Disclosure tone of the spin-off prospectus and insider trading

J. Account. Public Policy xxx (xxxx) xxx

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Disclosure tone of the spin-off prospectus and insider trading q Wonik Choi Steven G. Mihaylo College of Business and Economics, California State University – Fullerton, Fullerton, CA 92834, United States

a r t i c l e

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Article history: Available online xxxx Keywords: Spin-off Insider trading Prospectus Tone management

a b s t r a c t This paper documents a negative association between the abnormal tone (optimistic versus pessimistic) of the Management’s Discussion and Analysis in a spin-off prospectus and the insider trading pattern (buy versus sell) in the spun-off subsidiary within three months of the spin-off date. Additional tests show that the negative relation exists only for the transactions by insiders who have also been executives in the parent company before the spin-off. I find that the insider purchases result in substantial long-term excess returns, especially when they are accompanied by abnormally negative tone. Given that insiders are extensive net buyers of stock in new spin-offs, these findings suggest that managers may use more pessimistic tone in the prospectus to disguise the upside potential of the spun-off subsidiary to seize the opportunity to purchase shares at lower cost. Ó 2019 Elsevier Inc. All rights reserved.

1. Introduction Over the past two decades, many companies have restructured by spinning off one or more business units.1 Allen (2001) finds that, after spin-offs, insiders of the spun-off firm are substantial purchasers of the spin-off’s stock and that their trades earn large long-term abnormal returns.2 In this paper, I investigate whether insiders of the spun-off firm manage the tone of words in the spin-off prospectus in order to purchase their own firms’ shares at lower cost. Spin-off provides a unique setting to examine the relation between strategic disclosure and insider trading. First, a spinoff leads to the formation of a new public company and provides shareholders, including managers, with the opportunity to alter their stock holdings. During a short period after spin-off, outside investors face great uncertainty in valuing the new company, especially compared to its management. It is not only due to the lack of prior trading history and financial information, but also driven by structural selling by institutional investors (Brown and Brooke, 1993; Abarbanell et al., 2003) and decrease in analysts following (Feldman et al., 2014). However, previous empirical studies document high long-term abnormal returns for spin-off subsidiaries (e.g., Cusatis, Miles, and Woolridge, 1993; Desai and Jain, 1999). In sum, the market

q This paper is based on my dissertation completed at the Ohio State University. I am grateful to my dissertation committee: Darren Roulstone (Chair), Anil Arya, Anne Beatty, and Tzachi Zach for their continuous encouragement and guidance. I thank Marco Trombetta (the Editor) and two anonymous referees, Jongha Lim, Sophia Hamm, Joo-Kyung Kim, Igor Kadach (discussant), Shan Wang (discussant) and workshop participants at The Ohio State University, University of Massachusetts Boston, and California State University Fullerton, the 2014 AAA Annual Meetings, the 2015 California Corporate Finance Conference, and the 2016 AAA Western Meetings for helpful comments and suggestions. All errors and omissions are my own. E-mail address: [email protected] 1 Recent examples of diversified companies spinning off their businesses include Motorola (Mobility Holdings), Marathon Oil (Petroleum Corp), Fortune Brands (Home & Security Inc.), Marriot International (Vacations Worldwide), Conoco Phillips (Phillips 66), Kraft Foods (Foods Group), and eBay (Paypal Holdings). 2 Allen (2001) documents that insider transactions in the spun-off firms completed during the first 12 months following spin-offs yield an average excess return of 36.3 percent in the ensuing 12 months.

https://doi.org/10.1016/j.jaccpubpol.2019.106692 0278-4254/Ó 2019 Elsevier Inc. All rights reserved.

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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uncertainty allows insiders to exploit their private information regarding the spin-off firm value (i.e., purchase shares at lower cost). Second, spin-off provides managers with the incentive to increase their stock holdings and improve the long-term stock performance. Immediately after spin-off, there is a greater equity ownership by outside board members compared to a set of peer firms (Ahn and Walker, 2007). Managers may purchase more shares to maintain a certain level of ownership (Core and Larcker, 2002). The absence of a lock-up agreement in spin-off allows insiders to trade immediately following the distribution of the new shares. In addition, the stock compensation plan allows managers to be more effectively incentivized and disciplined based on the free-standing spun-off firm’s stock (Aron, 1991; Daley et al., 1997; Seward and Walsh, 1996). Thus managers are more likely to focus on the improvement in the long-term stock performance. Third, disclosure decisions in spin-offs are more clearly aligned with insider trading profit. Spin-offs are not motivated by a need to raise external capital. Instead, the subsidiary’s shares are simply distributed to the parent’s shareholders without involving underwriters. In other words, disclosure decisions in spin-offs are unencumbered by other factors prevalent in IPOs, for example, the trade-off between minimizing underpricing and avoiding under-subscription, which complicate issuers’ disclosure incentives. In sum, insiders of the spun-off firm, especially when they have served as the parent company management, could provide negative disclosure about the spin-off in order to increase their stock holdings at lower cost after the spin-off completion. The goal of this study is to show the plausibility of tone management in the spin-off setting with the aim of enhancing insider trading profits. I define tone as the extent to which managers favorably portray the unit to be spun-off. If managers neutrally present their beliefs, the variation in the prospectus tone might be positively associated with the variation in managers’ beliefs, proxied by their subsequent trading. However, if opportunistic managers prefer to purchase (sell) the spun-off firms’ shares at lower (higher) prices, they would alter their tone accordingly. Therefore, I estimate an abnormal tone conveyed in the spin-off prospectus using the determinants of the tone suggested by the literature (e.g., Li, 2010; Huang et al., 2014; Davis et al., 2015) and test whether the abnormal tone is consistent with the insider trading in the spun-off firm. For a sample of 230 spin-offs completed from 1995 to 2014, I apply textual analysis to the Management’s Discussion and Analysis (MD&A) section of the prospectus to determine its tone. My empirical findings show that the abnormal tone relates negatively to net insider trading following the spin-off. I also document that spin-offs in which executives are net buyers have higher long-run excess returns (15 percent over the one-year horizon) than other spin-offs. And insider buying is even more profitable when combined with an abnormally negative tone (37 percent over the one-year horizon). Given that neutral prospectus tone reflects the long-term fundamentals of the spin-off, the huge abnormal return from insider buying, following abnormally negative tone, suggests tone management.3 I conduct additional tests to investigate whether the negative relation exists only for insiders who could have possessed private information about the tone manipulation. I divide the full sample of executives into two groups, based on whether they have worked as executives in the parent company prior to the spin-off (‘‘pre-spin-off executives”). Consistent with my prediction, there is a negative relation between abnormal tone and insider trading only for the pre-spin-off executives who are more likely to have inside information. Abnormal tone is not related to the trades of insiders who were newly hired from outside the parent or were promoted from within the parent to an executive position at the subsidiary during the spin-off. This evidence supports that more informed managers could alter tone to increase their trading profits. Alternatively, managers could manipulate quantitative information (e.g., unaudited income numbers) to misinform investors about the future fundamentals. However, there are several benefits of investigating tone management, relative to earnings management. First, holding consolidated earnings constant, manipulating a spun-off unit’s earnings requires the over- or underestimation of earnings of the parent firm, which is unnecessary in manipulating the tone of the spinoff prospectus. Second, as managers have discretion over the tone of the qualitative presentation of the underlying performance, tone can be a tool for them to mislead investors by obscuring firm fundamentals (Huang et al., 2014). Third, managers may believe that expected legal costs associated with tone manipulation are lower than those associated with the manipulation of earnings. Although there are constraints on managers’ ability to make material misstatements in connection with the purchase or sale of a security (e.g., securities laws and accounting regulations), qualitative information is a softer type of disclosure that may be ambiguous enough to impede verification of materiality.4 There can be also alternative explanations for the negative association between tone and insider trading. Negative tone may simply reflect the poor underlying economics of the subsidiary, and managers might decide to purchase shares for several reasons. In the additional analyses, I provide evidence to rule out these alternatives, thereby lending credence to the tone management hypothesis. This study contributes to the literature in two ways. First, it extends the spin-off literature by examining whether insiders strategically disclose information to maintain their information advantage over outsiders. I report that the tone of the spinoff prospectus written by managers contradicts their subsequent trading patterns and that this trading generates abnormal profits in the long run, when combined with abnormal tone. Second, I add to the literature investigating an active managerial

3 When insiders would purchase the spun-off firm’s stock, the negative prospectus tone might contribute to the market’s delayed reaction to the spin-off. A maintained assumption underlying this argument is that short-term returns would have been higher for the spin-offs, absent the negative tone. I discuss the abnormal returns, information asymmetry driven by strategic disclosure in Section 5.4 and 6.5. 4 The literature shows that optimistic tone can be regulated by litigation risk, especially when insiders sell the firm’s equity (Rogers et al., 2011); however, it is still a debated topic in the legal community whether managers are legally liable for qualitative disclosures (e.g., O’Hare, 1998; Hoffman, 2006).

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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role in narrative disclosure by introducing a new scenario through which managers provide more pessimistic disclosures—in this case, to disguise the upside potential of a spin-off. This setting for manipulating disclosure tone has received limited attention from the researchers and regulators. It contrasts with other settings, in which managers have incentives to provide more optimistic disclosures to create profitable selling opportunities (e.g., earnings announcements). The remainder of the paper proceeds as follows. Section 2 provides an overview of related literature, and Section 3 develops my hypotheses. Section 4 details the sample and research design, and Section 5 reports the main empirical results. Section 6 presents the additional analyses, and Section 7 concludes.

