Governance through Threat:
`Does Short Selling Improve
`Internal Governance?
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`_______________
`
`Massimo MASSA
`Bohui ZHANG
`Hong ZHANG
`2013/83/FIN
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`CFAD VI 1067 - 0001
`CFAD VI v. CELGENE
`IPR2015-01103
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`

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`Governance through Threat:
`Does Short Selling Improve Internal Governance?
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`Massimo Massa*
`
`Bohui Zhang**
`
`Hong Zhang***
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`This paper can be downloaded without charge from the Social Science Research Network electronic
`library at: http://ssrn.com/abstract=2291474
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`
`
`*
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`
`**
`
`
`***
`
`The Rothschild Chaired Professor of Banking, Co-Director of the Hoffmann Research Fund,
`Professor of Finance at INSEAD Boulevard de Constance, 77305 Fontainebleau Cedex,
`France. Email: Massimo.massa@insead.edu
`
`Senior Lecturer at University of New South Wales, Sydney, NSW Australia.
`Email: bohui.zhang@unsw.edu.au
`
`Assistant Professor of Finance at INSEAD 1, Ayer Rajah Avenue, 138676 Singapore.
`Email: hong.zhang@insead.edu
`
` A
`
` Working Paper is the author’s intellectual property. It is intended as a means to promote research to
`interested readers. Its content should not be copied or hosted on any server without written permission
`from publications.fb@insead.edu
`Find more INSEAD papers at http://www.insead.edu/facultyresearch/research/search_papers.cfm
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`CFAD VI 1067 - 0002
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`Abstract
`
`
`
`We explore the relationship between internal governance and the disciplining mechanisms
`created by the threat of short selling (i.e., “short-selling potential”). We argue that the
`presence of short selling increases the cost of agency problems for shareholders and
`incentivizes them to improve internal governance. Our stock-level tests across 23 developed
`countries during 2003-2009 confirm that the threat of short selling significantly enhances the
`quality of internal governance. This effect is stronger for financially constrained firms and
`more pronounced in countries with weak institutional environments. The governance impact
`of short selling leads to an improvement in firms’ operating performance.
`
`Keywords: Short Selling; International Finance; Corporate Governance; Equity Incentives.
`JEL Codes: G30, M41
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`CFAD VI 1067 - 0003
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`Introduction
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`The last decade has witnessed a renewed interest in the role of financial markets in disciplining
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`managers. Shareholders – particularly blockholders – may induce good managerial behavior by exiting
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`and pushing down stock prices when bad managerial actions are taken (e.g., Admati and Pfleiderer,
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`2009; Edmans, 2009; Edmans and Manso, 2011).1 In this regard, informed trading (“exit”) provides an
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`alternative governance mechanism that shareholders can adopt in addition to the traditional
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`“intervention” type of internal governance (e.g., Parrino et al., 2003; Chen et al., 2007; McCahery et
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`al., 2010). Indeed, to some extent, exit and intervention offer substituting governance mechanisms that
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`shareholders can select based on their trade-off between benefits and costs (e.g., Edmans and Manso,
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`2011; Edmans et al., 2013).
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`A more general question is whether any type of informed trading that may reveal managerial
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`misbehavior to the market can substitute for internal governance. A notable example is short selling.
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`Short sellers are known to be informed (Senchack and Starks, 1993; Asquith et al. 2005; Cohen et al.
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`2007; Boehmer et al., 2008) and highly motivated to attack bad firms (e.g., Karpoff and Lou, 2010;
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`Hirshleifer et al., 2011).2 Short selling appears to discipline managers and reduce their incentives to
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`manipulate (Massa et al., 2013). It may therefore appear reasonable to conjecture that shareholders can
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`rely on the external disciplining mechanism of short selling instead of engaging in direct monitoring of
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`managers. If so, shareholders would optimally reduce their direct manager monitoring in the presence
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`of an effective short-selling market.
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`In this paper, we address this issue by exploring the impact of short selling on internal governance.
