Short Sellers and Credit Rating Quality: Evidence from a Natural Experiment

Abstract

Using Regulation SHO as a controlled experiment, we examine the effect of short sellers on credit rating quality. We find a larger improvement in rating quality for pilot firms than for non-pilot firms when short sale constraints are removed for pilot firms. Further analyses document two mechanisms through which short sellers increase rating quality: short sellers discipline rating agencies by threatening to expose rating inaccuracies and provide additional information to rating agencies. Overall, this study highlights an important market force’s (i.e., short sellers’) effect on rating quality. The findings should be informative to academics and regulators who remain interested in improving rating quality.