2. Background and literature review 2.1. Spin-off literature Some theoretical studies have explored motivations for spin-offs. Aron (1991) argues that a spin-off can improve the equity incentive scheme offered to divisional managers, because the stock price of the spun-off unit more cleanly signals managerial productivity. Habib et al. (1997) and Nanda and Narayanan (1999) show that, by spinning off an undervalued unit, the market value of the combined firm can be increased, because the market can accurately process information about the subsidiary (i.e., unlock the hidden value). A number of empirical studies show a positive equity market reaction to spin-off announcements (Hite and Owers, 1983; Miles and Rosenfeld, 1983; Schipper and Smith, 1983). Nonmutually exclusive explanations for this value creation include improved operating performance by focusing on the core business (Hite and Owers, 1983; Daley et al., 1997), greater investment efficiency by reducing agency problems (Gertner et al., 2002; Ahn and Denis, 2004), and achievement of appropriate value by improving the information environment (Krishnaswami and Subramaniam, 1999). There is also empirical evidence on the long-term value creation of spin-offs. Cusatis et al. (1993) document that the average excess return to parent firms and spun-off subsidiaries for the 24 months following the spin-off is 26.7 percent and 25.0 percent, respectively. Desai and Jain (1999) also find that firms involved in a focus-increasing spin-off outperform market benchmarks. These findings indicate that investors have not fully anticipated the total value created by the spin-off at the announcement date. However, McConnell et al. (2001) show that the long-term excess returns are sensitive to research design choice.5 Literature in accounting and finance shows that a spin-off permanently improves the information environment of involved firms. Krishnaswami and Subramaniam (1999) find that firms that engage in spin-offs have higher levels of information asymmetry than their control firms and document a substantial decrease in information asymmetry following spinoffs. Gilson et al. (2001) also report increased coverage by analysts who specialize in the subsidiaries’ industries, after stock breakups, and show that there are 30 percent to 50 percent improvements in analyst forecast accuracy for both parents and subsidiaries. While these studies focus on the long-term informational effect of spin-offs, Allen (2001) suggests that insiders, during a short period, use private information to determine whether spun-off firms are likely to outperform or underperform market benchmarks. He documents that insiders in spun-off subsidiaries extensively buy stock within six months and that their trades result in substantial excess returns.6 One explanation for this active insider buying is that insiders may hold favorable information regarding spun-off firms that is not fully revealed to market participants. Feldman et al. (2014) analyze the content of analyst reports written about units to be spun off and find that analyst research pays very limited attention to the unit. Overall, the information conveyed to the market through the spin-off prospectus should play a critical role in reducing the level of information asymmetry between managers and outside investors during a short period after the spin-off. 2.2. Strategic disclosure and insider trading Several studies find that insiders, to maximize their wealth, could strategically choose the timing of trades around disclosures (NOE, 1999), change the frequencies of voluntary disclosures around their trades (Cheng and Lo, 2006), or manage earnings before selling (Park and Park, 2004). Rogers (2008) tests the effects of insider trading on disclosure choice by examining the decision over which the manager actually has discretion—the quality of the disclosure. He finds that managers provide lower (higher) quality disclosures before insider purchasing (selling) to maintain an information advantage (to reduce the litigation risk). More recently, Billins and Buslepp (2016) show that managers provide inaccurate downward guidance to increase the positive surprise at the earnings announcement; and in turn, they sell more shares at a higher price following the earnings announcement. These studies suggest that insider trading is an incentive for strategic disclosure. Studies also show that the vast majority of lawsuits based on material misstatements before insider trading include insider selling allegations (e.g., Rogers, 2008; Rogers et al., 2011). The SEC reviews of corporate filings can be another important 5 McConnell et al. (2001) show that the excess returns are not robust to the selection of benchmarks, the holding period of buy-and-hold returns, and the treatment of a few outliers that perform extremely well. 6 I replicate the empirical work of Allen (2001), confirming that his finding is robust to alternative methods for tests of long-run abnormal returns (e.g., calendar-time portfolio approach; Lyon et al. (1999), Mitchell and Stafford (2000)).

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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mechanism limiting managers’ opportunistic disclosures, but there is no SEC review that comments on overly pessimistic tone. In contrast, SEC comment letters often request filers to revise their overly optimistic, positive, or promotional tone.7 2.3. Qualitative disclosure In the context of prospect theory, Tversky and Kahneman (1986) suggest that framing financial performance using more or less favorable terms influences investors’ perceptions of the results, relative to reference points. Empirical literature has provided evidence that the tone of various corporate disclosures is positively associated with the market reaction to the disclosure; this can be seen in press releases (Henry, 2008; Davis et al., 2015), MD&As (Li, 2010; Feldman et al., 2010), conference calls (Price et al., 2012), and IPO prospectuses (Ferris et al., 2013; Loughran and McDonald, 2013). Some studies further suggest that managers use the qualitative disclosure to systematically influence investors’ judgments by obscuring firm fundamentals (Davis and Tama-Sweet, 2012; Tama-Sweet, 2014; Huang et al., 2014; Lo et al., 2017). For example, Huang et al. (2014) propose the plausibility of tone management in earnings press releases by demonstrating that an abnormal level of tone relates to managerial incentives to manipulate investors’ perceptions. They show that managers exploit tone opportunistically to misinform investors, instead of revealing useful private information in such situation as SEOs, M&As, and stock option grants. My paper is in the same spirit as that of Huang et al. (2014) and focuses on insider trading in a spun-off subsidiary as an incentive to engage in tone management. 3. Hypotheses development A spin-off provides managers with the opportunity to trade the parent’s or the subsidiary’s shares as independent entities. Managers involved in the spin-off are likely to possess superior knowledge about the nature of the transaction and the prospects of investment projects of the spun-off subsidiaries. For a spin-off to be approved, the parent company should provide the market with adequate information. The spin-off prospectus included in Form 10 contains ample intangible information in the management discussion of operating results, liquidity and capital resources, and potential risks associated with the unit to be spun-off. Even though managers must report all material information through the prospectus, they actually have discretion over its tone. Tone should vary with the content of the disclosure in a neutral presentation of the quantitative information. The residual component of the variation in tone could be the output of the managers’ discretionary control over the tone and is the main variable of interest in this study.8 Suppose that managers of a soon-to-be-spun-off firm plan to buy their firm’s stock following the spin-off. Although accounting regulations and securities laws require them to report all material information, they may be able to manipulate the rhetoric in the prospectus, that is, either refrain from using positive words or choose to use more negative ones to mask the upside potential of their firm. A tone level that is incommensurate with the quantitative information will inhibit investors’ ability to determine the true value of the spin-off.9 Because making good news hard to extract deflates market prices only temporarily (Bloomfield, 2002), the opportunity to purchase the undervalued shares should be also temporary; nonetheless, purchases would be profitable in the long run, as the market discovers the true value of the spun-off firm. Given these incentives to purchase (sell) the shares at a lower (higher) cost after more negative (positive) tone in the prospectus, I test the following hypothesis. H1. The tone conveyed in the spin-off prospectus is negatively related to net insider trading (purchase versus sale) following the spin-off. Clearly, among insiders, there is variation in incentives and opportunities for strategic disclosure, depending on their respective roles in the parent company prior to the spin-off. A newly hired manager from outside the parent is less likely to be aware of the strategic purpose behind the tone conveyed in the prospectus. Thus, if the tone is negatively associated with trades of executives of the spun-off subsidiary only when they have also been executives in the parent prior to the spinoff, this supports the tone management argument; that is, tone is used by insiders to enhance their trading profits. However, if the negative relation holds across all subsamples of insiders, this can be interpreted as either that insider trading is simply a response to the market reaction to the spin-off or that the information advantage spills over into other insiders. Thus my second hypothesis is as follows. H2. There is a negative relation between the tone of the spin-off prospectus and net insider trading only for the executives of the subsidiary who have worked as executives in the parent prior to the spin-off.

7 Based on my research using Audit Analytics, examples of firms that received SEC comment letters requesting revisions to optimistic tone in their filings include Noranda Aluminum Holding Corporation (S-1, 1/15/2010), Execute Sports Inc. (SB-2, 6/16/2005), and iParty Corporation (10-K, 3/25/2005). 8 In general, giving greater emphasis to the selected benchmarks allows either favorable or unfavorable comparisons and this affects the tone. Another way to create either positive or negative tone is to offer positive or negative comments about future performance (Henry, 2008). 9 This view is consistent with the ‘‘incomplete revelation hypothesis (IRH)” (Bloomfield, 2002), which asserts that information is less completely revealed in market prices when the information is more costly to extract from public data.

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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Even among the executives of the parent company, only some of them might be directly responsible for drafting the prospectus. One document, published in Practical Law, reports that, the parent company’s top management, counsel, and the spin-off company’s top management are responsible for the spin-off prospectus.10 Other documents describing the IPO process state that the top management (especially CEO and CFO) and the counsel collaborate on the draft of the prospectus.11 The counsel assists the executives with preparation and revision, oversees the filing process, and responds to the SEC’s comments. Other members of the management serve less visible roles in drafting the prospectus.12 Therefore, it is an open empirical question whether the authorship of the prospectus is related to the hypothesized tone management. On the one hand, if executives who could directly affect the tone (e.g., CEO, CFO, and general counsel) exclusively possess the information about the strategic purpose behind the disclosure, the tone would be negatively associated only with the trades of these executives. On the other hand, as long as executives see an inconsistency between their evaluations of the spin-off and the tone conveyed by the prospectus, they might infer the strategic disclosure and trade their shares to increase profits. In this scenario, the tone would be negatively related to trades of other executives. Thus, I accordingly test the third hypothesis. H3. There is a negative relation between the tone of the spin-off prospectus and net insider trading only for the executives of the subsidiary who have worked as CEO, CFO, or general counsel in the parent prior to the spin-off.

4. Sample and research design 4.1. Sample The initial spin-off sample is obtained from the SDC Mergers and Acquisitions Database. I exclude spin-offs that are withdrawn, two-step spin-offs, and spin-offs that are in regulated industries. I also limit the sample to tax-free spin-offs to ensure that any spin-offs where the distribution is not pro rata (and therefore the ownership structure is not exactly replicated) are excluded from the sample.13 I identify an initial sample of 726 spin-offs completed between 1995 and 2014. The following data selection criteria are then applied to the initial sample. (1) I verify that each transaction is indeed a spin-off by checking news articles from Factiva, Google, or the company’s investor relations web site. Transactions involving tracking stock, stock splits, or equity carve-outs do not fall within the definition of spin-offs. (2) Some spin-offs are motivated by a big restructuring to facilitate a merger with another firm. I exclude spin-offs if other corporate events (e.g., merger-related stock issuances) occur within a year around the spin-offs. I do this following the literature because measuring the inherited ownership structure would be noisy for these transactions (Patro, 2008). (3) An announcement date and ex-date for the spin-off must be available. Spin-off ex-date reported in the SDC is within 30 days of CRSP price start date. For the main analysis, I collect spin-off prospectuses and 10-K reports of the parents for the last fiscal year prior to the spin-off from the SEC EDGAR website. I analyze the prospectus included in the final version of amended filings (10-12B/A or 10-12G/A) before the spin-off effective date.14 I then extract nonnumeric information of the MD&A sections of the prospectuses and 10-K filings.15 I hand collect historical accounting data for the unit prior to the spin-off from the prospectus. I obtain other accounting data from Compustat, stock price data from CRSP. I also collect insider trading and institutional ownership data from Thomson Reuters. The final sample in the main analysis includes 230 spin-offs. Table 1 summarizes sample selection.16 10 ‘‘Spin-offs: Overview,” Practical Law, http://www.sullcrom.com/files/Publication/48c0c4a3-1963-4fb0-818d-b61d3f463764/Presentation/PublicationAttachment/09f50d3c-9302-40a2-8f35-b78b44581cf8/September2010_SpinOffs.pdf. 11 ‘‘The Initial Public Offering Handbook: A Guide for Entrepreneurs, Executives, Directors, and Private Investors,” Merrill Corporation, http://www. merrilldirect.com/cps/rde/xbcr/merrilldirect/AllisonHallMcsheaNoCrop.pdf,‘‘An Overview of the IPO Process,” Practising Law Institute, http://www.pli.edu/ product_files/EN00000000050080/89220.pdf. 12 For example, the controller supports the CFO in creating the company’s financial model and forecasts. The board of directors oversees the preparation of the prospectus and authorizes the filing of and reviews and comments on the Form S-1, but it would not be typical for directors to attend drafting sessions. See Internet Appendix A to understand which insider groups are responsible for the key events in each stage of a spin-off and to see an example of a timeline. 13 According to Section 335 of the Internal Revenue Code, to be eligible for tax-exempt status, (1) a parent firm must distribute at least 80 percent of the outstanding shares of a subsidiary to its shareholders, and any shares retained by the parent firm must not constitute practical control of the subsidiary, (2) the separating subsidiary should have been in active operation for at least five years and have been owned, directly or indirectly, by the parent firm for at least five years, and (3) the parent firm and the separated subsidiary should each be engaged in the active conduct of a trade or business immediately after the distribution. 14 The narrative explanation in the MD&A section is not significantly revised over the multiple amendments. Loughran and McDonald (2013) also confirm that the tone of the final IPO prospectus (Form 424) is not significantly different from that of the first document (S-1 filings). 15 As in Li (2010), I eliminate boilerplate sentences found in the disclosure, such as those contained in safe harbor disclosures. I hand collect MD&A texts, reducing any error in parsing, which might produce extraordinary results. 16 Among spin-offs completed in 1995, electronic prospectus filing is available for four spin-offs on EDGAR. Only one of them is included in my sample, because historical earnings data prior to spin-offs is not available for the other three.