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`Our main contribution is to empirically document that the presence of short selling increases, rather
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`than reduces, shareholders’ incentives to monitor managers. To explore the economic rationale for this,
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`we also provide a simple model with multiple short sellers to show how short selling stimulates
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`shareholders’ investment in internal governance. For lack of a better expression, we label this effect
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`“governance through threat”.
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`Our main intuition is as follows. Suppose that a shareholder in a firm can choose between
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`investing in internal governance – e.g., monitoring and intervention – and optimally exiting if she
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`privately observes that the manager misbehaves. In the former case, the shareholder reduces the
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`probability that the manager takes a “bad” action, while in the latter case, she just tries to minimize the
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`1 For instance, Edmans and Manso (2011) conclude that “informed trading causes prices to more accurately reflect
`fundamental value, in turn inducing the manager to undertake actions that enhance value."
`2 Of course, other market participants may also influence the shareholders of firms in this way; however, the short-selling
`channel is particularly powerful because short sellers are known to be good at processing negative information (e.g., Karpoff
`and Lou, 2010; Hirshleifer et al., 2011).
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`1
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`loss by selling before the market realizes it. The existence of informed short selling, however,
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`introduces competition in trading over the same set of information. More competition, by revealing
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`more private information to the market, adversely affects the price at which the shareholder can exit.
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`Hence, short selling threatens the payoff of exit. This fact incentivizes the shareholder to spend more
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`on internal governance to reduce the likelihood of the bad action in the first place.
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`The impact of short selling should vary across firms as a function of the real cost of bad
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`managerial actions. For example, consider financially constrained firms that are more “dependent” on
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`the market for external financing (e.g., Baker et al., 2003). A bad managerial action may not only
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`directly destroy firm value but also impose additional damage to shareholders because the consequent
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`price drop would also significantly increase the cost of capital. Therefore, for these firms, the incentive
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`of shareholders to improve internal governance in the presence of short selling should be stronger.
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`Similarly, because the average agency cost is higher in countries with poor country-level governance
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`than in those with good governance, the marginal impact of short selling should be greater in countries
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`with poor governance.
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`These considerations also imply that it is the ex ante (“potential”) threat of short selling, which we
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`refer to as “short-selling potential” (SSP), rather than the ex post actions of the short sellers that
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`affects the shareholders’ governance decisions. 3 We therefore focus our empirical analysis on the
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`impact of SSP on internal governance. Given that short-selling potential is constrained by the capacity
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`of the market, i.e., the fraction of shares available to be lent to short sellers (“Lendable”), we use
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`“Lendable” as our main empirical proxy for SSP. 4
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`Moreover, this proxy for SSP provides several advantages. First, the number of shares available to
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`be lent is mostly determined by the supply-side conditions of short selling and is not directly related to
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`the stock price (e.g., Cohen et al., 2007). Second, more abundant lendable shares reduce short-selling
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`fees (Kaplan et al., 2013) and increase price efficiency in the global market (Saffi and Sigurdsson,
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`2011), directly conditioning the behavior of stock-price-driven managers. Third, and more importantly,
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`shareholders eager to exercise their monitoring/intervention roles are less likely to supply lendable
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`shares to short sellers on a large scale because doing so would transfer their voting rights and therefore
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`limit their ability to affect governance.5 In fact, this unique feature of the short-selling market would
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`3 For instance, a greater threat may lead to a more substantial improvement in governance, which reduces the likelihood of
`bad managerial behavior and the necessity for short sellers to punish it.
`4 An analysis of naked short selling goes beyond the scope of this paper because naked short selling may complicate the
`ownership and governance structure of firms by creating more voting shares than the total number of shares outstanding. One
`benefit of lendable shares is to exclude naked short selling because normal short selling requires short sellers to “locate
`securities to borrow before selling.” In this case, the lender of the shares receives dividends but relinquishes voting rights.
`The definition of ownership involving short selling is provided by the SEC: http://www.sec.gov/rules/final/34-50103.htm.
