FamilyControlledFimsInformedTradingEvidenceFromShortSales

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Family Controlled Firms and Informed Trading:Evidence from Short Sales

Ronald AndersonKogod School of Business, American University

Email: [email protected]

David ReebFox School of Business, Temple University


Wanli ZhaoWorcester Polytechnic Institute


January 11, 2010

Abstract

We examine the effect of family control on the level and informational content of short sales in

publicly-traded U.S. firms. We find significantly greater relative short sales in family controlled firms

than in diffuse shareholder firms. Focusing on the potential informational content of short sale

activity, we find that family controlled firms experience over 340% greater abnormal short sales

preceding negative earnings shocks than diffuse shareholder firms. These results are mostpronounced when either founders or their descendants actively manage the firm. Further tests

suggest that relative short sales in family firms contains valuable or useful information in forecasting

future stock returns however; this effect is not discernable in diffuse shareholder firms. In aggregate,

our analysis provides evidence suggesting that informed trading, at least in short sales, occurs more

readily in family controlled firms than in diffuse shareholder firms. One inference is that regulations

designed to limit trading by those with access to material, non-public information appear ill-suited

for family controlled firms.

We would like to thank Jerry Martin, Lalitha Naveen, Michel Robe, Oleg Rytchkov, and YuzhaoZhang for helpful comments and suggestions.


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I. Introduction

Prior literature suggests that short sale activity often anticipates negative firm performance.

Diamond and Verrechia (1987) observe that short sales are costly and therefore likely to reflect

interest by informed traders who have negative information about the firm. A rich empirical

literature supports this notion (e.g. Asquith et al 2005), suggesting, that despite extensive disclosure

and trading regulations, informed trading appears to drive a portion of short selling. Building on

this influential literature, we examine how organization structure can influence the potential for

informed trading. Our analysis focuses on short sale activity in one specific organizational structure,

founding-family controlled firms. Perez-Gonzalez (2006) notes the pervasiveness and prominence

of family ownership in publicly-traded U.S. firms while Shleifer and Vishny (1986) report that

families control about one-third of Fortune 500 firms. Prior literature however, indicates that family

controlled firms tend to be smaller with less institutional ownership than comparable diffuse

shareholder firms (Anderson et al. 2009). Christophe et al. (2004) observe that investors of smaller

firms and firms with less institutional ownership experience greater difficulty in borrowing shares for

shorting purposes; suggesting that traders face greater constraints in developing short positions in

family firms relative to diffuse shareholder firms.

Yet, founders and heirs (family owners) arguably possess strong incentives to engage in short

selling activity.1 As investors with access to privileged information, they may seek to maintain

corporate control and earn profits in light of adverse information (Morck et al. 2005). Families may

seek to create a divergence or wedge between their cash flow rights and control rights (Almeida and

Wolfenzon, 2006) by engaging in short selling. Family members also typically hold a highly

1 We use the term family firm to denote two types of controlling shareholders, namely founders and heircontrolled firms. One school of thought is that founder and heir controlled firms look similar but differ alongseveral key dimensions (Handler, 1994). In contrast, Anderson et al (2009) suggest that founder and heir firmsface similar economic incentives relative to diversified outside shareholders. Bennedson et al. (2007) note the needfor an additional consideration, in particular, the use of a professional, non-family member CEOs to run the firm.


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concentrated position of a single stock in their portfolios (Faccio et al. 2009), providing substantial

diversification incentives to engage in short-selling and thereby hedge portfolio risk. Family

members not actively engaged in firm management or board decisions unlike professional

executives or current directors potentially bear less scrutiny from regulators, thus minimizing

concerns about trading on privileged information.2 Beyond families private motives to engage in

short sales, family members could be a source of information leakage that provides outside investors

with incentives to engage in short selling. Consequently, if family owners seek profits via their

informational advantage, seek portfolio diversification benefits, and/or seek to affect the scope of

their control rights, then these influential shareholders arguably possess strong incentives to engage

in short-selling activity.

We explore the relation between founding-family control and short sale activity using

aggregate daily short sale data for publicly-traded U.S. firms. Our investigation centers on family

firms and differentiates between founder and descendant controlled, and those managed by outside,

professional CEOs. Focusing on how, or why, organizational structure can lead to the presence of

informed investors, we also investigate the relation between negative earnings shocks and relative

short sales for family and diffuse shareholder firms. Finally, we examine the influence of relative

short sales on subsequent stock returns, comparing and contrasting the relation in family and diffuse

shareholder firms. Because organizational structure can lead to varying levels of private information,

varying degrees of regulatory scrutiny, and varying investor demands for hedging activities, our

analysis centers on whether a specific structure family ownership and control influences relative

short sales.

2 U.S. regulations treat any individual with greater than 10% ownership as an insider of the firm thereby limitingtheir trading activity and requiring these investors to disclose their derivative positions in the firm. In familycontrolled firms, ownership is often dispersed among several individuals, keeping individual owners below the10% threshold. In section III, we discuss U.S. regulations concerning informed trading.


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Using a sample of 1,571 of the largest, U.S. industrial firms, our evidence indicates that

family control exhibits a positive relation to short sales as a percent of traded share volume (relative

short sales). Within our sample of firms, family-firms constitute 47% of the population with an

average ownership stake of 22.2%. The remaining 53% of the firms are classified as diffuse

shareholder firms. The results of univariate tests and multivariate regression analyses suggest that

family firms, on average, experience about 8.6% greater relative short sales than diffuse shareholder

firms even after controlling for other characteristics affecting short sale activity such as institutional

ownership, bid-ask spread, and option market depth. On an industry-adjusted basis, we find that

family firms have about 10% more relative short sales than their diffuse shareholder counterparts.

Our results further indicate that relative short sales do not appear to be uniform across the entire

spectrum of family firms. Although our analysis indicates greater relative short sales in all types of

family firms relative to diffuse shareholder firms, we observe that firms led by descendant CEOs

experience twice as much short selling than family firms with either founder CEOs or professional

CEOs. In aggregate, these results indicate that short sales comprise a significantly greater fraction of

traded volume in family controlled firms than in other firms.

Focusing on the potential informational content of short sales, we examine abnormal short

sale activity preceding negative earnings surprises. The analysis indicates that family controlled firms

experience over a 340% greater level of abnormal short selling prior to negative earnings surprises

than diffuse shareholder firms. This result is robust to the inclusion of several different proxies of

informed trading (bid-ask spread, Kyles Lambda, and the probability of informed trading or PIN).

Differentiating family firms based on CEO type (founder, heir, or professional CEO), we find that

all three types of firms exhibit greater abnormal short sales prior to negative earnings

announcements. Active family control (founder CEOs and descendant CEOs) though, tends to

magnify the relation between short sales and negative earnings shocks. Moreover, positive earnings


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surprises appear to bear no relation to abnormal short sale activity in either family or diffuse

shareholder firms. The contrasting results on negative and positive earnings surprises in family

firms do not support the hypothesis that speculators trade around information events because of

negative perceptions of family ownership. Rather, the results seem consistent with the notion that

informed trading, at least in short sales, occurs more readily in family controlled firms in comparison

to diffuse shareholder firms. However, as an important caveat, our data does not allow us to isolate

the identity of short sellers.

Another approach to test the informational content of short sales is to investigate whether

relative short sales predict future stock returns. In particular, using two distinct approaches, we ask

whether relative short sales in family firms better forecast future, short-term stock returns versus

relative short sales in diffuse shareholder firms. Our first set of tests focuses on abnormal returns

using both three- and four-factor models and equally-weighted portfolios based on short sale

rankings for sub-samples of family and non-family firms. In the family firm sub-sample, we find

that abnormal returns are decreasing in short sale activity. An investment strategy that buys the

portfolio of family stocks with the lowest level of short sales and simultaneously shorts the portfolio

with highest level of short sales (long-short strategy) earns abnormal returns of 59.4 basis points per

month. However, in diffuse shareholder firms, no clear relation exits between short sale activity and

abnormal stock returns in either the three- or four-factor model specifications. Although the

analysis indicates that a trader could earn abnormal profits from this long-short strategy, our

specification does not include portfolio-rebalancing costs that potentially outweigh profits.