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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Table 1 Sample Selection. Spinoff Sample Selection

N

Total Spinoffs in SDC M&A database ex-date between 1995 and 2014 Less: private parent Less: Not tax-free spinoff (% of distributed <80%) Less: Exact information about the spin-offs are not available in press release or the company’s website/ an announcement date and ex-date are not available/ other corporate events happen within a year around the spin-off/ the SDC ex-date is more than 30 days beyond the CRSP price start date/ spin-off prospectus not available in the SEC EDGAR website/ historical accounting information not available in the prospectus/ post-spinoff subsidiary’s accounting information not available in Compustat Final sample available for the study Year of spin-off completion 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

726 (96) (104) (296)

230 N 1 20 19 20 17 14 12 7 7 5 8 8 11 17 3 5 11 8 12 25

4.2. Classification of insiders The underlying assumption of the classification is that insiders in different positions have different responsibilities for preparing spin-offs, and thus they have heterogeneous abilities to obtain nonpublic information regarding the transaction or to affect the tone of the prospectus. To test the first hypothesis, I define insiders as the team of executives of the spunoff subsidiary. For comparison, I also define non-executive insiders as those who file with the SEC a statement of ownership but are not executives of the firm.17 Next, to test the second hypothesis, I divide the full sample of executives of the spun-off subsidiary, based on the role of each individual during the spin-off. Specifically, I classify the executives into those who have also worked as executives in the parent prior to the spin-off and those who have not. To do this, I identify executive’s prespin-off roles in the parent company by checking every single insider’s background information, which is available in the prospectus. Fig. 1 presents the number of insiders in each group categorized by pre- and post-spinoff roles. The full insider trading sample contains open market purchases and sales by 1128 insiders.18 The breakdown of the insiders gives 538 current executives in the subsidiary (EXEC) and 590 non-executive insiders (NONEXEC). Of these, 363 of the current executives have also worked as executives prior to the spin-off (EPAR), while 151 of the current executives were newly hired from outside the parent or were promoted from within the parent to an executive position (NONEPAR).19 To test the third hypothesis, I further divide the group of these 363 executives into two groups based on whether they have been the CEO, CFO, or general counsel (TEPAR, N = 185) or have held other executive roles in the parent (NONTEPAR, N = 178). 4.3. Measurement of insider trading The primary measures of insider trading are based on the net trading of executives during the three months after the spin-off, which is at a subsidiary-firm level. The first measure (BUY) is an indicator variable that is equal to one for the spin-off subsidiary, where the total value (i.e., number of shares*transaction price) of executives’ purchases is higher than 17 The definition of ‘‘executives” in this paper includes CEO, CFO, COO, CTO, CIO, chairman, president, general counsel, executive vice president, and senior vice president. ‘‘Non-executive insiders” include lower-level officers, outside directors, block-holders, and other affiliated persons. 18 The insider trading sample is restricted to be transaction code ‘‘P” or ‘‘S”. The sample excludes grant, award, or other transaction related to spin-off share allocation. 19 Examples of the 363 executives include (1) Sanja Jha, who was appointed as CEO of the spin-off Motorola Mobility Holdings Inc. and was formerly co-CEO of its parent, Motorola Inc., and (2) Christopher Klein, who served as CEO of the spin-off Fortune Brands Home & Security Inc. after holding the same position prior to the spin-off at the parent, Fortune Brands Inc.

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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EXEC Executives of post-spinoff subsidiary (N=538)

H1

7

NONEXEC Non-executive insiders of post-spinoff (N=590) subsidiary

EPAR (N=363)

Executives of post-spinoff subsidiary Executives of post-spinoff subsidiary NONEPAR who have not been executives in the who have been executives in the parent H2 (N=151) parent prior to the spin-off prior to the spin-off

TEPAR (N=185)

Executives of post-spinoff subsidiary Executives of post-spinoff subsidiary NONTEPAR who have been other executives (non who have been CEO, CFO, or General H3 (N=178) CEO, CFO, General Counsel) in the Counsel in the parent prior to the spinparent prior to the spin-off off

Fig. 1. Insider Groups. This figure presents the number of insiders in each group, categorized by pre- and post-spin-off roles. Post-spin-off roles in the subsidiary are identified from the Thomson Reuters insider trading database. Pre-spin-off roles in the parent are identified from each individual’s background information, available in the spin-off prospectus. First, the EXEC and NONEXEC groups are categorized based on the decomposition of full sample of insiders (N = 1128). Second, the EPAR and NONEPAR groups are a decomposition of the EXEC group. Finally, the TEPAR and NONTEPAR groups are a further decomposition of the EPAR group. The definition of ‘‘executives” includes CEO, CFO, COO, CTO, CIO, chairman, president, general counsel, executive vice president, and senior vice president. ‘‘Non-executive insiders” include lower-level officers, outside directors, block-holders, and other affiliated persons.

the total value of executives’ sale. As the second measure (VALUE), following prior studies (e.g., Cheng and Lo, 2006), I use the log-transformation of net trading value, to address a high skewness in trading value. The log-transformation takes the sign of net trading value and its magnitude is the natural logarithm of one plus the absolute value of net trading value in thousands. Accordingly, VALUE is zero for the subsidiaries with no insider trading and takes positive (negative) value for the subsidiaries with net insider buying (selling). To indicate that the trades are made by a specific insider group, I add the group name right to the variable. For example, VALUE_EXECi represents the log-transformation of net trading values of the executives in the spun-off firm i. Out of 230 my sample spin-off firms, 95 firms are ‘net buyers’, 18 firms are ‘net sellers’, and in the remaining 117 firms, executives never trade their shares during the three months following the spin-off.20 I select a three-month trading window in the main analyses. The underlying assumption is that managers with trading incentives might execute their ex ante trading plans before temporary mispricing created by the manipulation disappears. Following the spin-off, the subsidiary company provides financial information through 10-Qs or 10-Ks as an independent entity. Analysts also start to follow the subsidiary firm and provide useful information to outside investors. Therefore investors’ abilities to value firms are enhanced, which may curb managers’ opportunism.21 4.4. Abnormal spin-off prospectus tone The level of optimistic tone is calculated based on nonnumeric words included in the MD&A section of the spin-off prospectus. I focus on the tone of the MD&A because it is intended to reflect the management’s assessment of the current financial status and prospects of the firm.22 Research examining IPO prospectuses finds the strongest association between the content of the MD&A and IPO pricing, compared with other main subsections of the prospectus (e.g., Hanley and Hoberg, 2010). I evaluate whether management’s language in the MD&A is positive or negative using frequency counts of positive and negative words. I use Loughran and McDonald’s (2011) word list, which is customarily used in this sort of research to analyze language in corporate filings.23 The measure of optimistic tone of the MD&A of the spin-off prospectus, TONE, is calculated by the following equation.

TONE ¼ ðNumber of positiv e words  Number of negativ e wordsÞ  100=Number of total words in the MD&A section of the spin  off prospectus:

ð1Þ

20

As a robustness check, I performed the analysis using only net-buyers and net-sellers spin-offs, and the main findings do not change qualitatively. In an untabulated analysis, I find that stock performance of insider trading is abnormally profitable in the ensuing 12 months when the transactions are made during the three-month period, while the average abnormal return to insider trading occurring during the four to six-month period is not significantly different from zero. 22 In the Internet Appendix B, I provide an example of the MD&A section in a spin-off prospectus. 23 I thank Bill McDonald for sharing the word lists, which are available at https://sraf.nd.edu/textual-analysis/resources/. 21

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The assumption behind this measure is that the level of optimistic tone is jointly determined by underlying economics and managerial incentives. Therefore the model of tone should control for level of fundamentals that could generate an observed level of tone. Following Huang et al. (2014), I decompose TONE into a normal component (NTONE) and an abnormal component (ABTONE). The abnormal component reflects strategic choice of tone to misinform investors, and I examine whether the abnormal component is associated with insider trading. NTONE is the predicted value and ABTONE is the residual of the following regression model:

TONE ¼ a þ b1 TONE PAR þ b2 ROAt1 þ b3 SG þ b4 LSIZE þ b5 ROAt þ b6 EARNVOL þ b7 NSEG þ b8 LOSS þ b9 RET PAR þ b10 RETVOL PAR þ Spin  off Industry & Year Dummies þ e:

ð2Þ

The first control variable is the level of optimistic tone of the MD&A sections of the parent firms’ most recent 10-K reports (TONE_PAR) prior to the spin-off. This variable is to control disclosure characteristics (i.e., optimistic versus pessimistic) inherited from the parent to the subsidiary.24 A spin-off prospectus is written by the parent company’s management, which is also involved in drafting the parent company’s filings. Thus I expect a positive correlation between the tone of the spin-off prospectus and the tone of the parent’s 10-K report. This idea is consistent with the tone model used in Davis et al. (2015) which includes the manager fixed effects capturing commonalities in tone across the various firms for which a manager works. Following the literature (Li, 2010; Davis et al., 2015), I include spin-off firm-specific determinants of the tone of the MD&A. The operating income of the unit to be spun off during the last fiscal year prior to the spin-off (ROAt-1) captures the current operating performance. To control for the fact that growth firms face more economic uncertainty, I include sales growth of the spin-off unit (SG) by calculating percentage change in total sales during the last fiscal year relative to the previous year. The size of the subsidiary (LSIZE) reflects the prediction that larger firms have higher political costs and thus use more cautious statements. I also include the operating income during the first fiscal year (ROAt), to capture the impact of managers’ prospects on the tone. The volatility of earnings (EARNVOL) for the five years prior to the spin-off is to control for the impact of uncertainty on the tone. The number of segments (NSEG) captures the complexity of operations. To control for stock performance, which is not measurable at the subsidiary level prior to the spin-off, I include the parent firm’s annual abnormal returns (RET_PAR) during 12 months ending the month prior to the prospectus filing. This captures current firm performance that goes beyond earnings numbers (e.g., information about a new project). The monthly return volatility (RETVOL_PAR) of the parent company is calculated for 12 months prior to the prospectus filing date. Spin-off subsidiary’s industry fixed effects are also included to control for static industry-specific factors that might impact the tone. Definitions of all variables are provided in Appendix A. I report the estimation results of the expected tone model (2) in Appendix B. One concern is that the expected tone model can suffer from a ‘‘bad model problem.” Since any error in estimating the expected tone is set to be in abnormal tone, the abnormal tone may capture both strategic disclosure behavior and measurement error in the model. This is always empirically challenging when a key test variable is a discretionary measure; so it is important to find a strict set of control variables. I evaluate the expected tone model by running regressions with various combinations of control variables. The estimated coefficients presented in Appendix B are slightly different to those reported in prior studies (e.g., Li, 2010; Huang et al., 2014) mainly because of the different samples used (10-K vs. prospectus) and the strong explanatory power of one control variable, TONE_PAR. When I estimate the regression model with only firm-year dummies as control, the adjusted R2 is 16.3%. When I include the TONE_PAR, the adjusted R2 is increased to 32.6% and the inclusion of remaining control variables increases the adjusted R2 to 38.7%. Overall, the explanatory power of the control variables used in my expected tone model is relatively higher compared to prior studies.25 4.5. Main regression model To evaluate the hypothesis that the tone of the MD&A section of the spin-off prospectus relates negatively to the insider trading following the transaction, I run the following regressions:

