Disciplinary effect of short selling: evidence from mergers and acquisitions

Purpose Using Regulation SHO's pilot program as a natural experiment, we study how removing short-selling constraints affects a firm's mergers and acquisitions (M&A). Design/methodology/approach Difference-in-difference (DID) regressions. Findings We find that during the pilot program, firms in the pilot group significantly reduce their value-destroying M&A activities. The disciplinary effect focuses on firms with higher levels of agency problems and those with higher levels of CEO incentive pay, where equity-based compensation increases managerial sensitivity to market discipline. The impact of the pilot program on M&As does not focus on overvalued firms, indicating that stock overvaluation does not channel the impact. Finally, we show that the M&A deal quality of firms in the pilot group improves during the pilot program. The overall results indicate that the removal of short sale constraints can create an effective external monitoring system for corporate investment behavior. Originality/value Our paper contributes to the growing literature in several ways. First, our study extends Chang et al. (2019) to provide a different but equally important angle on how short selling disciplines M&As. Second, our results of using long-term post-acquisition stock performance supplement the study of Chang et al. (2019). Third, this paper extends Shi et al. (2021) to take advantage of the Regulation SHO's pilot program. Therefore, we investigate the effect of short selling on M&As from a policy perspective.