`5 A lack of voting rights is known to discourage institutional investors (e.g., Li et al., 2008).
`2
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`CFAD VI 1067 - 0005
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`suggest that lending shares – and therefore the ensuing ownership transfer – is orthogonal to
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`shareholder intervention. We will provide empirical evidence that supports this claim.
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`We test our hypotheses, using a unique dataset on worldwide short selling detailed at the stock
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`level across 23 developed countries during the 2002-2009 period. Our main proxy for corporate
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`governance, which we refer
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`to as
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`the corporate governance
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`index (CGI), comes from
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`RiskMetrics/Institutional Shareholder Services (ISS) and is the most widely used index of governance
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`at the firm level in the international context (e.g., Aggarwal et al., 2009; Aggarwal et al., 2011; and
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`Doidge et al., 2007). 6 We find strong evidence that the governance index is related to SSP, a
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`relationship that is statistically significant and economically relevant. A one-standard-deviation-higher
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`SSP is related to a 6.36% higher CGI.7 This pattern holds for both US and non-US firms, both before
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`and during the global financial crisis. Indeed, a one-standard-deviation-higher SSP is associated with a
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`6.97% (13.06%) higher CGI in the US (rest of the world) and a 7.45% (11.42%) higher CGI during the
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`crisis (non-crisis) period.
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`We further investigate whether the impact of short selling is stronger for firms that are more
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`dependent than others on equity markets for financing. Following Baker et al. (2003), we define equity
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`dependence as a higher KZ index (Kaplan and Zingales, 1997), lower levels of cash flow and cash
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`holdings, and higher leverage. The tests involving these variables lead to two results. First, including
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`these variables does not absorb the impact of SSP. Second, and more importantly, the interaction
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`between SSP and these variables is significant across all specifications, with signs that are consistent
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`with our hypothesis that the impact of SSP is stronger for firms that are relatively more equity
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`dependent.
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`When we consider country-level governance, we find that SSP promotes better internal
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`governance in all governance conditions. However, the effect is especially strong in countries with
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`weak institutions. In particular, a one-standard-deviation-higher SSP is related to a 9.78% (9.37%,
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`8.75%, 9.09%, and 13.81%) higher level of governance in countries regulated by civil law (poor
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`disclosure requirements, weak securities regulation, low accounting standards, and loose anti-director
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`rules, respectively). Because country-level governance is known to be complementary to corporate
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`governance (e.g., Doidge et al., 2007; Aggarwal et al, 2009), the substitution effect between short
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`selling and country-level governance further confirms that short selling also has a complementary
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`impact on internal governance.
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`6 The data on international firm-level governance come from Aggarwal’s website: http://faculty.msb.edu/aggarwal/gov.xls.
`7 Economic significance is based on the standard deviation of the corporate governance index.
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`Although CGI is a composite index, its components mostly concern the “monitoring/intervention”
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`facet of internal governance. 8 Therefore, the next step is to explore the “incentive” aspect of internal
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`governance by examining the impact of short selling on equity-based executive compensation. Our
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`model predicts that, other things equal, SSP also incentivizes investors to pay more equity-based
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`compensation to better align managerial incentives. Empirically, SSP has a strong positive impact on
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`equity-based compensation, a relationship that holds across different specifications and alternative
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`samples. A one-standard-deviation-higher SSP increases the CEO equity compensation ratio by
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`between 7.14% and 14.77%. In a series of robustness checks, we also show that SSP increases the
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`sensitivity of executives’ total compensation to firm performance. These findings suggest that SSP
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`pushes shareholders to significantly enhance the incentive aspects of executive compensation.
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`Thus far, all of the tests support the hypothesis that the threat of short selling promotes corporate
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`governance. The next question is whether such relationships imply causality. To address this
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`endogeneity issue, we first control for firm-fixed effects to rule out the possibility that the relationship
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`between SSP and governance is spurious because of omitted firm-level variables. We then address the
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`issue of reverse causality, i.e., whether the positive relationship between SSP and internal governance
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`exists because shareholders are eager to exert internal governance and supply lendable shares to short
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`sellers. In our context, economic theory and the institutional design of the short-selling market would
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`suggest that the opposite (with respect to our working hypothesis) direction of causality is highly
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`unlikely. Indeed, the ability to monitor requires holding shares and not lending them, even temporarily.