IT ¼ a þ b1 ABTONE þ b2 NTONE þ b3 LSIZE þ b4 ROAt1 þ b5 BTM þ b6 RET PAR þ b7 RETVOL PAR þ b8 EARNVOL þ b9 DINSTOWN þ Spin  off Industry & Year Dummies þ

e

ð3Þ

Following Huang et al. (2014), I include both ABTONE and NTONE in the regression model to examine the relative contribution of normal tone and abnormal tone. For testing H1, the dependent variable (IT) is BUY_EXEC or VALUE_EXEC, which measures executives’ trading during the three months following the spin-offs. H1 predicts the negative relation between the abnormal tone and the executives’ trading, so the estimated value of b1 would be negative. To examine whether the abnormal tone is exclusively related to the executives’ trading, I run separate regressions using the non-executives’ trading (BUY_NONEXEC or VALUE_NONEXEC) as the dependent variable. In this model, I expect that the estimated value of b1 would not be significant. For testing H2 and H3, BUY_EPAR (or VALUE_EPAR) and BUY_TEPAR (or VALUE_TEPAR) replace IT, 24

Cronqvist et al. (2009) shows significant persistence in firm policies and corporate culture which survives through a spin-off transaction. The adjusted R2 reported in Table 5 of Li (2010) ranges from 14% to 21%, and the adjusted R2 reported in Table 1 of Huang et al. (2014) is 4.4%. I also tried to include more general strategic disclosure (discretionary accruals) and other narrative disclosure (tone of risk factors section) as additional controls but main results do not change. 25

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respectively. H2 and H3 predict that the estimated value of b1 would be negative. In addition, I use BUY_NONEPAR (or VALUE_NONEPAR) and BUY_NONTEPAR (or VALUE_NONTEPAR) as the dependent variables, respectively, and expect b1 to be not significant.

5. Main empirical results 5.1. Descriptive statistics and correlations Panel A of Fig. 2 presents the monthly insider trading pattern of the spun-off subsidiary during the seven months following the transaction. During the first three months, there is relatively heavy purchasing, compared to selling. Purchases comprise 85.5 percent (1076/1259) of all open market trades made by executives of the spun-off subsidiary. This pattern is consistent with the findings of Allen (2001), who documents that insiders are extensive net buyers of stock in the new public subsidiary over its first six months. In contrast to the spun-off subsidiary insiders, parent company insiders are net sellers, in my sample. In Panel B, sales comprise 86.0 percent (369/429) of all open market trades made by parent company executives during the three months following spin-offs. When I expand the trading window to 24 months, sales comprise 94.6 percent of all open market trades (4152/4390). Panel A of Table 2 reports the descriptive statistics for the tone of the MD&A section of the spin-off prospectus (TONE) and that in the most recent 10-K reports of the parent firm (TONE_PAR). The mean of the tone variable of the spin-off prospectus (0.334) is slightly less negative than that of the parent’s 10-K (0.420). The average total number of nonnumeric words in the MD&A section is 6993. I also report the summary statistics for the insider trading variables. Executives are, on average, net buyers in 41.7 percent (96 out of 230) of the sample spun-off companies during the first three months. The mean of the net insider trading value for executives’ trades is higher ($132,576) than that for non-executive insiders’ trades ($43,959), suggesting that executives are more extensive net buyers immediately following these transactions.26 Panel A of Table 2 also shows descriptive statistics for control variables. The mean of operating income of the unit to be spun-off during the fiscal year before the spin-off (ROAt-1, 0.067) is lower than that of the spun-off firm as a separate entity during the first fiscal year after the spin-off (ROAt, 0.084). The size of the spun-off subsidiary at the end of the distribution month is on average 31.1 percent of the size of the parent firm at the end of the previous month (RELSIZE). The average institutional ownership of the parent firm at the last quarter prior to the spin-off (INST_PAR) is 65.7 percent, whereas that of the post-spinoff subsidiary at the first quarter following the spin-off (INST_SUB) is 58.7 percent. This is consistent with the structural institutional selling immediately following spin-offs documented in Brown and Brooke (1993). Panel B of Table 2 presents pairwise correlations between the tone measures, insider trading variables, and control variables used in my empirical models. Although I do not discuss the correlations between all variables, a few are noteworthy. The variables based on net trades of executives (BUY_EXEC, VALUE_EXEC) are negatively correlated with the prospectus tone and abnormal tone, which are significant at the 5% level. The tone of the parent firm’s most recent 10-K report (TONE_PAR) is positively correlated with the tone of the spin-off prospectus but is not correlated with any insider trading variables.

5.2. Abnormal tone and trades of insiders (H1) I report basic univariate relations between tone and insider trading in Panel A of Table 3. The table presents the average values of tone measures across subsidiary groups, classified based on whether executives are net buyers; that is, the total value of purchase is greater than total value of sales within three months following the spin-off. The mean value of the tone measure for the subsidiaries of which insiders are net buyers (0.414 for BUY_EXEC = 1) is lower than that for other spin-off firms (0.277 for BUY_EXEC = 0) and the difference is statistically significant at the 5 percent level. I also compare the mean value of the abnormal tone. The average abnormal tone for insider purchase group is 0.049 and that for other group is 0.035. The mean difference is significant at the 10 percent level. I further find that the mean difference for NegTONE is significant at the 1% level, indicating that the tone difference is mainly driven by the difference in the use of negative words. Comparing the median values of tone measures across groups, I find the same pattern. This finding is consistent with H1 that the tone of the MD&A of the spin-off prospectus relates negatively to executives’ trading. In Panel B of Table 3, I report the results of estimating Eq. (3), which is the primary test of H1 in a multivariate framework. Columns (1) and (2) presents estimation results for the logistic regressions, with BUY_EXEC, BUY_NONEXEC as the dependent variable, and Columns (3) and (4) presents estimation results for the OLS regressions with VALUE_EXEC, VALUE_NONEXEC as the dependent variable, respectively. Columns (1) and (3) report that the coefficients on ABTONE are negative (1.920 and 1.886) and statistically significant at the 1 percent level, supporting the first hypothesis. NTONE is not related to insider trading, which indicates that normal tone is not opportunistically used by managers. Overall, the regression results confirm that the trades of executives relate negatively to the abnormal prospectus tone. 26 Although the magnitude of the average net insider trading value seems small, individual executives’ trading volume can be huge. For example, John Malone has been the chairman of Liberty Media Corp. (parent) and became the CEO of Liberty Media International Inc (subsidiary) after the spin-off in 2014. His total value of open market purchases (n = 44) during the three months after the spin-off were $801,346,297.

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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W. Choi / J. Account. Public Policy xxx (xxxx) xxx

Panel A. Trades of spun-off subsidiary shares made by executives of the spun-off firm following spin-off

Panel B. Trades of parent firm shares made by executives of the parent around spin-off

Fig. 2. Executives’ Trades around Spin-off. Panel A presents the number of purchases and sales of executives in the subsidiary firms during the seven months following spin-offs. Panel B presents the number of purchases and sales of executives in the parent firms during the 13 months surrounding spinoffs.

To examine whether the relative possibility of possessing private information affects the relation between tone and insider trading, I compare the trades of executives with those of non-executive insiders. Columns (2) and (4) show that the coefficients on ABTONE are not significant. These suggest that the abnormal prospectus tone is not related with trades of nonexecutive insiders, such as lower level officers, whose ability to influence strategic disclosure may be limited. As a validation test on whether managers behave opportunistically in the choice of discretionary tone at the time of the spin-off, following Huang et al. (2014), I examine how ABTONE is related to future performance of the spin-off firm using the following regressions:

ROAtþn ðor CFOtþn Þ ¼ a þ b1 ABTONE þ b2 DA þ b3 ROAt þ b4 LSIZE þ b5 BTM þ b6 EARNVOL þ b7 RET PAR þ b8 RETVOL PAR þ Spin  off Industry & Year Dummies þ

e

ð4Þ

where n = (1, 2, or 3).

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

Panel A. Descriptive Statistics Variable

N

Tone Measure TONE PosTONE NegTONE TONE_PAR NTONE ABTONE ABNEGTONE Insider Trading (0–3 month) BUY_EXEC BUY_NONEXEC VALUE_EXEC VALUE_NONEXEC Raw Value of Insider Trading (in thousand $) VALUE_EXEC_RAW VALUE_NONEXEC_RAW Controls ROAt ROAt-1 SG SIZE_PAR SIZE_SUB RELSIZE LSIZE BTM NSEG LOSS EARNVOL RET_PAR RETVOL_PAR FOCUS INSTOWN_PAR INSTOWN_SUB DINSTOWN

Mean

Std Dev

P1

P25

P50

P75

P99

230 230 230 230 230 230 230

0.334 0.712 1.046 0.420 0.334 0.000 0.530

0.445 0.302 0.422 0.556 0.263 0.358 0.500

1.390 0.195 0.240 1.681 0.939 0.809 0

0.648 0.507 0.750 0.793 0.511 0.267 0

0.311 0.674 1.029 0.440 0.348 0.024 1

0.022 0.853 1.331 0.087 0.179 0.271 1

0.647 1.754 2.069 0.897 0.405 0.704 1

230 230 230 230

0.417 0.400 1.680 1.118

0.494 0.491 3.399 3.985

0 0 7.416 8.728

0 0 0 0

0 0 0 0

1 1 4.575 4.090

1 1 8.314 8.568

230 230

132.576 43.959

278.781 547.249

73.899 1717.840

0 0

0 0

96.075 58.750

977.219 1390.330

230 230 230 230 230 230 230 230 230 230 230 230 230 230 229 227 226

0.084 0.067 0.201 12010.7 2306.3 0.311 6.390 0.864 1.687 0.257 0.205 0.002 0.088 0.596 0.657 0.587 0.070

0.489 0.201 0.779 21644.4 5433.3 0.311 1.744 1.139 1.120 0.438 0.662 0.368 0.051 0.492 0.218 0.228 0.163

0.680 0.351 0.657 53.7 8.1 0.009 2.380 0.260 1 0 0.002 0.666 0.025 0 0.107 0.077 0.522

0.009 0.000 0.002 1054.4 169.6 0.090 5.133 0.218 1 0 0.024 0.196 0.053 0 0.508 0.423 0.150

0.073 0.076 0.051 4068.6 682.4 0.204 6.526 0.577 1 0 0.045 0.025 0.075 1 0.707 0.621 0.044

0.145 0.136 0.152 11358.4 2014.9 0.402 7.608 0.985 2 1 0.094 0.158 0.105 1 0.820 0.766 0.016

1.021 1.004 4.167 108040.0 26930.8 1.312 10.001 5.466 5 1 3.417 1.431 0.254 1 1.000 1.000 0.378

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Panel B. Correlations

(1) TONE (2) ABTONE (3) TONE_PAR (4) BUY_EXEC (5) BUY_NONEXEC (6) VALUE_EXEC (7) VALUE_NONEXEC (8) ROAt (9) ROAt-1 (10) SG

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

(12)

(13)

(14)

(15)

(16)

(17)

(18)

(19)

1 0.79 0.49 0.15 0.02 0.20 0.01 0.06 0.16 0.28

0.79 1 0.02 0.10 0.05 0.16 0.04 0.04 0.08 0.18

0.50 0.02 1 0.07 0.06 0.07 0.02 0.04 0.15 0.12

0.15 0.10 0.02 1 0.26 0.90 0.28 0.12 0.00 0.01

0.01 0.05 0.01 0.26 1 0.29 0.83 0.07 0.02 0.10

0.19 0.16 0.03 0.81 0.28 1 0.30 0.04 0.05 0.03

0.02 0.04 0.02 0.26 0.71 0.28 1 0.01 0.03 0.10

0.01 0.04 0.04 0.06 0.04 0.01 0.02 1 0.68 0.18

0.10 0.08 0.14 0.03 0.01 0.08 0.03 0.26 1 0.15

0.12 0.18 0.01 0.02 0.02 0.03 0.02 0.03 0.10 1

0.05 0.01 0.07 0.06 0.05 0.15 0.03 0.04 0.10 0.03

0.09 0.08 0.01 0.15 0.08 0.29 0.08 0.01 0.09 0.02

0.09 0.01 0.09 0.04 0.09 0.08 0.08 0.10 0.23 0.03

0.16 0.03 0.17 0.01 0.01 0.01 0.05 0.01 0.05 0.08

0.08 0.02 0.12 0.11 0.05 0.07 0.00 0.54 0.76 0.19

0.15 0.09 0.04 0.10 0.14 0.02 0.06 0.22 0.40 0.06

0.18 0.05 0.06 0.20 0.03 0.16 0.01 0.03 0.07 0.16

0.10 0.01 0.05 0.09 0.09 0.10 0.06 0.05 0.17 0.00

0.03 0.01 0.00 0.06 0.03 0.06 0.04 0.05 0.14 0.04

(continued on next page)

11

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

Table 2 Descriptive Statistics and Correlations.

