Home > Board Performance, Corporate Governance Theory, Investor Participation > The short-selling activities as a market mechanism for monitoring managers

The short-selling activities as a market mechanism for monitoring managers

In the last decades, many efforts have been deployed to understand the way market forces help control managers` activities in a corporate world where shareholders are absent from managerial activities in the firm. As a result of the early 2000`s scandals in corporate governance, (Enron, Worldcom, etc), and some other arising later, (Olympus, but mainly the 2008 financial sector debacle), many countries regulated corporate governance structures in favor of shareholders, who were said to hold and use (at least) the power to monitor and in extreme cases eject directors if a dysfunctional board did not generate satisfactory results in terms of shareholder wealth.

The problem emerges when shareholders do not react soon enough with the responsibility to use the power they have been granted. Let`s have a comment on that.

Some argue the monitoring role should be played mainly by Institutional Investors; as they have a fiduciary duty to their investors, mutual funds, pension funds and similar firms are said to be obliged to be active shareholders; they should dedicate efforts and resources to the analysis of management`s actions, and to participate in the General Meetings of  Shareholders actively, thus voting with information and criteria. The result is they strongly rely on the services of the proxy advisory firms, which very often provide them not so valuable counsel, because of the restrictions the face when dealing with the huge number of firms whose meetings they cover, the lack of resources, the conflicts of interest, and so on. Moreover, as Gilson and Gordon argue, Institutional Investors (II`s) don`t have a market incentive to deploy intense research activities; as they hold diversified portfolios, every profit deriving from that research would benefit all II`s while the cost would be borne by them; retail investors would choose their II`s in a profitability ranking, so no benefit would flow to the “active” II`s through higher future fees.

Some other arguments point to the role Retail Investors should play; but shareholder groups, forums, associations, and other interactive tools have been proposed with little if any success.

It is then often said that Activists Shareholders, and mainly hedge funds need to be allowed to have an economic incentive so that their activism benefits all shareholders, as some recent empirical studies show, even if some controversy appeared in the context of a historical debate between Director-centric model and Shareholder-centric model supporters. (2)

But, are hedge funds and other activist shareholders the only possible agents to effectively monitor managers and boards? Is there any economic incentive for the rest of normally passive investors to monitor managers?

Let`s try to unveil that with the help of Massimo MASSA, Bohui ZHANG, and Hong ZHANG`s “Governance through Threat:Does Short Selling Improve Internal Governance?” (3).

They argue that shareholders acting in an effective short-selling market are invited to press for better internal governance, even if there is a mechanism acting though short-selling threatening effect on managers, who are invited to perform, not to manipulate, etc. In fact, shareholders and not only managers are invited to improve internal governance, in what they call “governance through threat”.

They think that short-sellers compete with shareholders that face the choice between investing in monitoring, or simply exiting when a bad action by managers is observed; short-sellers affect the price exiting shareholders can obtain it they choose exiting. Accordingly, shareholders are pushed to more investment in governance by short-sellers. And the incentive is greater when the firm is more dependent on external financing, (a bad action would entail a damaging increase in the cost of capital); it should also be greater in countries with a poor Corporate Governance standard.

They also confirm that compensation is more performance-sensitive in markets with strong short-selling activities, thus allowing the conclusion that shareholders are incentivized to improve governance and also introduce equity compensation for managers.

In brief, short-selling activities are not only a substitute on better internal governance practices, but an incentive to shareholders to increase their efforts and investments in internal governance and equity compensation; and the result is better firm performance and increased shareholder value!

(1)  “The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights”, by Gilson and Gordon, Coloumbia Law School Working Paper Series.  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2206391,

(2) “The long-term effects of hedge fund activism”, by Lucian A. Bebchuk, Alon Brav, and Wei Jiang, http://www.columbia.edu/~wj2006/HF_LTEffects.pdf, and Martin Lipton, from  Wachtell, Lipton, Rosen & Katz, in http://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.22753.13.pdf,

(3) “Governance through Threat:Does Short Selling Improve Internal Governance?”, by Massimo MASSA, Bohui ZHANG, and Hong ZHANG (Insead),


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