Short sale constraints and information-driven short selling: evidence on NASDAQ

ABSTRACT

This article examines the impact of the NASDAQ’s bid test rule on the information content of short sales surrounding the U.S. Security Exchange Commission introduction of the pilot programme in 2005. It shows that abnormal short selling prior to analyst recommendation changes were very informative when stocks were restricted by the bid test rule. Such informativeness of short selling disappears when the bid test rule was temporarily suspended for pilot stocks. The results are robust after controlling for various factors that may contribute to this anomaly. Both the shorting efficiency hypothesis and the regulatory concern hypothesis are developed to provide explanations for this anomaly. Additional tests show that the regulatory concern is more consistent with the data.

KEYWORDS:

• Short sale constraints
• analyst recommendations
• the bid test rule
• the SHO regulation

JEL CLASSIFICATION:

• G10
• G14

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ Rule 10a-1 of Securities Exchange Act of 193, or so-called uptick rule, provides that an exchange-traded security may only be sold short at a price that is either above or equal to the last trading price. NASDAQ-listed stocks were not subject to Rule 10a-1 until the National Association of Securities Dealers (NASD) introduced a bid price test with the adoption of NASD Rule 3350 in 1994, which provides that when the bid is a downtick from the previous bid, short sellers other than market dealers can only short at prices one penny above the bid.

² For example, on 28 March 2008 Jim Cramer of CNBC offered the opinion that the absence of the uptick rule harms the stock market today. On 16 July 2008, Congressmen Gary Ackerman, Carolyn Maloney and Mike Capuano introduced a bill to require the SEC to reinstate the uptick rule. On 18 September 2008, U.S. Senator John McCain said that the SEC allowed short-selling to turn ‘our markets into a casino’. On 17 October 2008, the NYSE reported a survey with 85% of its members being in favour of reinstating the uptick rule with the dominant reason to help restore market confidence. On 25 February 2009, chairman of the Federal Reserve, Ben Bernanke, stated he favoured the SEC to examine the restoration of the uptick rule.

³ See description of contrarians short selling in Diether, Lee, and Werner (2009).