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`Nevertheless, we will address this issue econometrically.
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` We employ the same methodology as Aggarwal et al. (2011) in conducting Granger causality
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`tests. The tests produce two results: 1) changes in SSP strongly predict changes in internal governance;
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`and 2) changes in internal governance do not predict changes in future SSP. The first result is
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`consistent with a causal link that runs from SSP to governance, as hypothesized. The second result
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`confirms the conjectured institutional implication that shares to be lent are unlikely to be supplied by
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`shareholders engaged in improving governance. This observation rejects reverse causality and is
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`consistent with the general intuition of Khanna and Mathews (2012) that controlling blockholders,
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`who presumably play the monitoring/intervening roles, only have incentives, if any, to trade against
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`short sellers, to offset their negative price impact.9
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`8 CGI is based on 41 firm-level internal governance attributes. Out of 41 attributes, only the following three are directly
`related to equity compensation incentives: (37) Directors receive all or a portion of their fees in stock; (39) Options grants
`align with company performance and a reasonable burn rate; (40) Officers’ and directors’ stock ownership is at least 1% but
`not over 30% of total shares outstanding.
`9 The difference is that they examine how uninformed short-selling manipulations affect blockholders, whereas we, following
`the literature, explore the case where short sellers are informed and punish suspicious firms (e.g., Cohen et al., 2007;
`Boehmer et al., 2008; Karpoff and Lou, 2010; Hirshleifer et al., 2011; Dyck et al., 2010). However, the impact of short
`selling on price is the same in the two cases.
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`CFAD VI 1067 - 0007
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` The Granger causality tests confirm that there are shareholders not engaged in governance but
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`willing to supply lendable shares to the short-selling market. The interesting question is who these
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`shareholders are. We argue that institutional investors who passively track a benchmark with no
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`performance goals fit well into this economic role, e.g., exchange-traded funds (ETFs) or similar
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`passive institutional investors. Indeed, on the one hand, these investors are passive and typically do not
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`engage in governance-related activities because they lack the incentives to do so. For instance, Dyck et
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`al. (2010) provide a list of important players that blow the whistle on corporate fraud; not surprisingly,
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`short sellers are on the list, but ETFs are not. Our own diagnostic tests, which will be discussed shortly,
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`also confirm that ETFs do not directly enhance internal governance. On the other hand, ETFs supply
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`lendable shares to the short-selling market, and the astonishing growth rate of the ETF industry (40%
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`every year from 2001 to 2010) can provide large exogenous variations in the number of shares
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`available for short selling.10 Indeed, univariate regressions reveal that ETF ownership might explain
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`approximately 39% of SSP variation in the global market, which confirms that ETFs are a primary
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`supplier of lendable shares.
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`These properties allow us to extend the intuition of Hirshleifer et al. (2011) and use ETFs as an
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`instrument to proxy for the efficiency and potential impact of short selling. The main difference with
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`respect to Hirshleifer et al. (2011) is that they use overall institutional ownership to capture the impact
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`of short selling, whereas we focus on one special type of passive institutional investor to locate the
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`supply of governance-unrelated lendable shares. We show that instrumented SSP is strongly and
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`positively related both to CGI and to equity-based executive compensation. A one-standard-deviation-
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`higher instrumented lendable shares is correlated with a 16.86% higher quality of governance and a
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`20.57% higher level of equity-based compensation.