12

Panel B. Correlations

(11) (12) (13) (14) (15) (16) (17) (18) (19)

SIZE RELSIZE BTM NSEG LOSS EARNVOL RET_PAR RETVOL_PAR DINSTOWN

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

(12)

(13)

(14)

(15)

(16)

(17)

(18)

(19)

0.10 0.07 0.07 0.20 0.08 0.03 0.20 0.13 0.02

0.01 0.08 0.01 0.03 0.02 0.09 0.05 0.01 0.01

0.04 0.02 0.07 0.16 0.12 0.05 0.09 0.00 0.07

0.11 0.21 0.06 0.04 0.11 0.07 0.20 0.02 0.07

0.04 0.14 0.04 0.03 0.05 0.10 0.00 0.07 0.03

0.11 0.28 0.08 0.02 0.07 0.03 0.18 0.04 0.06

0.00 0.15 0.07 0.05 0.00 0.11 0.01 0.06 0.04

0.20 0.17 0.40 0.02 0.54 0.17 0.13 0.10 0.20

0.15 0.14 0.38 0.09 0.76 0.11 0.12 0.10 0.14

0.11 0.21 0.13 0.05 0.19 0.13 0.21 0.01 0.04

1 0.23 0.24 0.16 0.22 0.20 0.03 0.22 0.36

0.20 1 0.28 0.08 0.10 0.05 0.06 0.10 0.27

0.13 0.24 1 0.04 0.24 0.03 0.11 0.03 0.14

0.14 0.05 0.07 1 0.15 0.06 0.10 0.08 0.06

0.22 0.10 0.24 0.15 1 0.30 0.09 0.18 0.21

0.07 0.07 0.05 0.12 0.30 1 0.05 0.17 0.09

0.12 0.14 0.14 0.11 0.09 0.01 1 0.06 0.15

0.48 0.15 0.08 0.08 0.18 0.22 0.02 1 0.17

0.26 0.25 0.19 0.04 0.21 0.19 0.07 0.05 1

Panel A presents descriptive statistics for tone measures, insider trading variables, and control variables. All insider trading variables are based on trades during the zero to three-month period following the spinoff. Panel B presents Pearson correlations above the diagonal and Spearman correlations below the diagonal. Correlations in bold are significantly different from zero at the 5% level.

W. Choi / J. Account. Public Policy xxx (xxxx) xxx

Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

Table 2 (continued)

13

W. Choi / J. Account. Public Policy xxx (xxxx) xxx Table 3 Spin-off Prospectus Tone and Net Trades of Executives. Panel A. Univariate tests of differences of tone measures grouped by net trades of executives BUY_EXEC = 1 (N = 95)

TONE PosTONE NegTONE ABTONE

BUY_EXEC = 0 (N = 135)

Diff in Mean

Diff in Median

Mean (1)

Median (2)

Mean (3)

Median (4)

(1)–(3)

(2)–(4)

0.414 0.745 1.159 0.049

0.360 0.710 1.143 0.046

0.277 0.689 0.966 0.035

0.258 0.662 0.943 0.008

0.137** 0.057 0.194*** 0.084*

0.102** 0.048 0.199*** 0.054*

Panel B. Abnormal Spin-off Prospectus Tone and Net Trades of Executives Logistic Variables ABTONE NTONE LSIZE ROAt-1 BTM RET_PAR RETVOL_PAR EARNVOL

DINSTOWN Intercept Spin-off Industry & Year FE SE Clustered by Year Obs. (1), (2) Pseudo R2 or (3), (4) Adjusted R2

OLS

BUY_EXEC (1)

BUY_NONEXEC (2)

VALUE_EXEC (3)

VALUE_NONEXEC (4)

1.920*** (3.234) 0.696 (0.983) 0.345 (1.580) 1.898 (1.461) 0.238* (1.693) 2.221** (2.307) 20.19*** (3.314) 0.405 (1.135) 1.429 (0.927) 27.23*** (8.648) Yes Yes 226 0.325

0.168 (0.440) 0.332 (0.367) 0.00291 (0.0187) 0.437 (0.428) 0.349*** (2.908) 0.239 (0.388) 8.583** (2.456) 0.686* (1.726) 0.193 (0.113) 1.129 (0.509) Yes Yes 226 0.189

1.886*** (4.195) 1.453 (1.352) 0.349 (1.203) 1.490 (1.143) 0.0286 (0.134) 0.676 (0.933) 13.51* (1.860) 0.0254 (0.0530) 0.821 (0.344) 5.213 (1.336) Yes Yes 226 0.118

0.488 (0.625) 0.672 (0.427) 0.250 (0.868) 0.835 (0.496) 0.240 (0.879) 0.835 (0.861) 21.66*** (2.896) 0.464 (1.215) 0.499 (0.235) 10.95*** (4.021) Yes Yes 226 0.031

Panel A presents the average values of tone measures of the MD&A of the spin-off prospectus across subsidiary groups, classified based on executives’ net trades during the three months following the spin-off. Differences in mean and median are reported in the rightmost columns. Panel B presents the results of Logistic ((1), (2)) and OLS ((3), (4)) regressions of executives’ net trades on abnormal spin-off prospectus tone. BUY_EXEC is an indicator variable that is equal to one for the spin-off subsidiary where executives are net buyers during the three months after the spin-off. BUY_NONEXEC is an indicator variable that is equal to one for the spin-off subsidiary where non-executive insiders are net buyers during the same period. VALUE_EXEC is the log-transformation of net trading value by executives of the subsidiary during the same period. VALUE_NONEXEC is the log-transformation of net trading value by nonexecutive insiders during the same period. ABTONE, NTONE are residual, predicted value of the expected tone model regression presented in the Appendix B, respectively. All other variables are described in the Appendix A. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. Tstatistics are reported in parentheses.

Table 4 presents the estimation results of the model (4).27 For horizons from one and two years ahead, the coefficients on ABTONE in future earnings models are negative and significant (Columns (1) and (2)). For the future cash flow models, the abnormal tone is also negatively related to one year ahead cash flow (Column (4)). The evidence that abnormal tone is lower in firms with positive future fundamentals raises the question of whether managers exploit tone opportunistically to misinform investors instead of revealing useful information. This result does not necessarily suggest a directional prediction of opportunistic tone management. 5.3. Abnormal tone and trades of subsamples of insiders (H2 and H3) I also examine whether the abnormal tone-insider trading relationship depends on the likelihood that insiders can affect the tone or at least possess information regarding the strategic disclosure. In Table 5, I present the results of estimating the model (3), but the dependent variables are trades of the subsamples of executives. BUY_EPAR and VALUE_EPAR are based on the net trading value of executives of the spun-off subsidiary who have also been executives in the parent firm prior to the spin-off, while BUY_NONEPAR and VALUE_NONEPAR are based on the net trading value of executives who have not been 27 The number of observations for estimating the model is decreased because of the data availability to calculate discretionary accruals and future earnings and cash flows.

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Table 4 Spin-off Prospectus Tone and Future Financial Performance. Variables

ROAt+1 (1)

ROAt+2 (2)

ROAt+3 (3)

CFOt+1 (4)

CFOt+2 (5)

CFOt+3 (6)

ABTONE

0.0585* (1.763) 0.0537*** (3.216) 0.463*** (7.677) 0.0125 (1.431) 0.0573*** (5.181) 0.0223 (1.072) 0.0235 (0.754) 1.045*** (3.073) 0.0730 (0.952) Yes Yes 198 0.535

0.0705** (2.218) 0.0392** (2.539) 0.330*** (5.654) 0.00986 (1.273) 0.0499*** (4.128) 0.0632*** (3.090) 0.0200 (0.641) 0.167 (0.556) 0.0311 (0.452) Yes Yes 184 0.444

0.0368 (1.298) 0.0532*** (3.495) 0.361*** (7.310) 0.0114* (1.668) 0.0187 (1.526) 0.0632*** (3.639) 0.0218 (0.810) 0.194 (0.738) 0.0115 (0.190) Yes Yes 165 0.552

0.0645** (2.263) 0.0455*** (3.069) 0.371*** (7.176) 0.00792 (1.053) 0.0339*** (3.574) 0.0356** (1.990) 0.000991 (0.0371) 1.093*** (3.747) 0.117* (1.778) Yes Yes 198 0.529

0.0397 (1.399) 0.0867*** (6.693) 0.258*** (4.981) 0.0201*** (2.928) 0.0191* (1.778) 0.0232 (1.277) 0.0418 (1.508) 0.156 (0.582) 0.0763 (1.247) Yes Yes 183 0.326

0.0282 (1.260) 0.0618*** (5.230) 0.286*** (7.338) 0.0110** (2.046) 0.0108 (1.112) 0.0373*** (2.726) 0.0182 (0.854) 0.103 (0.496) 0.0204 (0.427) Yes Yes 165 0.506

DAt ROAt LSIZE BTM EARNVOL RET_PAR RETVOL_PAR Constant Spin-off Industry & Year FE SE Clustered by Year Observations Adjusted R2