In the second set of tests examining the information content of short sales, we use a Fama-

Macbeth approach to examine the relation between current short sales and future stock returns.

Consistent with the long-short portfolio strategy, the results indicate short-sales in family firms

contain valuable information in forecasting future stock returns but short sales have little predictive


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ability in diffuse shareholder firms. Focusing on active versus passive control by family members,

we find that short sales provide useful information in forecasting future returns when either

founders or founders descendants serve as CEO. Short sales however, contain little information in

predicting future returns when professional managers serve as CEOs in family firms. Although we

anticipated that short sales would exhibit a strong information effect in forecasting future returns in

family firms, the stark differences between family firms and diffuse shareholder firms in this relation

appear to be large and economically significant.

Our analysis in aggregate, offers evidence consistent with the notion that informed trading

has a greater effect on short sales in family firms than diffuse shareholder firms. However, other

possible explanations exist. Short sales for instance, may act as a conduit for private information

entering the market in family controlled firms while the option market serves this role in diffuse

shareholder firms.3 Alternatively, family firm opacity and family stock holdings may limit market

liquidity, suggesting that short sellers earn additional compensation for expanding the market in

family controlled firms (a liquidity provision), thereby providing what appears to be positive

abnormal returns. In our analyses, we include various control variables to address these concerns

(option market depth, Kyles Lambda, etc.). To further investigate these issues, we construct a

matched sample of family and diffuse shareholder firms based on industry, firm size, and stock

return volatility. The matched sample analyses yield similar results to those from the panel

regressions. Specifically, investors engage in greater levels of short selling in family firms relative to

diffuse shareholder firms and that this short selling appears to be particularly prevalent preceding

negative earnings shocks. We also continue to find that relative short sales better forecasts future

stock returns in family controlled firms than in diffuse shareholder firms.

3 Although short sales arguably provide the greatest breadth of coverage for examining informed trading andhedging activity, exchange traded options provide an alternative venue. Consequently, in our empirical analysis, wecontrol for the volume of traded put options on each firm. The results on short sale activity in family firms aresimilar including or excluding relative put options.


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This study makes three important contributions. First, our analysis highlights a path or route

that controlling shareholders can use to mitigate their firm-specific risk. Prior literature indicates

that family owners poor portfolio diversification can lead these influential investors to impose their

risk-aversion preferences upon the firm and outside shareholders. Our analysis suggests that short

sales can be an important mechanism for these influential investors to limit their down-side risk.

Second, the results indicate that a substantive portion of the short sale activity in family firms occurs

due to informed trading. Our investigation thus underscores another potential conflict between

family shareholders and outside investors that receives scant attention in the literature; specifically,

the ability of informed traders to use negative information events to take advantage of outside

shareholders.

Finally, we add to the literature on the regulation of trading by investors with access to

material, non-public information. Even though informed trading can facilitate corporate

transparency, U.S. regulators seek to restrict individuals from trading on material, non-public

information. In 1984, the U.S. Supreme Court ruled that trading based on information received

through breaches of fiduciary responsibilities, such as managers providing updates to family

shareholders so that they can trade on the information, represents illegal insider activity (Seyhun,

1992). Market experts have questioned the general efficacy of insider trading regulations in limiting

such activity by informed traders (Banerjee and Eckard, 2001). Our analysis suggests that

regulations to reduce informed trading, while potentially limiting such activity in diffuse shareholder

firms, appear substantially less effective in family controlled firms.


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II. Short Sale Activity in Family Firms

A. The Informational Content in Relative Short Sales

Practitioners and academics commonly perceive short sales as providing limited upside

potential and unlimited downside risk, leading these transactions to often reflect private information

by informed traders (Sharp, 1991). Two streams of empirical literature examine short sales and

informed trading. One stream focuses on relative short sales and stock returns. Early studies by

Seneca (1967) and Figlewski (1981) suggest that short sale activity is broadly related to lower future

stock returns. More recently, Desai et al. (2002) find that heavily-shorted NASDAQ firms

experience negative, one-month ahead abnormal returns of about one percent. Diether et al. (2009)

observe that relative daily short-sales predict future, negative abnormal returns. In general, studies

on short sales and stock returns suggest that informed trading affects short selling. A second stream

of research centers on short selling preceding specific corporate events. Christophe et al (2004) find

that relative short sales peak before earnings announcements that depress stock prices. Efendi et al.

(2005) and Karpoff and Lou (2008) document that short sales increase prior to public revelations

about earnings restatements and financial misconduct by the firm. Overall, this literature suggests

that even with extensive regulations of corporate officers and strictures on fair, market-wide

information disclosure, short sale activity appears to be influenced by non-public information.

Critics of short sales argue that this activity allows speculators to bet on a companys failure

and simultaneously creates incentives for traders to pursue activities that lead to the firms demise

(Hogan, 2009). Yet, traders have engaged in short sales for centuries with two reasons primarily

justifying the activity. First, short sales allow long investors to hedge their positions. Long

shareholders may wish to maintain their equity positions but yet seek some insurance against

downturns in the firms share price and thus short a fraction of their holdings. Second, short sales

potentially enhance the assimilation of negative information into stock prices and thereby improve


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stock price discovery (Asquith et al., 2005). Another price discovery argument centers on the

markets speed in incorporating negative information into a firms stock price. Diamond and

Verrechia (1987) explicitly model negative and positive information entering the market, with short

sales acting as key mechanism for incorporating negative information into prices. Hedging strategies

and price discovery play important roles in justifying short sale activities.

B. Family Control: Hedging and Price Discovery

Short selling can provide insurance that limits the familys downside risk. Founding families

often maintain poorly diversified portfolios by holding a large, concentrated position in a single firm

(Demsetz and Lehn, 1985). Anderson and Reeb (2003) report that families typically have over two-

thirds of their wealth invested in the firm. Shleifer and Vishny (1986) observe that one of the single

greatest concerns with family owners centers on the undiversified nature of their portfolios. Faccio

et al. (2009) find that large, controlling shareholders often influence the firms investment and

financing choices because of the concentrated nature of their portfolio holdings. As shareholders

with large, undiversified long positions, family owners typify the class of investor that potentially

derives substantial benefits from shorting their firms stock.

Short selling also allows the family to retain their voting rights associated with the shorted-

shares, thereby not diminishing family influence or control.4 For family members working actively

or directly with the firm, legal restrictions and firm policies potentially prohibit or deter short selling.

Yet, family members not working for the firm may face substantially fewer strictures from engaging

in short sales. Family owners can remove the stigma and potential liability of short-selling by

4 As an example, a family owner with a 25% ownership stake may decide to short 5% of the firms shares. Thefamily owner thus maintains a 25% control stake but in net, the owner only holds 20% of the cash flow rights.The family owner has created a wedge between his/her cash flow and control rights. See Bebchuk et al. (2000) fora discussion on divergences in cash flow and control rights.


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engaging the services of investment bankers who will undertake the position for the family.

Investment banks frequently offer synthetic portfolio-protection products that allow investors to

hedge long positions in stock. Goldman Sachs and BNP Paribas for instance, offer wealth

management and portfolio protection services to assist affluent investors in protecting their wealth.

Family owners purchasing a synthetic short portfolio from an investment banker have thus removed

at least by one degree this activity from their private portfolios and have also maintained

control/voting rights of their shares. The benefits that large, undiversified shareholders derive from

hedging activities suggest greater short sale activity in family firms than in diffuse shareholder firms.