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`The quality of the instrument is confirmed both by statistical tests (Staiger and Stock, 1997) and
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`by the finding that, although ETFs by themselves are positively related to corporate governance in
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`general, the positive relationship becomes insignificant when SSP is zero. The latter result suggests
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`that ETFs do not monitor managers by themselves; instead, SSP is the necessary channel through
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`which ETFs affect governance. This relationship fits the requirements of a good instrument, as it
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`confirms that omitted characteristics that may attract ETF ownership, but are orthogonal to SSP, do
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`not enhance governance (i.e., the exclusion restriction). The use of this instrument further confirms our
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`causal interpretation of the positive effect of SSP on corporate governance and offers additional
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`insights into the formation and evolution of the short-selling market.
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`10 ETFs are bound by rules on securities lending similar to those governing traditional mutual funds. For instance, in Europe,
`ETF providers can lend up to 80% of their basket of securities to a third party to generate revenues. The 2011 IMF “Global
`Financial Stability Report” provides more information about the potential role of ETFs in the short-selling market.
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`Finally, we conduct two additional tests to further refine the analysis of the impact of SSP on
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`corporate governance. First, we find that SSP improves the quality of the board structure of a firm.
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`Because a board internally monitors management behavior for the benefit of investors, this result
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`provides an explicit example of how short selling increases the monitoring incentives of investors and
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`complements our general tests that use the CGI index.11 Second, we assess whether the disciplining
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`effect of SSP on internal governance has any real implications for firm performance. We find that SSP
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`increases the future return on assets (ROA) of a firm through its impact on CGI or on equity-based
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`compensation. A one-standard-deviation-higher level of SSP-related governance (equity-based
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`compensation), for instance, is related to a 24.99% (16.64%) higher ROA. To the extent that firms
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`with good governance are known to have better performance, this result confirms that the
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`complementary impact of short selling on corporate governance achieves the same actual result.
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`Our results contribute to several strands of the literature. First, to the best of our knowledge, we
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`are the first to investigate the impact of the short-selling market on internal governance. The existing
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`governance literature has considered alternative actions between “voice and exit” (Maug, 1998; Kahn
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`and Winton, 1998; Faure-Grimaud and Gromb, 2004) and has focused on “voice” as the main
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`disciplining device. For example, hedge fund activism has been identified as an important source of
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`governance (e.g., Brav et al., 2008; Clifford, 2008; Greenwood and Schor, 2009; Klein and Zur, 2009,
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`2011). More recently, Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011)
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`show that walking the “Wall Street Rule” is a governance mechanism. In particular, Edmans and
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`Manso (2011) examine competitive trading among multiple blockholders, showing that such trading
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`disciplines managers. We extend their intuition and demonstrate that trading competition from short
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`sellers also significantly affects the tradeoff between voice and exit. In doing so, we also extend the
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`potential determinants of corporate governance and equity compensation from within the firm (e.g.,
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`Core and Guay 1999; Core et al. 1999; Bushman and Smith 2001; Armstrong et al. 2010; the latter
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`provides a recent survey) to external market participants, who do not have stakes in the firm but who
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`may trade on its private information.
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`Second, we contribute to the literature on short selling. The standard short-selling literature links
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`short-selling activities to stock returns (Senchack and Starks, 1993; Asquith and Meulbroek, 1995;
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`Aitken et al., 1998) through their effect on the informativeness of stock prices. For example, Cohen et
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`al. (2007) document the ability of short sellers’ trades to predict future stock returns, which suggests
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`that short sellers have access to private information and affect stock-market liquidity and efficiency
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`(e.g., Bris et al., 2007; Boehmer et al., 2008; Boehmer and Wu 2010; Saffi and Sigurdsson, 2011;
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`11 This test, as well as the tests based on equity compensation, also mitigates the potential impact on our analyses
`of anti-takeover provisions, whose role is debated in the recent literature (see, e.g., Smith 2013).
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`CFAD VI 1067 - 0009
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`Kecskes et al., 2013). We extend this line of research by examining the ex ante impact of short selling
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`on corporate governance, based on the ex post observation that short sellers attack bad managerial
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`actions (e.g., Karpoff and Lou, 2010; Hirshleifer et al., 2011). This approach provides explicit
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`economic channels through which information efficiencies provided by the short-selling market yield
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`a beneficial result in the corporate market.
