The Signaling of Short Selling Activity in Australia

1. The Signaling of Short Selling Activity in Australia 1

2. Reading Questions 1. What is the motivation for this Chapter? 2. Why was short selling legislation introduced in stock markets in 2008? 3. What were the specific regulatory actions in Australia? 4. What did earlier signaling theory have to do with short selling? 5. What does more recent literature suggest? 6. What kind of data were used for this study? 7. What was the final sample size and how was that arrived at? 8. What was the methodology used in this study? 9. What were the findings of the study? 10. What can be generally concluded from this chapter? 2

3. Motivation • It is the intuitive thought that when directors buy and sell shares in their own company they are trading on the basis of having superior knowledge about the future prospects of the firm. • It is put that sale completions by directors represent a signal of bad news, but also signal short selling profit opportunities in a bear market.

4. Regulation Directors’ decisions to sell stock in their own companies may have become a signal for those market players who wished to profit from a fall in the share price. Can we legally sell something that we do not own? Did selling directors either innocently or deliberately contribute to others short selling profits being generated on the basis of bad news? Did short selling exacerbate a fall in the Australian stock market? The Australia regulatory authorities felt the latter activity exacerbated the price slide and the bans on uncovered and covered short selling were introduced on 21st September 2008. The ban on covered short selling was lifted on 25th May 2009 primarily on the basis of a partial recovery in the Australian stock market, but reporting requirements remained.

5. Signaling Market signaling is actions taken by the agent of a company convey meaningful information about the true value of their organization and thereby have an effect on the stock price. An asymmetric model developed by Akerloff (1970). Since has been extended into finance by Spence (1973), Leland and Pyle (1977) and Miller and Rock (1985). Also Noe (1999), Hamill, McIlkenny and Opong (2002). Anand et al. (2002) and Ke et al. (2003) argued that directors engage in “insider selling” well in advance of a break in their firm’s earnings patterns to go “under the radar” and avoid inside information advantage. Ke et al. (2003) sampled 4,179 US firms between 1989 and 1997. Directors’ sales signal their knowledge of a break in the earnings pattern.   5

6. Data Information on director’s trades from confidential interview from The Insider Trader (2010).They record trades for all ASX companies. Only includes transactions bought and sold on the market at the discretion of the director and excludes such trades, which were the result of dividend reinvestment schemes, employee share purchase plans and the exercise of options and warrants.   A survivorship criterion used. Stocks not in either index in the full 5 year period removed. Any stock that had insufficient data for the one year pre and post-clean period removed. Only trades greater than $5,000 included. Final sample was 2,481 transactions with the ASX 200 Index (1,485) and the remainder from the Emerging Index. The final sample number of companies was 185 (ASX 200) and 150 (Emerging Index). 6

7. Method A standard event study methodology was used based on Easton et al. (2008) whereby they find that the returns to the directors after the day they trade, but before they announce the trade to the market, is not significantly different from zero. Two different event periods were constructed. In the first event period, the event day is defined as being the actual date of the transaction. In the second analysis, the event day is taken as 5 days after the transaction date. 7

8. Findings 1. Without the decomposition of trading transactions, director selling, results in a loss to directors (as the share price keeps rising after they sell). There is no signal to the market for short selling opportunities. 2. When the value of the trade is taken into account, directors’ sales are now information revealing. Profits are made where share prices decline and this must have represented a signal for other market players to short sell. 3. In addition, when multiple directors are selling, sales are also information revealing. This means that that when directors sell more than once within a single month, then it is likely to yield excess returns. 8

9. Findings 4. Moreover, when the analysis is further decomposed into the actual number of directors selling (That is, when directors sell 2 times in a month, 3 times in a month etc.), it is noted that, in the ASX 200, 4 sales within a month is the most credible signal. But, in the small cap stocks, 3 directors selling is the most credible signal (most directors in the small cap stocks are selling in multiples of 3 within a single month). Again, this represents a credible short selling signal. 9

10. Conclusion 1. Directors appear to sell in large parcels on imminent bad news. Also, when they sell in small parcels, it seems as though they are selling for private liquidity purposes. 2. Director selling decisions are their decisions and their business. They are selling what they already own and may do so within the law. 3. But, credible signals by selling directors were provided to the Australian share market of short selling profit making opportunities. Investors acting on these signals may have influenced the downward slide of share prices in Australia during the global financial crisis. These actions and signals probably influenced legislation in Australia to ban uncovered positions. 10