SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

2. Market efficiency and price discovery
General
DRAFT
Several comment letters acknowledge that short selling is also a necessary tool in price
discovery and market efficiency, particularly where a security is perceived by the market
to be overvalued (NYSE, BATS, CBOE, Citadel Investment Group, Wolverine among
others). As with the market quality evidence, most of the analysis on market efficiency
and price discovery focuses on short sale restrictions in general, not necessarily on the
uptick-type restrictions. Overall, these analyses fail to provide empirical evidence on how
much an uptick restriction, as opposed to a ban, would impede short selling, therefore
providing little support for their arguments.
Several studies conclude that short sellers improve the price discovery process to help
keep markets efficient (Citadel, Coalition of Private Investment Companies, and Autore).
For instance, Citadel Investment Group provides some evidence that the price discovery
process did not operate efficiently when the short sale ban was in place, harming the
investors who may pay prices that are unrelated to issuer fundamentals. Their analysis
concludes that the frequency of distorted price movements during the short sale ban is
consistent with the academic study showing that a significant number of buyers paid
inflated prices because of the inability of liquidity providers to sell short, (Lawrence E.
Harris, Ethan Narnvar & Blake Phillips, Price Inflation and Wealth Transfer during the
2008 SEC Short-Sale Ban, 2009). We caution that the prices of banned stocks may depend
on factors that the authors did not model so that the inflation they estimate may be due to
factors other than the SEC ban. Coalition of Private Investment Companies and Goldman,
Sachs & Co cite the research of Jonathan Karpoff and Xiaoxia Lou, (Do Short Sellers
Detect Overpriced Firms? Evidence from SEC Enforcement Actions, Working paper.
2008) that indicates that short sellers are able to anticipate the misrepresentation of
financial information by companies before it is publicly revealed. In addition, Don
Autore illustrates empirically that binding short sale constraints lead to overpricing
especially when the level of disagreement in the market is higher. However, this
conclusion is based on an analysis of analyst forecasts, which vary infrequently, making
the forecasts not very useful to draw conclusions in short periods of high market
turbulence such as the one analyzed by Don Autore.
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