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`Third, our results contribute to the literature that relates shareholder composition to firm
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`performance (e.g., Morck et al., 1988; Himmelberg et al., 1999, Holderness et al., 1999; Franks and
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`Mayer, 2001; Franks et al., 2001) and corporate governance (e.g., Claessens et al. 2000; La Porta et al.,
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`2002; Claessens and Laeven, 2003; Ferreira and Matos, 2008; Aggarwal et al., 2011; Laeven and
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`Levine, 2008; Doidge et al., 2007). Whereas the extant literature focuses primarily on large/controlling
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`shareholders with positive stakes, we are the first to present a positive role for a party who benefits
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`from negative information through negative stakes at a cost to existing shareholders, i.e., short sellers.
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`Finally, our findings provide evidence that firms shape their behaviors in response to the stock
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`market, which suggests or confirms a feedback effect recently proposed in the literature (e.g., Chen et
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`al., 2007; Edmans et al., 2011, 2012). Our contribution is to show that awareness of the existence of a
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`large group of short sellers ready to punish managerial slack can help a firm reduce slack in its
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`beginning stages.
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`The remainder of the paper is organized as follows. In Section II, we present our main hypotheses.
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`In Section III, we describe the data and the construction of the main variables. In Sections IV and V,
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`we provide the main evidence about the relations between short-selling potential and the quality of
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`internal firm governance. Section VI contains endogeneity tests. Section VII provides additional tests
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`related to board structures and value creation. A brief conclusion follows.
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`II. A Stylized Model and Hypotheses
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`We now outline our simple model and its main hypotheses and refer to Appendix A for all proofs.
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`Consider a three-period set up. In Period 0, the manager of the firm may take a “bad action” (e.g.,
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`investments in projects with negative net present value) that damages shareholders’ value but benefits
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`the manager privately. The bad action occurs with probability , which, for the time being, is
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`assumed to be exogenous. We use a variable ̃ to describe whether or not the bad action occurs. This
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`variable takes a value of 1 if the bad action occurs and 0 otherwise.
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`If no bad action occurs, the liquidation value of the firm in period 2 is . If the bad action occurs,
`the liquidation value of the firm is reduced by ̃. We assume that ̃ is normally distributed, i.e.,
` ̃ , where and are positive constants that denote mean and variance, respectively. The
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`parameters , , and are known by the market. However, before period 2, the market does not
`observe the managerial action or the realized value of ̃.
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`The firm has a representative informed shareholder (hereafter, the investor), who has shares of
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`firm stock to start with, as well as some liquidity traders (hereafter, the noise trader), who must trade
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` )). The total
` shares of the stock to cover their private liquidity shocks in the first period (
`number of shares is normalized to one. The investor is informed about the value of ̃ as well as the
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`managerial action. She can take two actions to maximize the total consumption or wealth that she can
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`derive from her shares.
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`First, the investor can invest some capital, , in internal governance, such as (though not limited
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`to) improving the monitoring of the manager and ensuring better disclosure and transparency. Without
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`loss of generality, we assume that the internal governance mechanism prevents the bad action from
`occurring with probability for any givern value of ̃. That is, governance spending reduces the
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` . We assume that is an
`probability that the manager takes the bad action from to
` are the first- and
` and
` , where
` and
`increasing and concave function of (i.e.,
`second-order derivatives of with respect to ).
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`Second, if the bad managerial action occurs (i.e., ̃ ), the investor can choose to sell shares
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`of the firm in the first period ( [ ]) and keep the remaining shares until the liquidation date of
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` , the investor’s consumption becomes
`period 2. In this scenario, which occurs with probability
` are the prices of the stock in the first and second periods,
` and
` , where
`
`
`
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`respectively, when ̃ . It is easy to see that the price in period 2 is
` is determined by the market, as we shall see below. If, instead, the bad action is not taken
`1 (
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` ̃. The price in period
`
`( ̃ ), then the price of the stock remains . In this scenario, the investor can hold the
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`stock until period 2 and enjoy consumption of .