The price discovery justification for short sales presumes that investors with private adverse-

information will engage in short selling. Cao et al. (2005) suggests that options markets would be

best for examining informed trading with extraordinary shocks, such as mergers and acquisitions,

while the equities market (i.e. short sales) would be best for more regular and normal changes in the

information environment. Prior literature focuses on measuring or detecting the presence of

informed trading in equity markets using traded volume (Kyles Lambda ), bid-ask spreads (adverse

information component), and trade classification data (probability of informed trading) to compute a

measure of informed trading. In our approach, we focus on the firms organizational structure in

detecting the presence of informed traders. Anderson and Reeb (2003) argue that outside

shareholders derive benefits from the familys long-standing knowledge and information base that

thus leads to superior firm monitoring. James (2006) suggests that family knowledge of the firm

provides an especially key advantage to the firm in their interactions with external capital markets.

Prior literature generally indicates that family investors are well-informed shareholders. Even

amongst the largest publicly-traded firms, Demsetz (1986) posits that insiders in family controlled

firms are likely to heavily engage in trading based on private information. Schulze et al. (2003)

observe that conflicts of interests amongst a myriad of family members with a claim on firm cash-


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flows, can lead to family members not employed by the firm to take destructive or harmful actions.

One such action would be to short the firms shares in the presence of negative information.

Top managers in both family and diffuse shareholder firms presumably have similar types of

non-public information. Yet, in family controlled firms, family members create another layer of

stakeholders with access to non-public information. Increasing the number of individuals with non-

public information, especially if not professional managers, potentially increases the probability of

inadvertent information leakage. Family-firm employees may also be disgruntled with family

interference or family domination of senior managerial posts; leading to a leakage of negative

information of firm activities. If short sale activity stems from informed traders with adverse

information ceteris paribus, then we should observe greater short sales in firms with greater

information leakage.

Our analysis centers on the relative proportions of informed traders and speculative traders

in the short sale market, arguing that family firms likely have more informed traders than diffuse

shareholder firms. Prior literature indicates that examining the role of earnings surprises in short

sale activity provides a route to investigate the price discovery explanation. If informed traders,

rather than speculators, drive short sales in family controlled firms, then we expect to observe an

increase in short sales prior to negative earnings surprise but not with positive earnings surprises. In

contrast, if speculators are repeatedly more attracted to family controlled firms, then short sales

should increase prior to both positive and negative earnings surprises.

The price discovery argument also suggests that shorts sales should be informative in

predicting future stock returns. Consequently, we also compare the relation between short sale

activity and future returns in family and diffuse shareholders firms. The hypothesis that family

controlled firms have greater informed trading than diffuse shareholder firms suggests that short

sales will better forecast future stock returns in family firms than in diffuse shareholder firms.


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III. Limits on Informed Trading and Short Sales

A. Informed Trading and the Law

Although informed trading by investors potentially improves market efficiency (Manne,

1966; Easterbrook, 1981), the Security and Exchange Commission (SEC) typically discourages

traders from engaging in this activity. U.S. courts have ruled that trading based on material, non-

public information obtained during the performance of corporate duties or through a breach of trust

by a corporate insider constitutes illegal, insider trading (Chakravarty and McConnell, 1999).

Managers violate their fiduciary duties to the firms other shareholders when conveying non-public

information to a select group of investors (Carlton and Fischel, 1983). The theory of

misappropriation of corporate information continues to require a breach of fiduciary responsibility

or duty but expands the realm of individuals covered by insider trading laws (Hoffman, 2007).

However, courts have held that trading based upon non-public information obtained without a

breach of fiduciary responsibility to be legal (see US v O Hagan, 1997).

The U.S. Congress and the SEC have severe monetary penalties for insider trading but do

not explicitly define this activity in legislation. Rather, Congress and the SEC typically allow courts

to define the scope of insider trading (Dolgopolov, 2004).5 Judicial definitions of illegal insider

trading have been developed through a series of court cases (e.g. SEC v Texas Gulf Sulphur(1966);

Dirks v SEC(1984); US v Carpenter(1986), US v OHagan (1997)) and require a breach of fiduciary

responsibility or duty for trades to be considered illegal. Thus, even after the passage of Regulation

5

A recent case illustrates this murky issue (SEC v Cuban, 2009). In this case, Mark Cuban received sensitiveinformation about a firm in which he was a shareholder (case briefs are available at www.fedseclaw.com ). As hedid not work for the firm and owned less than 10% of the stock he was not classified as an insider according toSEC regulations (www.sec.gov) and there was no breach of fiduciary duty in his receiving the information. TheSEC maintained that Mr. Cuban allegedly made an oral agreement to keep the information confidential which alsolimited his ability to trade on the information. A federal district court ruling on July 17th (2009) dismissed the SECscase; stating that third parties who accept confidential information from the firm without a breach of duty are notrestricted from trading on such information. The implication is that individual shareholders with less than 10%stakes can trade on material, non-public information as long as the information is obtained such that a breach oftrust is not violated.


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Fair Disclosure (FD) in 2002, Congress, the SEC and the courts maintain no legal expectation that

all shareholders will have equal information. The U.S. Supreme Court in 1980 made this explicitly

clear in Chiarella v US, whereby the court rejected the principle of a parity of information.

Insider trading rules though, still could mitigate informed trading in family firms and diffuse

shareholder firms. Based on an analysis ofDirks v SEC, founding-family shareholders with a 10%

or less ownership stake might be categorized as constructive insiders and thus acquire the status of

corporate insider. If ruled to be corporate insiders, these family members would then have a

fiduciary responsibility to represent the best interests of the firm. Moreover, when a family member

serves as CEO, the insider classification extends to his/her immediate family. Yet, enforcement of

insider regulations appears to be much more stringent for information on mergers and acquisitions

than on earnings announcements (Huddart et al., 2007); suggesting earnings shocks provide a

relatively robust test of informed trading in short sales. For instance, U.S. regulations provide for

more severe penalties for trading based on private information regarding mergers and acquisitions

relative to routine earnings announcements. Regulators explicitly justify the differential treatment by

arguing that long-term shareholders bear relatively little harm (or benefit) from short-term stock-

price fluctuations around earnings announcements (Coffee, 2007). Mergers and acquisitions

however, affect long-term shareholders in a direct fashion. Consequently, if informed trading occurs

more readily in family controlled firms relative to diffuse shareholder firms, then we expect this

should be reflected in the relation between earnings surprises and short sale activity. Finally, as prior

literature documents that shorts sales can predict future stock returns, any informational differences

in short sales in family and diffuse shareholder firms should be evident in return predictability.

More specifically, we expect the return predictability of short sale activity to be greater in family

controlled firms relative to diverse shareholder firms.


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B. Alternative Perspectives on Short Sales in Family Controlled Firms

While our analysis focuses primarily on the incentives of founding family shareholders to

engage in short sales, the incentives of other firm stakeholders may differ between family firms and

diffuse shareholder firms. Managers for instance may be concerned about future promotions, pay

differences, and the more limited discretion afforded them in family firms, leading to differences in

information leakage in family and diffuse shareholder firms. In addition, family shareholders may be

less concerned about protecting short term corporate data thereby allowing information to more

readily leak to hedge fund managers and other traders in the market.

The business press commonly depicts family shareholders as seeking to limit short sale

activity because, as they argue, this activity increases their cost of capital. Overstock.coms founder,

Patrick Byrne, argued that hedge funds engaged in short-selling of the firms stock to manipulate the

firms share price (Brewster and Hughes, 2008). Beyond chastisements in the press, Byrne has

attempted to use the courts to limit short-selling by hedge funds and their brokers. Other family

owners take a more conventional approach by attempting to increase the costs of covering a short

sale. For instance, in 2001, MicroStrategy a founder led firm asked shareholders to move shares

from their margin accounts into personal accounts thereby increasing borrowing costs for short

sellers (Barret, 2001). Similarly, family members can withhold their own substantial equity stakes

from circulation and thereby increase borrowing costs. In the U.S., when families remain in the

firm, they typically hold about 25% of the firms outstanding equity; suggesting a non-trivial portion

of the firms shares are unavailable for shorting purposes.

Institutional owners represent another important source of share borrowing for short sellers.

