Key findings:
1. Banks charge higher loan rates after short seller attacks, beyond what is justified by borrower risk.
2. The price hike is stronger when allegations are serious, for example involving fraud claims, and cause stock prices to drop.
3. Firms under attack are less able to switch lenders, giving banks more power to extract high rates.
4. Loan pricing increases more after U.S. Securities and Exchange Commission (SEC) enforcement, showing banks act more aggressively when allegations are substantiated.
When firms are attacked, their lenders may decide to be opportunistic
Activist short sellers may see themselves as Dark Knights of sorts, exposing public firms' wrongdoings – fraud, inflated numbers, conflicts of interest – yet they benefit from their so-called “short” position if the target's stock price declines. What about other stakeholders? The shockwaves may impact the targeted firms' banks, as was the case after Hindenburgh Research attacked the Indian conglomerate Gautam Adani, sparking worries about credit market stability. Yet my co-authors and I wondered if perhaps lenders exposed to the attacked firm didn't also exploit the situation. Our novel study shows that in such cases, banks don’t just respond to risk, they capitalize on it.
A corporate scandal causes loan prices to rise by 8%
In our study involving more than 1,500 short seller allegation campaigns, we compared attacked firms with similar, non-attacked ones. After adjusting for real changes in credit risk, we observed an 8% increase in loan spreads, equivalent to a 16-basis-point increase over the mean, on average, in the aftermath of the allegations. Why? Because banks with an ongoing relationship know they’ve got the upper hand have stronger bargaining power over the borrower. They extract a form of economic rent. In other terms, banks use their information advantage about the borrower to extract more value – in economic theory, it's known as an information hold-up problem.
Allegations of fraud trigger stronger reactions than mere market bubbles
Of course, not all short sellers’ allegations are equally impactful. If an attack leads to a drop in stock prices, meaning the market takes the allegation seriously, then banks will do so too. And if the short sellers publish reports documenting fraud, illegal activities, invalid patents, and the like, the effect is much stronger than, say, gripes about leverage or growth prospects. We found that fraudulent/serious allegations within the price drop category have 1.5 times the impact of non-fraudulent/non-serious allegations.
We found that fraudulent allegations within the price drop category have 1.5 times the impact of non-fraudulent allegations.
In other terms, lenders appeared to distinguish between less powerful allegations and severe cases. But once a campaign hit the firm’s market valuation or entered the regulatory radar, loan pricing followed.
Some firms escape rent extortion
Interestingly, the firms that remained with their incumbent lenders were the ones most affected by the rate hikes. Conversely, those that managed to switch lenders largely avoided this premium. But switching isn’t easy in this sort of case. After all, once a company has been exposed as having engaged in creative accounting or other corporate misbehavior, it will find its options narrowed when it goes knocking on doors to obtain loans. These observations confirm our hypothesis that the economic mechanism underlying our findings is rent extraction, with the banks making use of their “hold-up” power.
Regulatory scrutiny makes matters worse
We traced the timeline of this pricing behavior and observed an interesting pattern: after the initial hike in loan spreads, immediately after the scandal, there is a noticeable decline and stagnation, then an increase. The stagnation matches the period of U.S. Securities and Exchange Commission (SEC) investigations, which are not usually public, and given the regulatory body's limited resources, take some time. Then the surge coincides with SEC announcement or enforcement actions that validate the allegations.
Methodology
We combined a difference-in-differences research design with entropy balancing, examining over 2,700 U.S. syndicated loans from 2008 to 2018 linked to activist short seller attacks. This allowed us to isolate pricing effects beyond credit risk.
Applications
According to conventional wisdom, a long-term relationship between a firm and its bank is beneficial, as the bank is able to calibrate loan terms better than potential rivals thanks to the trove of information it has gathered over years of repeated interactions with its client. Yet we uncovered a scenario where it is not the case: when a firm is under attack by short sellers and the bank, opportunistically, tries to squeeze the troubled firm. In this predicament, and even despite the cost of switching lenders, it is worth looking for more lenient terms elsewhere.