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`Overall, the investor maximizes her expected consumption by optimally choosing the amount of
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`capital to invest in governance and the number of shares to sell in period 1 as follows:
`
`
`
` ) . (
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`
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`Next, we introduce short selling. Intuitively, because short sellers are informed (e.g., Senchack
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`and Starks, 1993; Asquith et al. 2005; Cohen et al. 2007, Boehmer et al., 2008), they compete with the
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`investor to trade on the basis of negative information about the manager taking the bad action. This
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`competition may adversely affect the stock price, making “exit” more costly and inducing the investor
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`to spend more on governance.
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`CFAD VI 1067 - 0011
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`To verify this intuition, we assume that there are N short sellers in the market and that the short
`sellers are as informed as the investor; i.e., the short sellers observe the private information of ̃ as
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`well as ̃. If ̃ , the kth short seller submits an order of shares of the stock to the market to
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`short sell the stock in Period 1. In Period 2, the shorts are covered. We also assume that there are
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`shares available to be lent to short sellers (i.e., lendable shares). This constrains the total amount of
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`feasible short selling, i.e., ∑ . Figure 1 illustrates the timeline.
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`Figure 1: The Timeline of the Model
`
`t = 1
`
`t = 2
`
`1. The investor decides
`how many shares to sell.
`2. Short selling occurs.
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`The remaining shares receive
`the liquidation value of the
`stock: when the bad action
`occurs and otherwise.
`
`
`
`t = 0
`
`
`1. A bad managerial action
`occurs with probability;
`2. The investor determines
`governance spending.
`
`
`
`Finally, we specify how the price is set in Period 1. We use the one-period version of Holden and
`
`Subrahmanyam (1992) to model potential competition among informed traders in the Kyle (1985)
`
`framework and extend it to allow for governance spending. 12 Specifically, each short seller maximizes
` ) . Because short sellers are informed about ̃, they
`
`her expected trading payoff: (
` ̃ before they trade. The market observes the summation of the order flows:
`
`
`directly observe
` ∑ . Following Holden and Subrahmanyam (1992), we examine a symmetric
`
`equilibrium in which all short sellers behave in the same way because they are similarly informed; i.e.,
`
`the optimal amount of would be the same for all short sellers.
`
`Before we solve the maximization problem of the investor, it is helpful to understand how
`
`competition affects trading behavior and the stock price in general. Thus, we first explore an economy
`in which N short sellers compete with each other in trading the signal ̃ that they observe; i.e., we
`
`ignore the investor for the time being. The general effect, which is summarized in Lemma 1 in
`
`Appendix 1, is that more competition among the informed short sellers induces them to trade more
`
`aggressively. This reveals more private information.
`
`The lemma also shows that the total number of lendable shares imposes a natural capacity
`
`constraint on the feasible degree of competition. The larger the number of shares available to short
`
`sellers (“lendable”), the higher is the level of competition among short sellers and the greater the
`
`degree of price efficiency. While the degree of competition can be affected by other economic
`
`
`12 Models with multiple informed investors can also be found in Kyle (1984) and Foster and Viswanathan (1993). Edmans
`and Manso (2011) examine the informed trading of multiple blockholders. Our paper mainly focuses on the case of one
`informed blockholder and multiple informed short sellers.
`
`9
`
`
`
`CFAD VI 1067 - 0012
`
`

`
`conditions, existing empirical evidence supports the intuition that lendable shares increase price
`
`efficiency (Saffi and Sigurdsson, 2011). Thus, evidence shows that this constraint is perhaps one of the
`
`most relevant ones in the short selling market, which motivates us to use the supply of lendable shares
`
`as an empirical proxy for short-selling potential.
`
`Next, we move on to the investor side. We solve the equilibrium in which the investor determines
`
`her optimal governance spending, , and the optimal exiting strategy in the first period, , in the
`
`presence of short sellers. This leads to the following proposition:
`
`Pr