Prior research though, indicates that institutions represent a substantially smaller fraction of the

shareholder base in family firms than in diffuse shareholders. For instance, Anderson and Reeb

(2003) report that large blockholders hold almost 40% more shares in diffuse shareholder firms


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versus family firms; again, limiting the share base for borrowers and short sellers. Anecdotal

accounts and prior research suggest a priori that firms with family shareholders will experience less

short sale activity than diffuse shareholder firms.

Perhaps the most straightforward argument for expecting greater levels of short sales in

family firms relative to diffuse shareholder firms rests on the notion of family expropriation and

mismanagement. Prior literature and anecdotal accounts indicate that family firms are more opaque,

less well-managed, and constitute an increased threat of insider expropriation than diffuse

shareholder firms (Anderson et al., 2009). Speculative traders thus develop substantial short

positions in family firms, awaiting the companys demise.

C. Research Focus

Our central research question focuses on the effect of organizational structure on short sale

activity. We examine whether the presence of large, concentrated shareholders family

shareholders affects the level and/or informational content of short selling. Family firms routinely

opine against short sales. Family shareholders however, may possess strong incentives to engage in

short selling to hedge portfolio risk and/or to trade on private information. To this end, we address

three specific questions. First, do family firms experience greater levels of short sales than diffuse

shareholder firms? Although only providing indirect evidence on hedging and informed trading

explanations for short sales in family firms, this test yields insights into any potential differences in

the magnitude of relative short sales between family and diffuse shareholder firms. Second, does

private information have a greater influence on shorting selling in family firms or diffuse shareholder

firms? Specifically, do negative earnings surprises better predict short sales in family firms or their

non-family counterparts? Third, does short selling better gauge future stock return performance in

family firms or diffuse shareholder firms? Because we focus on the firm as the unit of analysis, we


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cannot unambiguously differentiate amongst the various possible mechanisms for short selling

activity in family firms relative to diffuse shareholder firms. Our study provides a broad-based

empirical analysis on whether short sales, in levels or informational content, are influenced by

founding-family control, using data on the largest, industrial publicly-traded firms in the U.S.

IV. Data and Descriptive Statistics

A. Sample

We obtain short sale data based on SEC REG SHO from NYSE (including Archipelago,

merged with NYSE in early 2006), NASDAQ, AMEX, NSX, and FINRA. The SEC initiated a pilot

program that requires SROs (Self-Regulated Organizations; such as exchanges) to report any short

sales trades and make the information publicly available (see www.sec.gov/spotlight/shopilot.htm

for details). Short sale data is available from January 2005 through July 2007. Trades are also

reported to FINRA because some trades are executed through non-exchange channels such as

telephone. The short sale data is of intraday nature and contains the trading symbol of the stock,

the price, the short sale size, the date and the time of each trade. In addition, trades are also

indicated if short-exempt. The data does not identify the individual or institution undertaking the

short sale.

To construct our sample, we merge the short-data sample with the 2,000 largest, U.S firms as

of Dec 31, 2004. In defining the 2,000 largest U.S firms, we extract all firms from COMPUSTAT

and rank these based on market capitalization as of year-end 2004. Foreign firms, regulated public

utilities (SIC codes 4812, 4813, 4911 through 4991), and financial firms (SIC codes 6020 through

6799) are excluded because government regulation potentially affects firm equity ownership

structure. We extract daily data on stock returns, prices, shares outstanding, and trading volume

from CRSP. Observations with a stock price less than $1.00 per share at year-end are dropped


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from the sample. Based on these criteria, our sample consists of 1,571 firms or 4,270 firm-year

observations.

B. Primary Variable Measurement

Our primary measure of relative short sales is daily short sale volume divided by total daily

trading volume. In robustness testing, we also use daily short sale volume scaled by the firms shares

outstanding and find similar results. Our subsequent analyses use three different time periods

(annual, quarterly, and daily) to examine the relation between relative short sales, family firms, and

diffuse shareholders. For the annual measure (Average Daily Short Sales), we use daily short sale

volume divided by total daily volume, and then average across all-trading days of the year. Tests

dealing with quarterly data examine the relation between relative short sales and quarterly earnings

announcements. For the quarterly short-sale measure (Abnormal Short Sales), we average

preannouncement-period daily short sales (from day -30 to -1 relative to the earnings

announcement) and divide by average daily short sales outside of the preannouncement periods.

Finally, in the daily test, we examine the relation between daily relative short sales and future stock

returns.

We define family firms as those where the founder or the founders descendants continue to

maintain a presence as either a shareholder, top-level manager (chairman, CEO, etc.), or as a

director. In the empirical analysis, we examine founder-controlled and heir-controlled firms

separately, and also as a combined group (family firm). To be classified as a family firm, a family

member does not necessarily need to serve as the firms CEO, rather the classification refers to

families maintaining an equity stake in the firm. Family firms are denoted using a binary variable

that equals 1.0 when these controlling shareholders maintain a 5% or greater ownership stake

(Shliefer and Vishny, 1986). In additional testing, we also examine family influence on short sales


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using a continuous measure of ownership. The continuous measure is computed as the total

number of shares held by families (and their relatives) divided by total shares outstanding. For firms

with dual class share structures, we use the families total voting power as a measure of their

influence. Family shareholders can potentially exert further control over short sales by maintaining

an active role in firm management. Consequently, we subdivide family firms into actively-managed

(a founder CEO or a descendant CEO) and passively-managed firms (a professional, outside CEO).

To ascertain family ownership and their involvement, we examine corporate proxy statements and

company histories for each firm in our sample to determine the founder, their subsequent lineage,

and their involvement with the firm. Corporate histories for each firm in our sample come from

Gale Business Resources, Hoovers, and from individual companies.

In our analysis, we compare family firms against diffusely-owned, manager-controlled firms

(the omitted variable which we label as diffuse shareholder firms or diffusely-held firms).

Blockholders such as mutual funds, insurance companies, private equity groups and other

investment institutions often maintain stakes in many of the family firms and diffuse shareholder

firms (Tufano, 1996). For a subset of our sample firms, we obtain blockholding information and

find similar results on the relation between relative short sales, family firms, and diffuse shareholder

firms.

C. Control Variable Measurement

Previous literature indicates that short selling activity varies with firm characteristics.

Diether et al. (2009) note that short selling tends to be higher for large-cap stocks, stocks with low

book-to-market ratios, and stocks with high institutional ownership. Firm size is measured as the

natural log of year-end total assets. We control for growth opportunities using a book-to-market

ratio measured as the book value of common equity divided by market value of common equity.


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Institutional ownership is computed as the percent of common equity held by institutional owners

garnered from Thomson Financial 13-F filings. Less liquid stocks potentially expose short sellers to

substantial costs in the event these traders need to quickly cover their positions due to short

squeezes, margin calls, etc. (Shleifer and Vishny, 1997). We capture stock liquidity using trading

volume measured as daily trading volume averaged across all-trading days in the year. Firms with

differing levels of private information distribution amongst investors potentially experience differing

levels of short selling. The depth of private (asymmetric) information is proxied by the stocks bid-

ask spread calculated as the average of the daily bid-ask spread (over the year).6 Investors can also

make negative bets on stocks by buying put options thereby potentially drawing activity away from

the shorts market.

We control for put activity as the yearly average of daily put volume divided by daily share

volume. Firm performance is measured as return on assets from the prior year (t-1); computed as

earnings before interests, tax, depreciation and amortization (EBITDA) divided by total assets from

the prior year (t-1). Firms with greater stock-price volatility likely attract greater attention from

short-sellers. We capture stock price volatility as the standard deviation of daily stock returns for the

year. Diether et al. (2009) note that short selling differs substantially between NYSE and NASDAQ

stocks. We include a dummy variable that equals one when a stock is listed on the NYSE and zero

otherwise. Stocks with greater uncertainty in future earnings likely arguably attract greater relative

short sales than stocks with less uncertainty in earnings. To control for future earnings risk, we

include analyst forecast dispersion measured as standard deviation of earnings per share (EPS)

6 The analyses in Tables 2 and 3 use bid-ask spread as a control for the probability of informed trading. Inadditional testing, we use Kyles Lamda(Kyle, 1985) and the Probability of Informed Trading (PIN) as defined inEasley et al. (1996) with similar results.


