As informed traders, short sellers can help spot concerns with mergers and acquisitions and business-to-business relationships.

Recent research led by Professor and Luck Eminent Scholar Brian Connelly examined the important role of short sellers in mergers and acquisitions and business-to-business relationships.

“There is a potential dark side to B2B relationships, so managers must determine which relationships hold the most promise. They will make relationship-specific investments, or RSIs, in what they perceive to be the best B2B relationships,” Connelly said.

When making relationship-specific investment decisions, managers look for informational clues about the prospects of the business relationship. Short sellers may help provide those clues. “A key determinant of RSI decision-making could be the level of short selling at a manager’s potential partner,” Connelly said. “Short sellers are informed traders who can help top managers make wise decisions about how much to commit to a new relationship.

“Short sellers can spot weaknesses missed by the market, including management mistakes and even outright malfeasance.”

Enron is one infamous example.

In 2000, Enron was one of the energy industry’s leading lights, with claimed revenues of nearly $101 billion. By the end of 2001, Enron was bankrupt.

Government regulators eventually entered the situation, but it was short sellers who first waded into the web of Enron’s falsified financial statements and spotted improprieties.

More recently, short sellers dug into Luckin Coffee and exposed serious problems. A Chinese hedge fund, Snow Lake Capital, contracted with 1,500 people to visit thousands of Luckin Coffee locations, record video, collect receipts and count customers. This resulted in a report that accused Luckin Coffee of inflating sales figures. The allegations turned out to be true. By early 2021, Luckin Coffee was bankrupt and delisted from the stock exchange.

“In our research about short sellers, we find that they do influence company management,” Connelly said, “but in exactly the ways we’d expect in a free market. We found that an increase in short seller interest in a company causes management to become more conservative. Leaders under short pressure might be less likely, for instance, to introduce uncertain new products or enter into questionable mergers. But this is a feature, not a bug: Short sellers can act as a hidden hand of corporate governance that oftentimes keeps managerial behavior in check.”