and therefore a signal that a company may be overvalued. Board Members further indicated that they consider the following factors important:

• Contraction of the business • An event causing an over-reaction • Sale of stock by insiders

• Liquidity (ease of borrowing the stock) The results are shown below in Table 2.10.

Table 2.10: What are in your view the reasons for Hedge Funds to take a short position in a company’s stock (4)? Statistic Decreasing growth/ contraction expected An Event causing an over-reaction in upward valuation Sale of Stock by insiders Majority of Analysts giving a "Buy" recommendation Ease of Borrowing the stock Market liquidity *) Min Value 3 3 2 2 3 4 Max Value 5 4 5 4 4 5 Mean 4.00 3.80 3.20 3.00 3.80 4.20 Variance 0.50 0.20 1.70 0.50 0.20 0.20 Standard Deviation 0.71 0.45 1.30 0.71 0.45 0.45 Total Responses 5 5 5 5 5 5

*) trading volume per day sufficient to be able to buy back the shares relatively quickly

These outcomes are in line with the outcomes of the surveys with Hedge Fund Managers. Sale of stock by insiders was considered a less important reason by Board Members (mean of 3.20) compared to the answer by Hedge Fund Managers (mean of 3.83). Again, cognitive dissonance may be applicable here (Board Members that justify the sale of stock by themselves).

Hypothesis IV to VI Short Selling has a disciplining effect

The Board Members were asked their opinion on the potential disciplining effect of short selling. The questions test if:

• Short selling improves corporate governance (Hypothesis IV)

• Companies decrease abnormal high Accruals/total Assets positions after a short position (Hypothesis V)

• Companies improve their book-to-market value after a short position (Hypothesis VI) Respondents were asked to comment on the "Effects of Short Selling: Please give your opinion" with the following results (Table 2.11):

Table 2.11: Effects of Short Selling: please give your opinion

The Board Members are more neutral (mean of 3.40 and 3.00 for the first two questions) regarding their view on a potentially disciplining effect of short selling’s potential than the Hedge Fund Managers (mean of 3.67 and 3.50 of the first two questions). A mean of 3.00 on the question if short selling contributes to better governance indicates a neutral answer which is not consistent with findings that Massa, Zhang and Zhang (2012) summarize in their introduction of their paper: "short sellers may amplify the effect of shareholders walking the "Wall Street Rule" (page 1). Saffi and Sigurdson (2011) found that short selling improves price efficiency and therefore conveys information about a company’s stock to the market. This should then have a disciplining effect on the behavior of managers, since they cannot ignore the market in a structural manner. Board members seem to underestimate the potential of the role short selling could have on companies and their management.

Regarding the direct disciplining effect the Board Members disagree that this effect would take place (means below 3.00). This is a similar response as the Hedge Fund Managers. This result confirms the findings from the survey with Hedge Fund Managers that short selling could have a disciplining effect because of its potential rather than having a direct effect on an individual company. Respondents do not think that companies improve their corporate governance nor financial ratio’s after a short position has been taken. Overall only on the first question regarding the disciplining effect Board Members do answer that this could a reason for hedge funds taking a short position. On the remaining questions their answers show that Board Members do not consider short selling to have a disciplinary effect, which is not in line with findings from the literature as mentioned earlier.

Furthermore Board Members were asked "Please give your opinion on the following statements"; the answers are included in Table 2.12:

Statistic Short Selling contributes to disciplining management Short Selling contributes to better governance Short selling has a disciplinary effect by putting pressure on management to avoid earnings manipulation Companies improve their Corporate Governance after a short position has been taken Companies decrease their Accrual versus Total Assets ratio after a short position has been taken Company's book to market value increases after a short position has been taken A perceived over valuation as expressed by a Company's Enterprise Value/ EBITDA ratio decreases after a short position has been taken Cash Flow to price ratio increases after a short position has been taken (Cash Flow = operating income after depreciation -/- accruals) Market Cap/ earnings ratio decreases after a short position has been taken Min Value 2 1 2 1 1 2 3 3 2 Max Value 5 5 5 4 3 4 4 4 4 Mean 3.40 3.00 3.00 2.60 2.20 3.00 3.40 3.20 3.20 Variance 1.30 2.50 2.00 1.80 0.70 0.50 0.30 0.20 0.70 Standard Deviation 1.14 1.58 1.41 1.34 0.84 0.71 0.55 0.45 0.84 Total Responses 5 5 5 5 5 5 5 5 5