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forecast scaled by the prior year-end stock price.7 Finally, we include dummy variables for each

Fama-French industry to account for industry effects and year dummy variables to capture time

effects.

D. Descriptive Statistics

Table 1, Panel A provides descriptive statistics on short selling and firm characteristics for

our sample. Average daily short sales is 0.21 with a standard deviation of 0.05, indicating that on a

typical trading day, about 21% of total trading volume constitutes short selling. On average,

institutional shareholders hold about 75% of the firms shares with a median of 82%. The typical

firm employs about 18% long-term debt in its capital structure with a standard deviation of

approximately 20%. Firm size, as measured by total assets, averages $5.4 billion with minimum and

maximum value $19.5 million and $795 billion, respectively; suggesting substantial variability in firm

size across the sample.

Panel B presents the results of difference of means tests between family firms and diffuse

shareholders firms. For the sample, family firms constitute 740 firms (1,888 firm-year observations)

with the remaining 831 firms (2,382 firm-year observations) characterized as diffuse shareholder

firms. The results of the difference of means tests indicate that family firms are smaller, less debt

intensive, and equally as risky as diffuse shareholder firms. Further, we note that family firms tend

to have greater forecast dispersion amongst stock analysts and higher bid-ask spreads than diffuse

shareholders. Institutional ownership also appears to be substantially lower in family firms than

diffuse shareholder firms. Institutional owners hold about 69.8% of the firms shares in family firms

versus 81.6% in diffuse shareholders firms. The results of the univariate analysis also indicate

7 Prior literature notes that higher price stocks experience greater short selling. In our analysis, we substitute thenatural log of stock price for the book-to-market ratio and continue to find similar inferences between relativeshort sales, family firms, and diffuse shareholder firms.


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significantly greater levels of short-sale interest in family firms (21.9%) than in diffuse shareholder

firms (20.7%) suggesting that short sales are about 5.8% greater in family firms.

V. Multivariate Tests

A. Family Ownership and Short Sales

Our central argument focuses on whether firm organizational structure affects short sales

activity. To examine this proposition, we estimate the following regression.

Short Salesi,t = + 1(Family Variablei,t) + 2(Sizei,t) + 3(Performance(t-1)i,t) + 4(Bid-Ask Spreadi,t) + 5(ForecastDispersioni,t ) + 6(Book-to-Marketi,t ) + 7(Inst. Ownershipi,t ) + 8(Return Volatilityi,t ) + 9(NYSEi,t) +10(Trading Volumei,t) + 11(Put Volumei,t) + X(Industry Dummiesi,t) + Y(Year Dummiesi,t) + i,t (1)

Where;

Short Sales= Either (i) average daily short sales that equals daily short sales divide by daily tradingvolume averaged over all-trading days of the year, or (ii) Industry-adjusted short sales equal thefirms average daily relative short sales less the median daily short sales for firms in the sameFama-French industry classification.

Family Variable= family firm equals one if the family holds 5% or more of the firms equity; familyownership equals the fraction of the firms equity held by the family; active family managementequals one if a family member holds the CEO post; founder CEO equals one if the founderholds the CEO post; or descendant CEO equals one a descendant of the founder holds the

CEO post.Size= natural log of total assets.Performancet-1 = return of total assets from the prior year.Bid-ask Spread= daily bid-ask spread averaged over the year.Forecast Dispersion= standard deviation of analysts forecast dispersion divided by previous year-end

stock price.Book-to-Market= book value of equity divided by market value of equity.Institutional Ownership = fraction of firms equity held by institutional shareholders.Return Volatility= standard deviation of daily stock returns for the prior 12-months.NYSE = dummy variable that equals one if the firms stock trades on the New York Stock

Exchange and zero otherwise.Trading Volume= natural log of daily trading volume averaged over the year.Put Volume= daily put option volume divided by daily trading volume averaged over the year.Industry and Year Dummies= one of each Fama-French industry; one for each year of the sample.

Columns 1 and 2 of Table 2 show the regression results of average daily relative short sales

on the family firm binary variable and family ownership, respectively. The results of both


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specifications indicate that family firms experience significantly greater levels of short selling activity

than diffuse shareholder firms. Using the results from column 1 with a binary variable for family

presence/control, we find that short sales, on average, are about 8.57% greater in family firms

relative to diffuse shareholder firms. We calculate this difference as the coefficient estimate on

family firm divided by the level of short sales for the entire sample (i.e., 0.018/0.21 = 0.0857).

When using a continuous measure of family ownership, column 2, we find that a one standard

deviation increase in family ownership (= 0.196) is associated with a 9.41% increase in short sales.

Columns 4 and 5 of Table 2 provide alternative specifications for analyzing the relation

between short sales and family presence. Column 4 shows the results when using industry-adjusted

short sales as the dependent variables. Industry-adjusted short sales are measured as the firms

average short sales less the median short sales for firms in the same Fama-French industry

classification. Column 5 provides results using a matched sample specification. In particular, we

match family firms with diffuse shareholders based on the 49 Fama-French industry groups, firm

size (within 30%), and stock return volatility (within 15%). The matching process produces a

sample of 362 family firms, 362 diffuse shareholder firms and a total sample of 2,078 firm-year

observations. The results from the industry-adjusted short sales specification and matched sample

specification continue to indicate that family firms experience significantly greater levels of short

sales activity than diffuse shareholder firms.

Column 3 of Table 2 segregates family firms into those actively managed by a family

member either a founder CEO or descendant CEO and those passively managed by a

professional manager (Bertrand et al. (2008)). Although our analysis continues to indicate greater

levels of short selling in family firms regardless of CEO type than in diffuse shareholder firms,

we do note differences between active and passive family management. Specifically, when a

descendant serves as CEO, the results indicate that family firms experience significantly greater


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levels of short selling than when either a founder or a professional manager serves as CEO of a

family firm. Firms with descendant CEOs appear to experience twice as much short selling than

family firms with either a founder or professional manager CEO. 8 Yet, regardless of active or

passive family management, we find significantly greater levels of short selling in family firms than in

diffuse shareholder firms.

Our hypotheses and empirical analysis thus far, imply that short sales activities arise from

family control or presence. We focus primarily on family presence rather than ownership because

the familys ownership level could be a function of their ability to hedge or insure at least a portion

of their equity stake. In particular, the familys willingness to maintain a large, undiversified equity

stake potentially depends on their ability to protect a portion of their wealth against negative stock

price movements; indicating short sales affect the level of family ownership. Theoretically, the

direction of causality between family ownership and short sales potentially flows in both directions.

Econometric techniques can provide insight into this causality concern, however examining short

sale activity prior to specific information events provides a more robust examination of the effect of

family control on informed trading through shorting activity.9

In the subsequent sections, we

examine abnormal short sales activity prior to negative earnings surprises and relative short sales in

forecasting future stock returns, allowing a more direct test of the informed trading hypothesis with

a clear direction of causality.

8

In F-tests examining the probability that descendant CEO equals founder CEO (F=3.09) and descendant CEOequal professional CEO (F=3.98), we reject the null. The F-test between founder CEO and professional managerCEOs (F=0.07) is not significantly different from zero.9 Using an instrumental-variable, two-stage least squares (IV-2SLS) approach, we estimate the relation betweenshort sales and family ownership. For the instrument for family ownership, we use the fraction of votes that G.W.Bush received in the 2004 Presidential Election in the county where the firm maintains its corporate headquarters.We argue that family owners are more likely to maintain corporate headquarters in business-friendly regions versusareas less accommodating to affluent shareholders (Milyo and Groseclose, 1999). In this IV-2SLS framework, wecontinue to find a positive relation between the predicted value of family ownership and short-sale activity.


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B. Earnings Shocks, Family Ownership and Short Sales

Our results indicating that family firms experience greater levels of short selling than diffuse

shareholder firms provides evidence consistent with three explanations: greater speculative trading,

greater informed trading, and greater trading to hedge large long-positions. In this section, we

investigate the relation between abnormal short sales and future earnings surprises to discern

between these three explanations.