This table presents the results of OLS regressions of future earnings and cash flows on abnormal spin-off prospectus tone. ABTONE is residual of the expected tone model regression presented in the Appendix B. DA is discretionary accrual using the modified Jones model, which is residual of the following regression for each two-digit SIC-year: TAcct = b0 (1/Assetst-1) + b1 (DSalest - DARt) + b2 PPEt + vt. where: TAcc (total accruals) = income before extraordinary items – cash flow from operations. Assets = total assets. DSales = annual change in sales. DAR = change in accounts receivable from operating activities. PPE = gross property, plant, and equipment, all scaled by lagged total assets. All other variables are described in the Appendix A. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

executives in the pre-spinoff parent firm. In Panel A, Columns (1) and (3) present that the coefficients on ABTONE (1.634 and 1.721) are negative and significant at least at the 5% level. While Column (2) shows the negative coefficient on ABTONE (2.401) which is significant at the 10% level, the coefficient is not statistically significant in Column (4). These results suggests that the negative relation between abnormal tone and insider trading exists mainly (not exclusively) for the trades of executives who have also been executives in the parent company, which supports H2. I further examine whether the trades of CEO, CFO, and general counsel mainly drive the association between tone and insider trading. BUY_TEPAR and VALUE_TEPAR are based on the net trading value of executives who have filled these roles in the parent firm, while BUY_NONTEPAR and VALUE_NONTEPAR are based on the net trading value of executives who have been other executives in the pre-spinoff parent firm (e.g., chief marketing officer). In Panel B of Table 5, I report that the estimated coefficients on ABTONE are significantly negative only in Columns (1) and (3), while they are not statistically significant in Columns (2) and (4), consistent with H3. The CEO, CFO, and general counsel represent the parent company management, whose members collaborate on drafting the spin-off prospectus. I consider them to be the group most able to choose the tone of the qualitative documents. Therefore the results reported in Panel B indicate that only executives who could directly affect the tone possess the information about the strategic purpose behind the tone of the reported prospectus. 5.4. Tone and profitability of insider trading I have shown that abnormal tone of spin-off prospectus is negatively associated with insider trading following the spinoff. A necessary condition for this finding to support the tone management hypothesis is that insiders knew that tone would influence stock price. In this section, I investigate whether and how the abnormal tone affects the profitability of insider trading. As shown in Fig. 2, there are active insider purchases in the spun-off subsidiary. Panel A of Fig. 3 shows that these trades are followed by superior long-run stock performance. The average daily buy-and-hold abnormal returns (BHAR) to the subsidiary in which executives are net buyers (net-buyers subsidiary) are higher in the long run than those to the subsidiary in which executives are net sellers or never trade the firm’s shares. More interestingly, Panel B shows that the superior long-run stock performance of insider buying is mainly driven by the subsidiaries for which the abnormal tone is negative. Please cite this article as: W. Choi, Disclosure tone of the spin-off prospectus and insider trading, J. Account. Public Policy, https://doi.org/ 10.1016/j.jaccpubpol.2019.106692

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W. Choi / J. Account. Public Policy xxx (xxxx) xxx Table 5 Spin-off Prospectus Tone and Net Trades of Subsamples of Executives. Panel A. Abnormal spin-off prospectus tone and net trades of pre-spinoff executives group (EPAR) Logistic Variables ABTONE NTONE Controls Spin-off Industry & Year FE SE Clustered by Year Obs. (1), (2) Pseudo R2 or (3), (4) Adjusted R2

OLS

BUY_EPAR (1)

BUY_NONEPAR (2)

VALUE_EPAR (3)

VALUE_NONEPAR (4)

1.634** (2.372) 0.126 (0.158) Yes Yes Yes 226 0.288

2.401* (1.869) 2.541 (1.444) Yes Yes Yes 226 0.376

1.721*** (3.974) 0.841 (0.688) Yes Yes Yes 226 0.113

0.316 (0.786) 0.471 (1.040) Yes Yes Yes 226 0.157

Panel B. Abnormal spin-off prospectus tone and net trades of pre-spinoff CEO, CFO, or general counsel group (TEPAR) Logistic Variables ABTONE NTONE Controls Spin-off Industry & Year FE SE Clustered by Year Obs. (1), (2) Pseudo R2 or (3), (4) Adjusted R2

OLS

BUY_TEPAR (1)

BUY_NONTEPAR (2)

VALUE_TEPAR (3)

VALUE_NONTEPAR (4)

2.223** (2.095) 0.825 (1.103) Yes Yes Yes 226 0.291

0.285 (0.229) 0.455 (0.413) Yes Yes Yes 226 0.338

1.418** (2.433) 0.367 (0.430) Yes Yes Yes 226 0.026

0.678 (1.042) 1.159 (0.828) Yes Yes Yes 226 0.063

Panel A presents the results of Logistic ((1), (2)) and OLS ((3), (4)) regressions of pre-spinoff executives’ net trades on abnormal spin-off prospectus tone. BUY_EPAR is an indicator variable that is equal to one for the spin-off subsidiary where pre-spinoff executives are net buyers during the three months after the spin-off and zero otherwise. Pre-spinoff executives are executives of the subsidiary who have been executives in the parent prior to the spin-off. BUY_NONEPAR is the same measure, except for that the trades are made by executives of the subsidiary who have NOT been executives in the parent prior to the spin-off (e.g., lower level officers, outsiders). VALUE_EPAR is defined as the log-transformation of pre-spinoff executives’ net trading value. VALUE_NONEPAR is the same measure, except for that the trades are made by executives of the subsidiary who have NOT been executives in the parent prior to the spin-off. Panel B presents the results of Logistic ((1), (2)) and OLS ((3), (4)) regressions of pre-spinoff CEO, CFO, or general counsels’ net trades on abnormal spin-off prospectus tone. BUY_TEPAR is an indicator variable that is equal to one for the spin-off subsidiary, where pre-spinoff CEO, CFO, or general counsels are net buyers during the three months after the spin-off and zero otherwise. BUY_NONTEPAR is the same measure except for that the trades are made by executives of the subsidiary who have been other executives in the parent prior to the spin-off (e.g., COO, president, and EVP). VALUE_TEPAR is defined as the log-transformation of pre-spinoff CEO, CFO, or general counsels’ net trading value. VALUE_NONTEPAR is the same measure except for that the trades are made by executives of the subsidiary who have been other executives in the parent prior to the spin-off. Detailed definition of the insider groups are presented in Fig. 1. ABTONE, NTONE are residual, predicted value of the expected tone model regression presented in the Appendix B, respectively. Control variables included in the models are identical to those included in Table 3. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

The average daily buy-and-hold abnormal return to insider net purchases with abnormally positive tone is mostly less than zero. It indicates that the signal of insider purchase to the market does not always lead to a positive stock performance.28 To provide further evidence to support my interpretation, I run the following OLS regressions.

BHAR ¼ a þ b1 BUY EXEC þ b2 BUY EXEC  ABNEGTONE þ b3 ABNEGTONE þ b4 LSIZE þ b5 ROAt1 þ b6 BTM þ b7 RET þ b8 FOCUS þ Spin  off Industry & Year Dummies þ e:

ð5Þ

where ABNEGTONE is an indicator variable that is equal to one if ABTONE is less than zero. Table 6 presents estimation results, in Columns (1), (2), and (3), for the regressions with short-term returns (BHAR (0, 20)) and, in Columns (4), (5), and (6), for regressions with long-term returns (BHAR (0, 254)) as the dependent variable, respectively. BHAR is calculated by the daily compounding returns of the spin-off firms minus the returns of the size deciles that were formed for the CRSP NYSE/AMEX/NASDAQ file. Results reported in the first three columns suggest that insider purchases are not significantly profitable in the short run. However, the coefficients reported in Column (4) indicate that the average one-year BHAR (254 trading days) is 14.5% (estimated coefficients a + b1) for the net-buyers subsidiary, while that for all other subsidiaries is 3% (estimated coefficient a). From the reported coefficients in Column (5), we can see that the 28 Instead, the profitability of insider purchase is related to firm fundamental. Please see Section 6.5 for the discussion and see the Internet Appendix Table IA3 for the results.

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Panel A. Abnormal returns on subsidiaries based on insider trading

Panel B. Abnormal returns on net-buyer subsidiaries based on prospectus tone

Fig. 3. Stock Performance of Post-spinoff Subsidiary. Panel A presents the average daily buy-and-hold abnormal returns on the subsidiaries where executives are net buyers during the three months following the spin-off (N = 95) and where executives are net sellers (N = 18) and where executives never trade during the same period (N = 117). Panel B presents the average abnormal returns on the net-buyer subsidiaries separately based on whether their spin-off prospectuses have abnormally negative tone (N = 49) or abnormally positive tone (N = 46). Panel C presents the average abnormal returns on the no-trades subsidiaries separately based on whether their spin-off prospectuses have abnormally negative tone (N = 61) or abnormally positive tone (N = 56). Abnormal tone is the residual of the expected tone model regression, presented in the Appendix B. Daily compounding returns are adjusted for the size deciles that were formed for the CRSP NYSE/AMEX/NASDAQ file based on the market value of equity of each firm at the end of the year prior to the period measured. Deciles are recalculated annually for each firm in the sample.

average one-year BHAR for the net-buyers subsidiary with abnormally negative tone is 36.9%, while that for the net-buyers subsidiary with abnormally positive tone is 7.8%.29 After controlling for firm-specific and spin-off-specific factors, Column (6) shows that the coefficient on the interaction term (BUY_EXEC*ABNEGTONE) is still significantly positive. Overall, these findings

29 Sum of the estimated coefficients for abnormally negative tone, a + b1 + b2 + b3, (0.0004–0.0786 + 0.510–0.0624) is 0.3694. Sum of the estimated coefficients for abnormally positive tone, a + b1 (0.0004–0.0786) is 0.0782.

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Panel C. Abnormal returns on no-trades subsidiaries based on prospectus tone

Fig. 3 (continued)

Table 6 Post Spin-off Stock Performance. BHAR (0, 20)

BHAR (0, 254)

Variables

(1)

(2)

(3)

(4)

(5)

(6)

BUY_EXEC

0.0125 (0.611)

0.0242 (0.692) 0.0238 (0.553) 0.0188 (0.654)

0.175** (2.533)

0.0842 (0.914) 0.513** (2.482) 0.0709 (0.705)

0.0210 (1.210) No Yes 227 0.003

0.0120 (0.485) No Yes 227 0.011

0.00297 (0.0663) 0.0369 (0.668) 0.0464 (1.342) 0.0222** (2.232) 0.0211 (0.227) 0.00462 (0.227) 0.0704 (1.678) 0.00463 (0.101) 0.128 (1.449) Yes Yes 227 0.060

0.0300 (0.480) No Yes 223 0.009

0.00402 (0.0509) No Yes 223 0.037

0.294 (1.577) 0.930*** (3.274) 0.231** (2.286) 0.139* (2.053) 0.645* (1.806) 0.115** (2.124) 0.0598 (0.262) 0.0589 (0.329) 0.905* (1.927) Yes Yes 223 0.132

BUY_EXEC*ABNEGTONE ABNEGTONE LSIZE ROAt BTM RET_PAR FOCUS Intercept Spin-off Industry & Year FE SE Clustered by Year Obs. Adjusted R2

This table presents the results of OLS regression of buy-and-hold abnormal returns on the executives’ net trades. BHAR (0, 20) and BHAR (0, 254) are the 20 and 254 trading day buy-and-hold abnormal returns of the spun-off firm, commencing from the spin-off distribution date. Daily compounding returns are adjusted for the size deciles that were formed for the CRSP NYSE/AMEX/NASDAQ file based on the market value of equity of each firm at the end of the year prior to the time period measured. Deciles are recalculated annually for each firm in the sample. BUY_EXEC is an indicator variable that is equal to one for the spin-off subsidiary where executives are net buyers during the three months after the spin-off and zero otherwise. ABNEGTONE is an indicator variable that is equal to one if ABTONE is less than zero; and zero otherwise, where ABTONE is residual from the expected tone regression which is presented in the Appendix B. All other variables are described in the Appendix A. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

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indicate that insider buying predicts the long-term abnormal return of the spun-off firm, especially when there is abnormally negative prospectus tone. Panel C of Fig. 3 shows that the abnormal tone does not dramatically affect the stock performance when insiders never trade the shares. The neutral prospectus tone seems to reflect the long-term fundamentals of the spin-off, absent insider trading. Thus the observed high excess return for the net-buyers subsidiary with abnormally negative tone suggests tone management.30 In calculating the abnormal returns, I use the size-based reference portfolio. Barber and Lyon (1997) show that the use of reference portfolio in the long-term event study is subject to the new listing, rebalancing, and skewness biases. As a robustness check, I use a matched control firm approach for calculating abnormal returns. I match a spin-off firm to a control firm with the same two-digit SIC code and closest in size. Using this method, the results (presented in the Internet Appendix Table IA-1) remain qualitatively unchanged. The average one-year BHAR for the net-buyers subsidiary with abnormally negative tone is 22.5%, while that for the net-buyers subsidiary with abnormally positive tone is 8.5%. The coefficient on BUY_EXEC*ABNEGTONE is also positive and statistically significant at the 1% level.

