Short-selling Constraints and Capital Structure: Evidence from a Randomized Experiment

This paper is the first study exploring the relationship between short-selling constraints and capital structure. To establish causality I exploit the randomized experiment known as the Pilot Program in which the SEC temporarily removed short-selling constraints for a sample of companies. I find that the removal of short-selling constraints negatively affects firm leverage. This result is mostly explained by an increase in expected distress costs of debt, as short-selling constraints preserve companies from fraud disclosures and, respectively, from public scandals, spoiled reputation, and judicial proceedings. In addition, there is some suggestive evidence that the removal of short-selling constraints decreases adverse selection costs and makes equity issuance more attractive, consistent with mitigating information asymmetry problem. I contribute to the existing literature that studies the short-selling constraints in the corporate settings by explaining how a shock in the stock market impacts financing policy.