From the perspective of informed trading, if family firms suffer from greater information

leakage than diffuse shareholders firms, then we expect to observe greater short selling prior to the

announcement of a negative earnings surprise. In contrast, we do not expect to observe an increase

in shorts sales prior to a positive surprise. Speculative trading suggests alternative predictions

between earnings surprises and short selling. If speculators simply engage in greater levels of short

selling in family firms relative to diffuse shareholders firms, then we expect to observe greater short

sales prior to both positive and negative earnings surprises. That is, speculators do not know the

content of the earnings announcement but simply take short positions in the hopes of negative

news. However, not knowing the content of the announcement, speculators will also assume short

positions on good news; suggesting greater levels of short selling prior to both positive and negative

earnings surprises. Finally, long-term investors with large, undiversified positions may seek to limit

their downside exposure as a type of insurance. These investors however, may be indifferent to

short-term phenomena such as quarterly earnings shocks. Consequently, the hedging explanation

suggests little, if any, differences between the effects of positive and negative earnings shocks on

abnormal short sales. We use the following specification to examine the arguments.

Abnormal Short Salesi,t= + 1(Unexpected Earnngs Surprisei,t) + 2(Family Firmi,t) +3(Unexpected Earnings Surprisei,t* Family Firmi,t) + X(Control Variablesi,t) + i,t (2)

Where;


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Abnormal Short Sales= average daily short sales from -30 calendar days to -1 day prior to the quarterlyearnings announcement (preannouncement period) divided by the average daily short sales forthe year outside the preannouncement period. [(Short Sales (-30, -1))/(Average Short SalesExcluding (-30, -1))]-1.0.

Family Control= dummy variable equals one if the family holds 5% or more of the firms equity.Unexpected Earnings Surprise= the residual term from the following regression specification for each

firm-quarter of the sample. EPSi,q = + 1EPSi,q-1 + 2EPSi,q-4 + 3EPSi,q-8 + i,t., where; EPS isactual earnings per share of the announcement quarter (q), the prior quarter (q-1), one-year ago(q-4), and two-years ago (q-8). In the robustness testing, we use an alternative measure of actualearnings less analysts average forecasted earnings.

Control Variables= same controls and definitions as in equation 1.

Table 3 Panel A presents the analysis. Columns 1 and 2 display the results for negative

earnings surprises and column 3 displays the results for positive earnings surprises. 10 For ease of

interpretation, we use the absolute value of negative earnings surprises in the regression

specification.

The results generally indicate increasing levels of abnormal short sales for all firms family

and diffuse shareholder firms as the magnitude of negative earnings surprises increases. The

stand-alone unexpected earnings terms in columns 1 and 2 bear positive and significant coefficient

estimate; suggesting short selling increases preceding negative earnings shocks for both family firms

and diffuse shareholder firms. Short sales appear to contain information useful in forecasting the

announcement of negative earnings surprises for all firms.

The analysis moreover indicates that family firms experience incrementally greater levels of

short selling prior to negative earnings surprises than diffuse shareholder firms. Specifically, we note

that the interaction terms between family firms and unexpected earnings surprises exhibit positive

10

For robustness, we also use analysts forecast errors measured as the difference between the analysts averageforecast and the firms announced quarterly earnings. We drop observations with fewer than three analystsfollowing the firm. Overall, we find similar results between short selling, earnings surprises, and family firms anddiffuse shareholder firms as those reported in Table 3 Panel A. Analyst forecast errors, at least at first blush,arguably appear to be a better measure of earnings surprises as these incorporate current information into theanalysts estimates. However, using analysts forecast errors as a measure of earnings surprises requires anadditional assumption regarding the distribution of analysts across the sample. Specifically, the assumption thatanalysts are randomly distributed across both family and diffuse shareholder firms. Anderson et al. (2009) notesystematic differences between analyst following for family firms (about 5.3 analysts per firm) and diffuseshareholder firms (7.1 analysts per firm).


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and significant relations to short sales, indicating that family firms experience substantially greater

short sale activity prior to negative earnings shocks than diffuse shareholder firms. The difference in

short sales preceding negative earnings surprises between family firms and diffuse shareholder firms

appear to be quite large short sales are over six times greater in family firms than their non-family

counterparts. We calculate this multiple as the coefficient estimate on the interaction term of family

firm and unexpected earnings divided by the coefficient estimate on unexpected earnings

(0.127/0.020=6.35).

The stand-alone family firm variables provide additional insight in understanding the relation

between negative earnings shocks and abnormal short sales. The specification in columns 1 and 2

show the relation between abnormal short sales and family presence for only negative earnings

surprises. The unexpected-earnings variables capture the magnitude of the earnings surprise. The

stand-alone family-firm terms capture whether short selling increases prior to negative shocks

regardless of the magnitude or size of the surprise. The results indicate that family firms experience

greater short selling preceding negative earnings surprises regardless of the size of the surprise

than diffuse shareholder firms. Specifically, we note positive and significant coefficient estimates on

the stand-alone family firm variables. Coupled with our earlier results from the interaction terms

between family firm and unexpected earnings, our analysis indicates that short sales in family firms

appear to contain particularly valuable information in predicting the announcement of negative-

earnings surprises.

Column 3 of Panel A (Table 3) examines the level of short sales preceding positive earnings

surprises. The analysis indicates that short sales bear no relation to positive earnings shocks in either

family or diffuse shareholder firms. In particular, the coefficient estimates on unexpected earnings,

family firm, and the interaction of family firm and unexpected earnings are not significant at

conventional levels. The results of the analysis on the relation between short sales and


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negative/positive earnings surprises, taken together, provides evidence consistent with the notion

that informed trading affects substantially greater levels of short-selling in family firms than diffuse

shareholder firms.

To assess whether our results arise due to differences in firm characteristics between our

samples of family firms and diffuse shareholder firms, we repeat our analysis using the matched

sample outlined in the prior section. Table 3 Panel A, columns 4 and 5, shows the results for the

relation between short sales and negative earnings surprises for the matched sample and column 6

shows the results for positive earnings surprises. Consistent with our earlier results, we continue to

find greater levels of short selling for all firms family and diffuse shareholder prior to negative

earnings surprises. Yet, family firms appear to experience substantially greater levels of short sales

than diffuse shareholder firms preceding negative shocks. The results from the matched sample

again suggest that the difference in magnitude of short sales prior to negative shocks between family

firms and diffuse shareholder is quite large, about 3.4 times greater. 11

The result in the prior section of greater short selling in family firms than diffuse shareholder

firms indicated that this effect was particularly prevalent in descendant-controlled firms relative to

founder-controlled or professionally-managed firms. Panel B of Table 3 examines short sales

preceding negative (and positive) earnings surprises for founder-, descendant, and professionally-

managed family firms relative to diffuse shareholder firms. The results indicate that the observed

greater levels of abnormal short selling prior to negative earnings shocks appears to be magnified in

founder-led firms (column 1) and descendant-led firms (column 3) in comparison to family firms

managed by professional CEOs (column 5). That is, abnormal short selling significantly increases

before negative earnings surprises when families actively manage the firm.

11 We calculate this multiple as the coefficient estimate on the interaction term of family firm and unexpectedearnings divided by the coefficient estimate on unexpected earnings (0.136/0.040=3.4).


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In summary, we draw three inferences from the results in Table 3. First, prior to the

announcement of negative earnings shocks, short sale activity increases in family and diffuse

shareholder firms relative to non-announcement periods. No such relation exists for positive

earnings surprises. We interpret this evidence to be consistent with the notion of informed trading

in both family and diffuse shareholder firms. Second, preceding negative earnings surprises, family

firms experience significantly greater levels of short sales than diffuse shareholders firms. No

relation exists between positive earnings surprises and short sales for family or diffuse shareholder

firms. The difference in short sales between family firms and diffuse shareholder firms prior to

negative surprises appears to be quite large on the order of 3.4 to 6.5 times greater relative to their

non-family counterparts. The evidence appears to suggest that informed trading plays a particularly

important role in understanding short selling activity in family firms. Third, founder-led and

descendant-led firms primarily account for the increased level of short selling prior to negative

earnings shocks rather than family firms managed by an outside, professional CEO. Active family

management seems to play an important role in understanding the information content of short

sales.

