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Insider trading scandals are a recurring theme in conversations on business ethics, the most recent of which involves Lordstown Motors, an Ohio-based electric vehicle startup. Lordstown faces scrutiny over five of its top executives selling chunks of their company stock a month before it posted unexpectedly high losses in March. Insider trading scandals, where company executives profit from price-sensitive, non-public information, have routinely gored corporate reputations, claimed jobs of CEOs and others, and attracted regulatory fines and jail time.
In that chastening environment, more and more companies are cognizant of the sensitivity of material, non-public information their executives have access to before it is publicly available and sufficiently assimilated in their stock prices, according to a recent paper titled Determinants of Insider Trading Windows by experts at Wharton and the University of Southern California. The paper is based on a study that identified patterns in insider transactions at about 4,000 companies between 2012 and 2020. The paper’s authors believe their study is the first “to explore the informational determinants of the length and timing of company-imposed insider trading windows.”
“Insider trading often gets a bad rap,” said Wharton accounting professor Wayne Guay, who co-authored the paper with Wharton Ph.D. student Shawn Kim and University of Southern California accounting professor David Tsui. “Our paper seeks to highlight another side of the story – that most boards, executives, and general counsel also find unscrupulous trading behavior to be problematic and go to significant lengths to constrain it. Our findings provide evidence that companies are thinking about this very carefully.” Kim added that in framing insider trading policies (ITPs), many companies are voluntarily imposing restrictions on insider trades that are above what is required by law. “They’re doing it to address and mitigate some risks, whether they are legal or reputational,” he said.
The news media often has reports “about insiders taking advantage of this or that, but it’s a two-way street,” said Guay. “Companies recognize that this can be a real problem. It could be a public relations nightmare. There can be litigation costs. What we find is that companies are thinking carefully about how to mitigate these costs and how to make sure that their executives are not taking advantage of every opportunity they can to trade. The point of our paper is to see how companies put the brakes on this kind of behavior.”
The timing of the paper is significant because “there’s been a lot of pressure on companies to provide more information about how they constrain insider trading,” said Guay. Gary Gensler, the new chairman of the Securities and Exchange Commission (SEC), recently said that his agency is drafting new rules to restrict plans that corporate insiders use. Specifically, they relate to loopholes in the SEC’s so-called Rule 10b5-1, which allows senior company executives to set up plans with a pre-established formula to trigger stock sales at times when they don’t have access to inside information. Wharton accounting professor Daniel Taylor and four other experts explored those loopholes in a recent study.
“Most boards, executives, and general counsel also find unscrupulous trading behavior to be problematic and go to significant lengths to constrain it.” –Wayne Guay
Corporate Policy Decisions
While companies generally identify their senior executives and other employees with stock compensation as insiders, the SEC and other enforcement agencies such as the Justice Department use an expanded definition that covers external parties including investment advisers, auditors, lawyers, and others with access to material, non-public, and price-sensitive information.
Company insiders have access to two main types of such information. One is routine information such as quarterly earnings releases, and the other relates to less routine events such as an M&A deal or regulatory approval for a new drug, or even adverse developments such as unanticipated losses. Insider trading policies at companies are framed by their boards of directors and general counsel, and not by senior executives who may have conflicts of interest.
Specifically, the study explored the determinants of three corporate policy decisions: 1) How soon after each quarterly earnings announcement should insiders be allowed to trade; 2) Once trading is allowed to commence after the earnings announcement, how long should insiders be allowed to trade before the window is again closed, and 3) For what types of firm-specific events will an ad hoc blackout window be imposed on insider trading. Additionally, it looked at whether an abnormal absence of trading in a given quarter is related to information about material future corporate events that may trigger capital market responses such as changes in share prices or trading volumes.
The study predicted that the length and timing of insider trading windows each quarter are partly related to how quickly information is impounded in price at the time of the earnings announcement, as well as how private information about the firm tends to build up during a quarter. “Specifically, we expect that the faster information asymmetry is resolved following the earnings announcement, the sooner the trading window will open,” the paper stated. “Similarly, when information asymmetry builds up more quickly during a quarter, we expect that firms will close down the open trading window sooner.”
The length of trading windows varies widely and is guided by how closely a company is watched and tracked by analysts, the news media, and others investor watchdogs. A company that has many analysts tracking its performance and many investors who actively trade in its stock might feel more comfortable letting insiders trade almost immediately after an earnings announcement, Guay said. Other companies that are not as closely followed may wait three, four, or five days before allowing insiders to trade, he added. “Our main finding is that firms’ information asymmetry concerns and external and internal monitoring mechanisms are major factors that go into the design of insider trading policies,” said Kim.
The study also explored whether external monitoring from stakeholders may pressure firms to employ shorter open trading windows, or if such monitoring may serve as a substitute governance mechanism that allows firms to keep trading windows open longer.
Finally, it considered whether a firm’s compensation practices might influence the length of trading windows. It found that firms that provide executives and employees with greater amounts of equity-based compensation may allow longer trading windows to help them meet their liquidity needs.
