Overstock, Biovail, and the Trouble with Short-Sale Constraints

As the current Overstock and Biovail cases are showing, short-sale constraints on stocks can take many forms. They can be direct financial borrowing costs, availability of stock to short, legal restrictions, the risk that borrowed stock will be recalled, and so on. Alongside those short-selling constraints are company-specific ones, like legal action taken against short-sellers, such as suing them or sending in the detectives. Firms also work with shareholders to withdraw stock from the lending market, thus artificially drying up the supply of stock to short. All these things create constraints in the market for short-selling.

The seminal work in this area is a lovely 2002 NBER paper (XLS date here) by Yale’s Owen Lamont. In it he looks at 327 events from 266 public firms (during the period March 1977 to May 2002) where said companies mounted some sort of defense against short-sellers, or accused short-sellers of wrong-doing.

The absolutely predictable result:

The evidence shows that when firms take anti-shorting actions, their stock returns are extraordinarily low over the subsequent months and years. The evidence confirms the hypothesis that short sale constraints allow stocks to become overpriced.

Or to paraphrase a Doonesbury cartoon that I’ve cited here before, “Guilty, guilty, guilty!”