C. Short Sales and Future Returns: Family vs. Diffuse Firms

Our evidence suggests that informed trading affects substantially greater levels of short sales

in family firms relative to diffuse shareholder firms. Asquith et al. (2005) moreover, contend that

high short sales forecast low future stock returns. A question thus arises as to whether the observed

greater levels of short sales in family firms provides valuable or useful information in predicting

future abnormal stock returns. In particular, we ask whether relative short sales in family firms

better forecasts stock returns versus relative short sales in diffuse shareholder firms.

We answer this question by ranking and categorizing family firms and diffuse shareholders


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firms (separately) into quintiles based on relative short-sales on day t. We then calculate future

abnormal stock returns at day t+2for each of the five family-firm portfolios and each of the five

diffuse-shareholder firm portfolios using standard asset pricing models, i.e., Fama-French three and

four factor models. The stocks in the portfolios are equally-weighted and rebalanced daily. Daily

return data comes from CRSP and to mitigate concerns with the bid-ask bounce (Kaul and

Nimalendran, 1990), we eliminate day t+1 from the analysis and focus our attention on the ability of

relative short sales at daytto forecast portfolio returns on dayt+2.

We calculate abnormal returns for each portfolio using Fama-French three factor (excess

market return, SMB, HML) and four factor (three factor model plus momentum) specifications.

The specifications are:

Three Factor: rp,t rf,t= p + M,p(rM,t rf,t) + S,pSMBt+ B,pHMLt+ p,t (3)

Four Factor: rp,t rf,t= p + M,p(rM,t rf,t) + S,pSMBt+ B,pHMLt+ U,pUMDt+ p,t (4)

Where:

rp,t= the return on the portfolio on dayt+2based on the short-selling rankings from dayt.rf,t= the daily risk-free rate on dayt+2derived from the 1-month T-bill rate.rM,t rf,t= market excess return on dayt+2.SMBt = return factor on a portfolio of small stocks less the return on a portfolio of big stocks

on dayt+2.HMLt = return factor on portfolio of high book-to-market stocks less the return on portfolio of

low book-to-market stocks on dayt+2.UMDt = return factor on a portfolio of prior winners less the return on a portfolio of prior

losers on dayt+2.

The daily return factors are obtained from Kenneth Frenchs website. The intercept () terms in the

three and four factor models are our measures of dayt+2abnormal returns.

Panel A of Table 4 presents the abnormal returns on day t+2 for the five family-firm

portfolios and the five diffuse-shareholder firm portfolios based on relative short sales on day t. The

upper portion of the panel presents the results for family firms and lower portion shows the results

for diffuse shareholder firms. The analysis indicates that the family-firm portfolio with the lowest


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level of daily short selling (Low), generates positive abnormal returns of 3.7 and 3.3 basis points

from the Fama-French three and four factor models, respectively. In contrast, the family-firm

portfolio with the greatest level of short selling (High), earns abnormal returns of only 0.9 (0.9) basis

points from the three (four) factor model. The analysis moreover indicates that abnormal returns

appear to be decreasing as a function of short sales. Specifically, moving from the portfolio with

lowest level of short sales to the portfolio with highest level of short sales, we observe a generally

decreasing trend in abnormal returns. An investment strategy of buying the family-firm portfolio

with the lowest level of short sales and shorting the family-firm portfolio with highest level of short

sales (i.e., a long-short strategy) generates a daily abnormal return of 2.8 basis points or 61.6 basis points

per month.

Diffuse shareholder firms present a substantively different picture. When ranking diffuse

shareholder firms based on relative short sales, we note little difference in abnormal returns amongst

the portfolios. The diffuse shareholder portfolio with the lowest level of short sales generates a

positive abnormal return of 1.7 basis points. In contrast, the diffuse shareholder portfolio with

highest level of short sales earns an abnormal return of 2.3 basis points. The abnormal returns of

the diffuse shareholder portfolios in addition, do not exhibit any discernible pattern as relative short

sales increases. An investment strategy of buying the diffuse-shareholder firm portfolio with the

lowest level of short sales and shorting the diffuse-shareholder firm portfolio with highest level of

short sales (i.e., a long-short strategy ) generates a daily abnormal return of -0.6 basis points or -13.2

basis points per month. Overall, the analysis indicates that relative short sales in family firms

provides valuable information in forecasting future, short-term stock returns. Relative short sales in

diffuse shareholder firms however, shows little, if any, power in predicting future returns. We

interpret this evidence to suggest that informed trading appears to drive a greater level of short sales

in family firms than in diffuse shareholder firms.


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To assess whether our results arise due to differences between the family firm sample and

the diffuse shareholder sample, we repeat the above analysis on the matched sample outlined in

Section V, Part A. The results are shown in Panel B of Table 4. Similar to the full sample, we

continue to find that family-firm abnormal returns decrease as a function of short sales. A long-

short investment strategy for the family-firm matched sample earns a daily (monthly) positive

abnormal return of 1.3 (28.6) basis points based on the Fama-French three factor model. A similar

strategy for the diffuse-shareholder firm matched-sample earns a daily (monthly) positive abnormal

return of only 0.2 (4.4) basis points. We again do not observe any discernible pattern in returns for

the diffuse-shareholder firm portfolios. The results from the matched sample provide evidence

consistent with that from the full sample; indicating that short sales in family firms appear to contain

more valuable information in forecasting future return than short sales in diffuse shareholder firms.

The analysis generally suggests that short sellers of family firms are better able to forecast

future short-term abnormal returns than short sellers in diffuse shareholder firms, providing

evidence consistent with our informed trading argument. Yet, the differing relation between short

selling and future returns for family firms and diffuse shareholders firms may also be affected by

other factors such as stock-price momentum, share liquidity or stock price uncertainty that influence

relative short sales (Diether et al., 2009). To further investigate our central finding and to control

for other factors that potentially affect short selling, we examine future returns using the following

specification.

ri,t+2= + 1(Short)i,t+ 2(rt-5 to t-1) i,t+ 3(Rank t-5 to t-1) i,t+ 4(Risk)i,t + 5(Turnover)i,t+ i,t (5)

where;

ri,t+2= return on stockiat dayt+2Shorti,t= relative short sales on day t measured as short sales volume on day tdivided by total

stock trading volume on dayt.rt-5 to t-1 = the return on stockifrom dayt-5to t-1.Rank t-5 to t-1 = the rank of an individual stocks return based on rt-5 to t-1 amongst all stocks in the

sample, normalized to a range from 0 to 1.0.


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Riski,t = the difference between the high and low price of stock ion day tdivided by the highstock price on dayt.

Turnoveri,t = the average share turnover of stock i from day t-5 to t-1. Share turnover is thetrading volume divided by shares outstanding.

The above regression specification, using a Fama-Macbeth methodology, examines whether current

short-sale interest (dayt) exhibits a capacity in predicting future short-term returns (dayt+2).12 The

returns in the model are raw, unadjusted returns. The term, r t-5 to t-1, captures the effect of past,

short-term stock price movements on future returns, i.e., a momentum effect. To allow for the

likelihood of a non-linear relation between past and future returns, we rank each of the individual

stocks into quintiles based on their returns over the past 5-days and assign the stock a standardized

value ranging from zero to one. Those with the return in the top quintile receive a value of one and

those with the return in the bottom quintile receive a value of zero. Risk allows for the possibility

that traders engage in greater short selling due to greater information uncertainty around the

stock/firm. Turnovercontrols for the possibility that high trading volume (liquidity) signals a demand

shock that potentially leads to greater future returns (Llorente et al., 2002).13

Panel C of Table 4 presents the regression results. Columns 1 and 2 show results for family

firms and diffuse shareholder firms, respectively, across the full sample. Columns 3 and 4 show the

analysis for our matched sample of family firms and diffuse shareholder firms. The full- and

matched- sample yield the same inferences and as a consequence, only the full-sample results are

discussed. After controlling for liquidity, risk, and momentum factors that potentially affect short

sales, the results of the panel regressions confirm those from the Fama-French specifications.

