Corporate officers use their informational advantage regarding confidential SEC probes to avoid negative trading outcomes, suggests a new paper by four business school professors.
A pronounced spike in insider trading by corporate officers occurs at the outset of SEC’s investigations, according to a new paper by four academic researchers. In examining data on the targets of all SEC investigations closed between 2000 and 2017, the study suggests that SEC investigations are often material non-public events, and that insiders opportunistically trade based on private information about these events in order to avoid financial losses. The paper also provides some interesting insight into the scope of SEC investigations, which may be broader than some had previously thought.
The paper, "Undisclosed SEC Investigations," was authored by Terrence Blackburne of the Oregon State University College of Business, John D. Kepler from the Stanford University Graduate School of Business, Phillip J. Quinn of the University of Washington Foster School of Business, and Daniel Taylor from the Wharton School at the University of Pennsylvania. The authors summarize their paper in an article posted to The CLS Blue Sky Blog published by Columbia Law School. The full paper may be downloaded from SSRN.
One in ten. Using both formal Freedom of Information Act requests and direct communications with the SEC’s FOIA office, the authors obtained nonpublic data on the targets of 12,861 formal SEC investigations closed between January 1, 2000, and August 2, 2017. The investigations pertained to exchanged-listed companies, registered investment advisers and broker-dealers, investment companies, and other entities falling within the SEC’s regulatory scope. Each data record provided information about the target, the originating SEC office, whether the investigation was related to securities, and the open and close dates of the investigation.
The study found that 10 percent of all publicly listed firms are targets of an SEC investigation in the average year, a much broader scope of SEC investigations than might be indicated by the rate of enforcement actions and shareholder suits. The industry distribution suggests that no one industry is targeted by the SEC. Twenty percent of the investigations did concern the largest firms, perhaps reflecting a tendency by the Commission to target large companies (with potentially the largest scope of wrongdoing).
Harbingers of decline. The paper finds that investigations serve as harbingers of meaningful declines in company performance, with firms having a median market-adjusted return of -5.73 percent for the first year after the opening of an investigation and a -9.35 percent return two years after the outset. Despite these declines in shareholder value, however, only 19 percent of targeted firms disclose the SEC investigation at the outset, while 44 percent disclose the investigation by its conclusion. The undisclosed nature of the vast majority of these investigations, coupled with material, long-lived declines in performance, suggests that insiders who have knowledge of the details of the investigation have a substantial information advantage, the authors state.
The study finds no evidence of abnormal trading around the opening of an investigation for the average firm. Companies with extreme negative outcomes, however, did show a pronounced spike in insider selling activity. The study also suggests that the suspicious trading activity in these firms is attributable to corporate officers, with the data providing no evidence of abnormal trading among independent directors.
The absence of a capital market reaction indicates a significant internal information event occurring around the opening of an SEC investigation, the study observes. When conjoined with a spike in insider trading activity, the results further suggest that insiders are trading based on this event. Given that the abnormal selling activity at the investigation’s outset allows insiders to avoid significant losses, the absence of mandatory public disclosure surrounding SEC investigations allows insiders to exploit opportunistically their informational advantage, with potential implications for securities regulators, the authors observe.
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