Aurora Borealis
1 May 2016 CFA Institute Journal Review

Insider Trading before Accounting Scandals (Digest Summary)

  1. Richard D. Long

A study of more than 500 companies shows little evidence of increased insider selling at companies that negatively restated earnings. But when the authors differentiate the insiders, they find that the top management subgroup had increased share sales during the misstated period. These sales increased if the accounting restatement was relatively large, if the restatement resulted in a loss, and if the restatement occurred over a period of more than four quarters.

What’s Inside?

Accounting scandals occurred frequently in the early 2000s at various companies, such as Enron and WorldCom. These scandals often occurred in conjunction with falling stock prices, regulatory investigations, and management changes. In some cases, the senior management of these companies sold shares of stock before earnings were restated and consequently before share prices fell. The authors research the prevalence of insider trading at firms that restated earnings downward. Specifically, they look for instances in which shares were sold before earnings were restated and before stock prices fell. The overall results show little evidence of increased insider selling at the companies that restated earnings. The authors compared insider sales in the misstatement period with insider sales in earlier periods. There was also little evidence of increased insider trading at the firms that restated earnings compared with a control sample of similar firms.
The authors next examine stock sales by subgroups of insider investors. The top management group showed significantly increased company stock sales during the restatement periods. No other subgroup had increased share sales by an abnormal amount. The authors then differentiate the selling activity of the top management subgroup by restatement characteristics. The largest increases in insider sales occurred when the negative restatement amount was large, either by dollar amount or by percentage; when the restated earnings were negative; when there were more than four restated quarters; and when the potential loss from not selling was the largest. These results are highly significant, especially for firms that restated earnings for more than four quarters and for firms in which top management had the highest potential loss.

How Is This Research Useful to Practitioners?

The authors examine the prevalence of insider trading at firms involved in accounting scandals. The results suggest that during the period studied, top managers were willing to manipulate their firm’s earnings to be able to sell shares at inflated prices. These results give an indication of the pervasiveness of this strategy, especially before the passage of the Sarbanes–Oxley Act. Policymakers and regulators should be interested in these results. Companies should also be interested, especially when they are designing incentive compensation plans.
The authors offer three caveats about this research that should be noted by practitioners. First, they consider selling only by registered company insiders, not by all informed parties. Second, insider trading may also be understated if other investors make trades based on the knowledge of the registered insiders. Third, they assume registered insiders do report trades to the SEC.

How Did the Authors Conduct This Research?

The authors examine 518 companies that negatively restated earnings at some point between January 1997 and June 2002 for trading by corporate insiders. The amount of trading by insiders was also examined for a control group of firms that did not restate earnings over the same time period. The control group was constructed of similarly sized companies in similar industries as those in the main sample. The authors considered net sales by insiders over the study period. Transactions are compared for a period before the misstatement and for the misstatement period.
The authors next examine stock sales by subgroups of inside investors. These subgroups were top management (chair, CEO, chief operating officer, and president), top financial officers (chief financial officer, controller, and treasurer), all corporate officers, members of the company’s board of directors, and company block holders (owners of 10% or more of the company’s outstanding stock). The authors then differentiate the selling activity of the top management subgroup into different subsamples by restatement characteristics. These characteristics include large negative restatements, negative earnings after restatement, restatements by number of quarters affected, and large potential losses from not selling.

Abstractor’s Viewpoint

This article is well written and thoroughly researched. I was surprised by the prevalence of insider trading by top management before and during a period of restated earnings. It would be interesting to know whether the sales were made because of an upcoming restatement or whether the restatement was made to facilitate stock sales at inflated prices. I believe these results also illustrate the need for accounting regulations.

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