“Firms’ information asymmetry concerns and external and internal monitoring mechanisms are major factors that go into the design of insider trading policies.” –Shawn Kim
Guay noted that most senior executives at public companies receive the vast majority of their compensation in the form of stock, options, and restricted stock. One approach those companies might adopt is to be “super conservative and tie their [executives’] hands behind their back and only let them trade a few days each quarter, maybe to make sure that they are really being transparent,” he added. But many companies have hundreds of employees who get most of their compensation in the form of stock, he noted. “If you tell them that their ability to trade this compensation or sell this compensation is going to be highly constrained, you’ve got a big disadvantage and you’ve got a workforce that’s going to be really upset with you.”
The study also found that information asymmetry is a key factor when companies specify start and end dates for insiders to trade in their shares. It found that boards allow insiders to trade more quickly following earnings announcements at firms where, after an earnings announcement, “information asymmetry is less of a concern.” Trading windows also tend to end earlier in a quarter at firms whose stock price movements are more concentrated around earnings announcement dates or have greater average bid-ask spreads over the quarter. Here again, those shorter trading windows suggested that information asymmetry concerns are an important factor shaping trading windows, the paper noted.
Another finding was that “firms with greater analyst following, institutional ownership, and board independence have trading windows that end earlier in the quarter.” That pattern suggested that “external monitoring disciplines the strictness of ITP, rather than serving as a substitute mechanism for monitoring insider trading that could allow for less restrictive trading windows,” the paper noted.
The study found mixed evidence that the liquidity needs of executives or other employees shape the design of insider trading windows. For example, firms whose CEOs hold more equity tend to face stricter ITPs, but firms with higher insider trading volumes and stock price volatility tend to impose less stringent policies, the paper stated.
A major challenge for the study was that firms are not required to disclose their ITPs; only a few firms choose to do so voluntarily. The researchers worked around that problem by studying actual insiders’ trades, estimating the start and end of each firm’s trading window, tracking it over a rolling eight-quarter period. It validated that using a small sample of firms that publicly disclose their ITPs, where it found “a high correlation” — about 60% — with the trading window dates in their ITPs.
Identifying ad hoc blackout windows was also challenging for the study because firms generally do not disclose the occurrence or the length of these periods. Here again, the researchers inferred the presence of those ad hoc blackout windows using actual insider trading data. The study found evidence that firms impose ad hoc blackout windows before “material corporate events,” and that “such windows are leading indicators of these future corporate events or disclosures.”
“There’s not a one-size-fits-all insider trading policy.” –Wayne Guay
Pointers for Regulators and Investors
Guay called for “a balance” in the approach regulators take to insider trading. “Regulators seem to be focused on more constraints, more disclosure and pulling back on insider trading [to prevent] misbehavior,” he said. “What we’re trying to do with this paper is to see if we can figure out how seriously companies are taking this. We’re finding that companies give this a lot of thought. They’re not just randomly putting in insider trading policies. There’s not a one-size-fits-all insider trading policy. Companies recognize their informational problems, and the liquidity concerns their executives have, and are tailoring their insider trading practices, policies, and restrictions as a function of their current situation.”
The SEC requires all companies to institute insider trading policies, but their disclosure is voluntary. Guay said that by making those ITPs public, all investors will know when a company’s insiders are “not in the market or in the market.” Company executives would be “rightly a little apprehensive” that other investors could take advantage of that information, he noted. “On balance, I wouldn’t be opposed to seeing more disclosure of insider trading policies,” he said. “Maybe at the end of the day, that’s a relatively low cost to greater transparency.”
For investors, a major takeaway from the study is from the trading patterns it observed during blackout periods. “There’s evidence that investors don’t seem to quickly and efficiently impound all the information from the absence of trading during blackout periods,” said Guay. “Investors see there’s no trading in a quarter, but they don’t seem to fully internalize that. They seem to be a little sluggish with respect to how they’re pricing this. If there’s an eerie absence of trade, investors should be taking that as a signal that there might be something [significant] that’s coming up. And they don’t seem to be fully impounding that [in the share prices].” He saw an opportunity here to educate investors to be more alert to trading absences.
Even with the requisite checks and balances, insider trading abuses will not vanish, but studies such as his will help catalyze the right approaches among companies, Guay noted. The Lordstown Motors case referenced earlier is an example of seemingly brazen ways to profit from insider trading at the expense of minority shareholders.
“It does seem to me like a pretty cut-and-dry example of executives that engaged in behavior they certainly shouldn’t have, and a case where the corporate controls around insider trading were either lax or flawed or both,” Guay said during an interview on the Wharton Business Daily radio show on SiriusXM. (Listen to the podcast above.) As it happens, Lordstown Motors also faces an unrelated regulatory probe into allegedly misleading business forecasts, which led to the exits of its CEO and CFO.
“One can never eliminate such behavior, but it is helpful for firms to understand the actions that their peers are taking to reduce it,” said Guay. “This kind of research is how we triangulate toward figuring out best practices.”