6. Additional analysis 6.1. Alternative research design In the previous section, I estimate a regression model (3) to examine the association between the abnormal prospectus tone and the insider trading following spin-off. As an alternative analysis, I estimate the incremental effect of insider trading on the tone by including insider trading variables (IT_MAIN and IT_CONTROL) in the expected tone model (2). The main independent variable (IT_MAIN) is BUY_EXEC or VALUE_EXEC, which measures executives’ trading in the spin-off. I include the variable (BUY_NONEXEC or VALUE_NONEXEC) in the place of IT_CONTROL to compare executives’ trading patterns with those of non-executives insiders. H1 predicts that the estimated coefficients on IT_MAIN would be negative. One benefit of this alternative test is that the determinants of the MD&A tone are well developed in the literature and they are mostly measurable at the subsidiary level (e.g., historical accounting data). In Table 7, Columns (1) and (2) show that the coefficients on BUY_EXEC (0.152) and VALUE_EXEC (0.0212) are negative and statistically significant at the 5 percent level, consistent with H1, whereas, the coefficients on BUY_NONEXEC and VALUE_NONEXEC are not statistically significant. These findings confirm that the tone of the spin-off prospectus relates negatively to trades of executives, not with trades of non-executive insiders. In Columns (3) through (6), I report the results of the regression models using the decomposed measures of tone. Columns (3) and (4) show that executives’ trading is positively related to the portion of negative words (NegTONE), while non-executives’ trading is not significantly associated. Columns (5) and (6) report that there is no significant relationship between executives’ trading and the portion of positive words (PosTONE). These suggest that the negative relationship between tone and executives’ trading is mainly driven by the variation in the portion of negative words in the MD&A.

6.2. Sensitivity tests To ensure that my conclusions are not influenced by research design choice, I perform several sensitivity tests. I first use an alternative insider trading window, the period between the spin-off month and the subsidiary’s first periodic filing month (10-Q or 10-K). The average number of days between the spin-off distribution date and the first filing date is 50.2. In Table 8, Columns (1) and (3) show that the net trades of executives during the alternative window are negatively associated with abnormal prospectus tone, unlike those of non-executive insiders (reported in Columns (2) and (4)). For the main analyses, I use Loughran and McDonald (2011) word list (LM) to classify the frequency of positive versus negative words. As a robustness test, I use an alternative list by Henry (2008). Column (1) of Table 9 shows that executives’ trading is not related to the abnormal prospectus tone, measured using this list (ABTONE_Henry). However, as reported in Column (2), there is more abnormal negative tone (ABNegTONE_Henry) in a spin-off prospectus with executives’ net buying after spin-off. Column (3) shows that the coefficient on ABPosTONE_Henry is not significant. These results are consistent with the findings in Tables 3 and 7 that the variation in the negative tone measure mainly drives the negative relationship between abnormal tone and insider trading. The main results using the abnormal tone seem to be sensitive to the list of words used. In a recent study by Loughran and McDonald (2015), they state that Henry’s list has only 85 negative words compared to 2329 LM negative words and none of the most frequently occurring LM negative words in a 10-K appear on Henry’s list. Thus, LM is more comprehensive list of potentially negative words managers could use to describe current or future operations. 30 Assuming that the short-term price of the ‘net buyers’ subsidiary would have been higher than the observed price absent abnormal negative tone, managers could purchase the shares at a lower price with providing the abnormal tone.

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W. Choi / J. Account. Public Policy xxx (xxxx) xxx Table 7 Regression of the Spin-off Prospectus Tone on the Net Trades of Executives. TONE Variables

(1)

BUY_EXEC

0.152** (2.519) 0.0426 (0.691)

BUY_NONEXEC VALUE_EXEC VALUE_NONEXEC TONE_PAR

0.282*** (5.243)

NegTONE (2)

(3)

PosTONE (4)

0.150** (2.783) 0.0636 (1.297) 0.0212** (2.593) 0.000616 (0.0848) 0.280*** (5.495)

NegTONE_PAR

0.0234*** (3.206) 0.00681 (0.961)

0.357*** (6.545)

SG LSIZE ROAt EARNVOL NSEG LOSS RET_PAR RETVOL_PAR Intercept Spin-off Industry & Year FE SE Clustered by Year Obs. Adjusted R2

0.0118 (0.0780) 0.0635 (1.685) 0.00204 (0.0727) 0.155 (1.094) 0.127*** (3.187) 0.0215 (0.818) 0.181*** (3.068) 0.188** (2.217) 0.340 (0.320) 0.177 (0.485) Yes Yes 230 0.401

0.0210 (0.132) 0.0578 (1.479) 0.00355 (0.115) 0.144 (0.983) 0.125*** (3.280) 0.0211 (0.756) 0.174** (2.830) 0.200** (2.330) 0.407 (0.357) 0.283 (0.702) Yes Yes 230 0.404

0.0487 (0.352) 0.0611* (1.841) 0.0167 (0.588) 0.0788 (0.646) 0.135*** (3.719) 0.000177 (0.00801) 0.205** (2.700) 0.00259 (0.0363) 0.168 (0.156) 0.114 (0.433) Yes Yes 230 0.456

(6)

0.00149 (0.0468) 0.0223 (0.721) 0.00287 (0.566) 0.00734* (1.964)

0.359*** (6.721)

PosTONE_PAR ROAt-1

(5)

0.0408 (0.301) 0.0541 (1.575) 0.0168 (0.553) 0.0690 (0.544) 0.134*** (3.866) 0.000034 (0.00141) 0.198** (2.545) 0.00321 (0.0450) 0.132 (0.116) 0.0553 (0.204) Yes Yes 230 0.461

0.369*** (9.095) 0.0501 (0.400) 0.00534 (0.244) 0.0144 (0.958) 0.0795 (0.587) 0.00691 (0.155) 0.0154 (1.363) 0.0445 (1.044) 0.166** (2.556) 0.107 (0.198) 0.285 (1.040) Yes Yes 230 0.350

0.370*** (8.738) 0.0501 (0.387) 0.00675 (0.302) 0.0131 (0.825) 0.0789 (0.596) 0.00832 (0.196) 0.0150 (1.301) 0.0456 (1.097) 0.172** (2.657) 0.204 (0.356) 0.328 (1.133) Yes Yes 230 0.357

This table presents the results of OLS regression of tone measure (TONE) and decomposed tone measures on the executives’ net trades. TONE is the level of optimistic tone of the MD&A section of the spin-off prospectus. NegTONE, PosTONE are percentage of negative, positive words in the MD&A section of the spin-off prospectus, respectively. All variables are described in the Appendix A. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

6.3. Other reasons of insider trading The negative association between tone and insider trading supports the tone management hypothesis, under the following assumption: Managers could have decided to trade their shares, before writing the prospectus, and their ex ante trading plan is consistent with actual trading. If these assumptions hold, any mismatch between tone and insider trading suggests that, with foreknowledge of a trade, managers could manipulate their tone to enhance their profits. However, since the timing of the trading decision is unobservable, it is challenging to clearly distinguish between tone management and alternative explanations. In this section, I discuss possible alternative motivations and evaluate how they can explain the association I document. First, managers may purchase their own firms’ shares to maintain a certain level of ownership (Core and Larcker, 2002). In this case, any active insider buying after the negative tone might be explained by the tone management frame; that is, managers to provide pessimistic tone before purchasing shares at lower costs. In addition, these types of trades are more pronounced for newly hired managers, who should be less informed about their firms’ prospects. Second, the prospectus tone may simply reflect underlying economics, and managers may observe a short-term mispricing driven by market uncertainty about their spin-off. This then leads to their insider trading. Related to this, previous studies show that there is often structural selling pressure by institutional investors immediately following a spin-off (Brown and Brooke, 1993; Abarbanell et al., 2003). Many institutions must rebalance their portfolios, according to fiduciary restrictions, by selling the small-cap stocks, and new spin-offs may fall into this group. Managers could then increase stock holdings at

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Table 8 Spin-off Prospectus Tone and Alternative Measure of Executives’ Net Trades. Logistic BUY_EXEC

OLS BUY_NONEXEC

VALUE_EXEC

VALUE_NONEXEC

Trading window = (spin-off date, first SEC filing date) Variables

(1)

(2)

(3)

(4)

ABTONE

1.820*** (3.508) 0.996 (1.292) Yes Yes Yes 226 0.366

0.382 (0.897) 0.316 (0.363) Yes Yes Yes 226 0.187

1.476*** (3.671) 1.240 (1.098) Yes Yes Yes 226 0.111

0.0969 (0.144) 0.229 (0.161) Yes Yes Yes 226 0.017

NTONE Controls Spin-off Industry & Year FE SE Clustered by Year Obs. (1), (2) Pseudo R2 or (3), (4) Adjusted R2

This table presents the results of Logistic ((1), (2)) and OLS ((3), (4)) regressions of alternative measures of executives’ net trades on abnormal spin-off prospectus tone. BUY_EXEC is an indicator variable that is equal to one for the spin-off subsidiary where executives are net buyers during the period between the spin-off distribution date and the first filing date. BUY_NONEXEC is an indicator variable that is equal to one for the spin-off subsidiary where non-executive insiders are net buyers during the same period and zero otherwise. VALUE_EXEC is the log-transformation of net trading value by executives of the subsidiary during the same period. VALUE_NONEXEC is the log-transformation of net trading value by non-executive insiders during the same period. ABTONE, NTONE are residual, predicted value of the expected tone model regression presented in the Appendix B, respectively. Control variables included in the models are identical to those included in Table 3. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

Table 9 Alternative Measure of the Spin-off Prospectus Tone and the Executives’ Net Trades. BUY_EXEC Variables ABTONE_Henry NTONE_Henry

(1)

(2)

ABNegTONE_Henry

2.575** (2.536) 1.590 (0.985)

NNegTONE_Henry ABPosTONE_Henry NPosTONE_Henry Controls Spin-off Industry & Year FE SE Clustered by Year Obs. Pseudo R2

(3)

0.0910 (0.217) 0.343 (0.414)

Yes Yes Yes 226 0.298

Yes Yes Yes 226 0.343

0.721 (1.525) 0.640 (0.732) Yes Yes Yes 226 0.314

This table presents the results of Logistic regressions of executives’ net trades on alternative measures of abnormal spin-off prospectus tone. TONE, NegTONE, PosTONE are obtained using the alternative Henry (2008)’s word list. ABTONE_Henry, ABNegTONE_Henry, ABPosTONE_Henry are residual; and NTONE_Henry, NNegTONE_Henry, NPosTONE_Henry are predicted value of the expected tone model regression presented in the Appendix B. BUY_EXEC is an indicator variable that is equal to one for the spin-off subsidiary where executives are net buyers during the three months after the spin-off. Control variables included in the models are identical to those included in Table 3. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

lower costs if this institutional selling leads to temporary underpricing. However, in this case, there is no clear incentive for managers to provide negative disclosures before they observe the mispricing. To evaluate how this might explain the relationship between tone and insider trading, I perform several supplementary analyses (untabulated). First, I find that the change of institutional ownership does not affect the negative relation between

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tone and insider trading.31 If insider trading is largely driven by the institutional selling (not by tone management), then the change of institutional ownership would attenuate the relation between tone and insider trading. Second, I investigate whether institutional selling induces managers to purchase the spun-off firm’s stock. To do this, I examine the relation between institutional selling and insider trading as well as the relation between institutional selling and the short-term market reaction to the spin-off. I find that the change of institutional ownership (DINSTOWN) does not affect the first-month abnormal return (BHAR (0, 20)) of the spin-off’s stock. This is consistent with the finding of Abarbanell et al. (2003) that there are no significant relations between preference-induced institutional trading and the abnormal returns of spin-offs. I also show that that institutional selling is not related to the executives’ net trading value during the first three-month period (VALUE_EXEC). Overall, these findings suggest that ownership targets and institutional selling pressure do not provide alternative explanations to the negative relationship between tone and insider trading.

