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.
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
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.