Specifically, current short sales (dayt) in family firms tend to be predictive of future negative stock

12 For these regressions, we use a Fama-Macbeth method of regressing daily returns (day t+2 ) on relative shortsales (dayt) for the family-firms and diffuse shareholder firms for each day of the sample period. The coefficientestimate on the short variable (and other controls) from the daily regressions are then averaged across all-days ofthe sample period to yield the Fama-Macbeth coefficient estimates and t-statistics provided in Table 4.13 In additional testing, we included a control variable for stocks trading on the New York Stock Exchange(NYSE). With the inclusion of the NYSE dummy, we continue to find that relative short sales forecasts futurereturns in family firms but not in shareholder firms.


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returns (day t+2 ). The negative and significant coefficient estimate on short sales (SHORT) in

column 1 indicates that higher short-interest today forecasts a decline in future returns.

Economically, a 10% increase in todays short sales for a family firm predicts a 2.88 basis point

decline in returns (two-days hence). This corresponds with a monthly decline of 0.63 percent;

suggesting an economically significant effect.

In contrast, the results in column 2 for diffuse shareholder firms indicate that current short

sales bear no significant relation to future stock returns. Although negative, the coefficient estimate

on short sales (SHORT) for diffuse shareholder firms is not significant at conventional levels.

Short sales appear to have little capacity in forecasting future returns for diffuse shareholder firms.

The control variables generally indicate that past positive stock returns (r-5, -1 ) and information

uncertainty (Risk) are associated with future negative returns.

The analysis from the panel regressions provides evidence supportive of the results from the

Fama-French three and four factor models. Specifically, short-sales in family firms contain valuable

information in forecasting future stock returns but short sales have little predictive ability in diffuse

shareholder firms. We interpret the evidence to suggest that informed trading appears to affect a

greater portion of short sales in family firms than diffuse shareholder firms.

D. Family Control, Short Sales and Future Returns

Our earlier multivariate analyses indicate that short sales are not uniform across the entire

range of family firms. Panel A of Table 5 presents abnormal returns from Fama-French three and

four factor models for the family-firm sample segregated by founder CEOs, descendant CEOs, and

professional-CEOs. The results indicate that abnormal returns appear to be decreasing as a function

of short sales in actively-managed family firms. Moving from the founder and descendant portfolios

with lowest level of short sales (Low) to the portfolios with highest levels of short sales (High ), we


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observe a decreasing trend in short-term abnormal returns. A long-short investment strategy with

the founder portfolios yields a positive abnormal return of 2.1 basis points (46.2 basis points per

month). A similar strategy for the descendant portfolios earns an abnormal return of 2.6 basis

points (57.2 basis points per month). Interestingly, for professional-CEO family firms, we find no

discernible relation between relative short sales and abnormal returns. A long-short investment

strategy for this group of firms provides a negative, abnormal return of 0.1 basis points (-2.20 basis

points per month). Short sales appear to contain useful information in forecasting future returns

when either the founder or a founders descendant serves as CEO. Short sales however, contain

little information in predicting future returns when professional managers serve as CEOs in family

firms. We interpret this evidence to suggest that informed trading appears to drive a greater level of

short sales in family firms when a family member (founder of descendant) serves as CEO rather

than a professional manager.

VI. Conclusion

Prior literature suggests that short sales activity reflects trading by informed investors and

thus relative short sales provide useful information in forecasting or predicting future stock returns.

We examine the role of organization structure in short sale activities and the predictability of future

stock returns by focusing on the effect of an influential, prevalent, and concentrated investor; family

shareholders. On the one hand, family firms tend to be smaller and have less institutional

ownership than their non-family counterparts, potentially limiting short sale activity in family

controlled firms. Yet, family owners via their informational advantages and their need to hedge large,

undiversified long-positions arguably maintain strong incentives to engage in short selling.

Using daily short sale data, our empirical results suggest significant differences in short sales

between family and diffuse-shareholder firms. Our analysis indicates that family firms experience


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greater levels of short selling than diffuse shareholder firms after controlling for other characteristics

affecting relative short sales such as institutional ownership, option-market depth, liquidity, and

information asymmetry. The results further indicate short selling appears to be particularly

prevalent in family firms preceding negative earnings surprises. We find that family controlled firms

experience 340% greater relative short sales prior to negative earnings shocks than diffuse

shareholder firms. The investigation moreover suggests that relative short sales in family firms

contain valuable or useful information in forecasting future, short-term stock returns. Short sales

however exhibit no discernible relation with future returns for diffuse shareholder firms. The

relation between short sales and future returns appear to be most pronounced for the group of

family firms with either a founder or descendant serving as CEO rather than an outside, professional

manager. One interpretation of our results suggests that short sale activity in family firms reflects

greater levels of trading based on adverse, non-public information than short-sale trading in diffuse

shareholder firms. Family controlled firms potentially suffer from greater information leakage than

their non-family counterparts.

Although short sales can reduce asymmetric information problems amongst investors and

promote market efficiency, U.S. regulations prohibit individuals from trading on material, non-

public information obtained during the performance of corporate duties or through a breach of trust

by a corporate insider. Officers, directors, and large-individual owners (>10% of equity holding) are

considered corporate insiders and have fiduciary duty to the firms shareholders. Corporate insiders

must report their derivative positions with respect to the firm and face legal and firm-level

constraints on short-term trading activities. Our analysis generally indicates that regulations and

strictures to limit informed trading appear to work better in diffuse shareholder firms than in family

controlled firms. Although we cannot unambiguously eliminate a relation between short sales and

future stock returns for diffuse shareholder firms, our results provide rather strong evidence that


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short sales in family firms contain valuable information in forecasting future returns. In aggregate,

our empirical results suggest that material, non-public information appears to have a greater effect

on short sales in family firms than in diffuse shareholder firms.

In our analysis, we do not take a stand on whether greater information leakage in family

firms relative to diffuse shareholder firms yields costs or benefits to the firms other investors. On

the benefits side, informed trading can facilitate market efficiency through better price discovery and

limiting the effects of idiosyncratic risk on corporate investment policy. On the cost side, informed

trading potentially undermines investor confidence in the markets ability to provide a fair and level

playing field and/or limits capital market development. Our results at first glance however, argue

for clarifying the designation of those considered corporate insiders. Yet, our results on relative

short sales and future stock returns indicate that the most pronounced effect occurs when a founder

or founder-descendant serves as CEO.

Our study contributes to the understanding of the effects of organizational structure on

short sales and information leakage to the wider market. In particular, our analysis suggests that

short sale activity bears a strong relation to the presence of large, influential, undiversified

shareholders, i.e., family shareholders. Our empirical results on the relation between relative short

sales and family control suggest the need for a broader investigation into the effectiveness of

regulations limiting informed trading, if that is the desired outcome of regulatory control. In

aggregate, the analysis indicates that organizational structure plays a critical role in assessing the

informational content of short sale activity in large, publicly-traded U.S. firms.


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References

Almeida, Heitor V., and Daniel Wolfenzon, 2006. A theory of pyramidal ownership and familybusiness groups.Journal of Finance, 61 (6): 2637-2680.

Anderson, Ronald C., and David M. Reeb, 2003. Founding-Family Ownership and Firm

Performance: Evidence from the S&P 500.Journal of Finance, 58 (3): 1301-1328.

Anderson, Ronald C., Augustine Duru, and David M. Reeb, 2009. Founders, heirs, and corporateopacity in the United States.Journal of Financial Economics, 92 (2): 205-222.

Asquith, Paul, Parag A. Pathak, and Jay R. Ritte

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