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Short Selling in Initial Public Offerings

By Harvard Law School Program on Corporate Governance

In our paper, Short Selling in Initial Public Offerings, forthcoming in the Journal of Financial Economics, we use short sale transactions data recently made publicly available to explore the nature of short selling in initial public offerings. Many academic papers rely on the assumption that short selling is constrained early in the IPO process and that such constraints contribute to the high level of underpricing of some IPOs. In contrast, we find that short selling is prevalent on the initial trading day and many short sales occur close to the open.
 
Tests of whether short selling is related to divergence of opinion indicate that short selling is increasing in the level of the first day return. While our results are consistent with the hypothesis that short sellers are attracted to IPOs with more divergence of opinion and hence, higher first day returns, they are inconsistent with the notion that short selling constraints are the reason for high underpricing.
 

The perceived inability of short sellers to borrow securities for settlement is one of the primary reasons cited by others for constraints on short selling in IPOs. We test whether short sellers are avoiding regulatory constraints on locating and borrowing shares for shorting (i.e. engaging in ?naked? short selling) by examining whether IPOs with greater short selling are also more likely to have failures to deliver. While we document that most IPOs have failures to deliver on the first settlement date and approximately 30% of IPOs in the sample qualify for the Regulation SHO threshold list on the first possible date, our findings do not indicate that the level of short selling on the offer date is related to fails to deliver or to the qualification for the threshold list. In fact, the factors that are correlated with increased short selling are uncorrelated with fails to deliver.
 
Instead, we argue that fails to deliver are potentially related to underwriter price support activities and present evidence that the level of failures to deliver are related to IPOs with a high probability of underwriter price support. Thus, we conclude that the observed short selling is not due to an avoidance of short selling constraints and therefore, short selling constraints might not be as onerous as presumed.
 
Prior literature has documented a significant role of market makers in the aftermarket trading of IPOs. Using the ?exempt? indicator on the short sale transaction as a proxy for potential market making activity, we test whether our results may be due to the presence of market makers and find no evidence that market makers are the primary driver of our findings.
 
Finally, we present evidence that the magnitude of short selling (after removing market maker activity) on the offer day has a weakly negative statistical relation to subsequent price movements. Once loan fees are considered, however, there is no relation between short selling and profitability. While it appears that a small fraction of short sellers make substantial profits, the average short sale loses almost 4% in the first three months of trading. Therefore, short sellers are unlikely to significantly mitigate the magnitude of the underpricing.

Our results may have implications for the argument that the loosening of short sale constraints due to the expiration of lock-ups lead to an increase in the supply of shares resulting in the collapse of internet stocks. Even though the period studied here does not include the tech bubble because of data availability, our findings on rebate rates are surprisingly similar to those documented by Geczy, Musto, and Reed (2002) during the bubble period. Thus, our findings complement Schultz (2008) regarding the impact of lock-up expirations on short sale constraints during the tech bubble as we document that short selling is prevalent early in IPO aftermarkets long before such lock-ups expire.
 
The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on May 03, 2010 (boomark / email).