Can Short Sellers Detect Internal Control Material Weaknesses? Evidence from Section 404 of the Sarbanes-Oxley Act

We examine whether short sellers are interested in, and capable of, identifying firms with an upcoming revelation of Internal Control Material Weaknesses (ICMW). We show that short sellers accumulate positions in firms that are about to disclose ICMW under Section 404 of the Sarbanes-Oxley Act for the first time when internal control problems are severe. We find that the short interest build-up is mainly due to the use of private rather than public information, which suggests that their trades contain incremental prediction power of the upcoming internal controls failure. Furthermore, the ability of short sellers to predict ICMW is more pronounced in firms operating in poor information environments. Finally, we find no evidence that trades by short sellers prior to the ICMW disclosure creates a cascade of selling that leads to an overreaction of ICMW. Overall, we present evidence that corporate governance information in the form of ICMW is part of the short sellers' information set, and we establish a path through which ICMW impacts equity investors