6.4. Self-selection – insider trading profit for high risk Since a spin-off is a firm’s choice, there is a potential self-selection problem, which can lead to biased coefficients. In particular, pre-existing traits may make a firm more or less likely to spin off a unit and may influence the likelihood that its prospectus tone relates negatively related to insider trading. Consider a firm that opts to spin off an underperforming unit. This would inevitably lead to a negative tone (i.e., more risk factors). Once the unit is trading separately, some executives might want to purchase its shares if they expect higher returns simply to compensate for the additional risk. To address this issue, I split the sample into two groups based on the tone of the risk factors section in the prospectus and re-visit the empirical analyses (untabulated). I find that regardless of the spin-off’s riskiness, insider purchases with negative prospectus tone precede the long-term abnormal returns, and there is a negative association between tone and insider trading. These findings are not consistent with the explanation that insiders earn abnormal return for the greater risk they undertake.

6.5. Information asymmetry and delayed market reaction In Section 5.4, I document that insider purchases within three months after spin-off with abnormally negative tone yield positive excess returns (BHAR (0, 254)). To clarify how long the profitability of insider trading takes to be realized, I estimate the regression model (5) using various trading windows (1, 5, 10, 20, 60, 127, 254 trading days). I find that the coefficient on BUY_EXEC*ABNEGTONE is significantly positive when the trading window is longer than 127 days, indicating that insider purchases with abnormally negative tone become profitable at least six months after spin-off. In this section, I discuss how strategic tone disclosure contributes to the delayed market reaction to these insider purchases. Prior studies examining informed insider trading assume that insider’s objective is to maximize trading profits due to his information advantage (e.g., Huddart and Ke, 2007). Although a specific insider’s private information is not directly observable, these studies view that informed trading is driven by two components of information asymmetry: the uncertainty in the marketplace regarding firm value and the precision of insider’s information. There is a great uncertainty in the market regarding the newly formed firm value after the spin-off. Prior literature shows that it is partly due to the mispricing driven by institutional selling (e.g., Brown and Brooke, 1993; Abarbanell et al., 2003) and the fact that analyst research pays very limited attention to the spin-off subsidiary (Feldman et al., 2014). Using my spinoff sample, I find that analyst following is significantly decreased after spin-off; and using the measures by Krishnaswami and Subramaniam (1999) (analyst forecast error, forecast dispersion, and stock return volatility), I show that information asymmetry is more pronounced during the first few months following spin-offs (presented in the Internet Appendix Table IA-2). During a short period after spin-off, however, managers could purchase their own firms’ shares based on their private information (with high precision) about strong firm fundamentals. To examine this, I estimate the model (4) using insider purchase (BUY_EXEC) as the main independent variable (presented in the Internet Appendix Table IA-3). The coefficients on BUY_EXEC in both future earnings and future cash flows models (one and two years ahead) are significantly positive. Overall, insider purchase after spin-off is positively related to the future firm performance. Within this framework, Veenman (2012) shows that disclosures of insider purchases resolve investor uncertainty regarding the valuation implications of reported earnings.32 In sum, while investors face great uncertainty, they can incorporate the insider trading news in the spin-off firm valuation. However, a tone level that is incommensurate with the quantitative information will inhibit outside investors’ ability to determine the true value of the spin-off. To reconcile these two competing cues, investors should rely on alternative information provided by the market, which is still limited. Overall, strategic tone disclosure increases the market uncertainty after spin-off, thereby delaying the market reaction to the signal of insider purchases. 31 I include an interaction term, VALUE_EXEC*DINSTOWN, in the model (2) and find that the coefficient on the interaction term is not significant. I additionally split institutions into four groups: bank trusts, insurance companies, investment advisers (including mutual fund companies), and pensions and endowments, because bank trusts face more strict fiduciary requirements (Del Guercio, 1996). However, I find similar results across all types of institutions. 32 When an insider executes a transaction, he or she must file a Form 4 within two business days following the transaction date. Before the Sarbanes-Oxley Act of 2002, the filing requirement was by the tenth day of the next calendar month.

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6.6. Focus-increasing spin-off Prior literature (Hite and Owers, 1983; Daley et al., 1997; Desai and Jain, 1999) find that there is a greater value creation in corporate restructuring that increases focus. Desai and Jain (1999) show that non-focus-increasing spinoffs tend to be the results of separating underperforming subsidiaries from the parents. In this section, I examine how a focus-increasing spinoff is different from a non-focus-increasing spin-off; and further test whether this feature affects the relation between abnormal tone and insider trading. In my spin-off sample, there are 137 focus-increasing and 93 non-focus-increasing spin-offs. I perform the tests of mean difference of tone, stock performance, insider trading, and fundamental variables between two groups (untabulated). I find that the 2-year BHAR and the pre-spinoff ROAt-1 are higher for the focus-increasing spin-offs, which are significant at the 5% and 10% level, respectively. The finding that focus-increasing spin-offs are superior to non-focus increasing spin-offs in terms of their past operating results and future stock performance is consistent with prior studies. However, I do not find any significant difference in other dimensions between two groups, such as tone variables (TONE, ABTONE), short-term returns (BHAR (0, 20)), insider trading (BUY_EXEC), and other fundamentals (LSIZE, SG, EARNVOL, etc.). Thus my sample spin-off data does not provide enough evidence to use the focus-increasing feature as a proxy for the underlying reason of a spin-off (i.e., spinning off a good unit versus a bad unit). More interestingly, information environment of a focus-increasing spin-off can be different from that of a non-focusincreasing spin-off (Gilson et al., 2001; Feldman et al., 2014). Since focus-increasing spin-off firm’s industry is different to the parent’s, analyst research pays very limited attention to the spin-off firm, thereby presumably providing insiders with greater opportunity of strategic disclosure. I perform a cross-sectional test to examine whether the tone-insider trading relationship is more pronounced for focus-increasing spin-offs. In Column (2) of the Internet Appendix Table IA-4, I present that the sum of the coefficients, b1 + b2, is significantly negative (p-value = 0.026). This provides a weak evidence that the abnormal tone of the spin-off prospectus is negatively related to the executives’ net trading value only when the business of the spun-off subsidiary is unrelated to that of the parent firm. 6.7. Forward-looking statements and other sections in the spin-off prospectus I further investigate whether tone of the specific context or topic in the spin-off prospectus is more associated with insider trading. I calculate the spin-off prospectus tone using the forward-looking sentences in the MD&A section (TONE_FLS).33 In my sample (presented in the Internet Appendix Table IA-5), the portion of the forward-looking sentences in the MD&A of the spin-off prospectus is 12.7% and the mean value of TONE_FLS (0.004) is higher than that of TONE (-0.334). I also calculate the tone of other sections (Risk Factors, Reasons for Spin-off) in the spin-off prospectus (TONE_RISK, TONE_REASON). The mean values of TONE_RISK and TONE_REASON are 1.424 and 1.890, respectively, indicating that firms use more negative/positive words describing risk factors/reasons related to the spin-off. In the logistic regression analysis, I find that the coefficient on ABTONE_FLS is negative and significant at the 10% level. However, the abnormal tone measures of other sections are not significantly related to the insider trading. Overall, these suggest that managers’ opportunistic use of tone is concentrated on the forward-looking statements describing the future performance of the spin-off firms. 7. Conclusion This paper investigates the relation between the tone of spin-off prospectuses and insider trading following spin-offs. I find that insider trading following spin-offs is negatively associated with the abnormal tone conveyed in their prospectuses. I also find that this association is concentrated in the trading of executives who could affect the tone of the prospectuses. In addition, I provide evidence that the insider trading is profitable in the long run, especially when spin-off prospectuses are more pessimistic. Overall, my findings suggest that managers can manipulate the tone of these prospectuses to affect investors’ perceptions and enhance profits from their trades. Consistent with the literature, I document that insiders of a spin-off are, on average, net buyers of their own firm’s shares following the transaction. Taking advantage of this pattern, I expand upon the strategic disclosure literature by examining a setting in which managers can obscure good news or accentuate bad news in publicly available information. Based upon the argument that an overly pessimistic tone, coupled with subsequent insider buying, is difficult to regulate, managers may believe that they face low litigation risks relating to the manipulation of this disclosure. Consistent with the findings of Allen (2001), I show that the insider purchases in spin-offs are followed by the superior long-run stock performance by the spin-off. My findings suggest that the abnormal profitability of insider trading may be attributable to opportunistic disclosures by managers who write the spin-off prospectus. Even though managers are obligated to report all material information regarding the spin-off, they might attempt to mislead investors using their discretion over the tone of the qualitative portion of the prospectus.

33

I follow the approach used in Bozanic et al. (2018) to identify forward-looking sentences.

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This study does not prove that managers intentionally manipulate a critical disclosure to mislead investors—intention is difficult to demonstrate, and I have no access to the internal discussions of the management teams whose trading I examine. However, this study does suggest the possibility of managerial opportunism in an important corporate disclosure. Future research might delve more deeply into why the disclosure and trading patterns documented here exist. Data availability Data are available from the public sources cited in the text. Appendix A. Variable Definitions Variable Tone Measures TONE

ABTONE

ABNEGTONE TONE_PAR

Definition

Data Source

TONE = PosTONE - NegTONE. PosTone and NegTone are percentage of positive and negative words in the MD&A of the spin-off prospectus that are on Loughran and McDonald (2011)’s word list, respectively. Residual from the following regression: TONE = a + b1TONE_PAR + b2ROAt-1 + b3SG + b4LSIZE + b5ROAt + b6EARNVOL + b7NSEG + b8LOSS + b9RET_PAR + b10RETVOL_PAR + Spin-off Industry & Year Dummies + e Indicator variable that is equal to one if ABTONE is less than zero; and zero otherwise. TONE_PAR = PosTONE_PAR - NegTONE_PAR. PosTone_PAR and NegTone_PAR are percentage of positive and negative words in the MD&A of the parent company’s most recent 10-K prior to the spin-off that are on Loughran and McDonald (2011)’s word list, respectively.

Spin-off prospectus

Insider Trading Measures BUY Indicator variable that is equal to one for the spin-off subsidiary where the value (transaction price*#shares) of insiders’ purchases is higher than the value of insiders’ sales during the three-month period after the spin-off (’net buyers’). _EXEC, _NONEXEC, _EPAR, _NONEPAR, _TEPAR, _NONTEPAR are added to the variable names to distinguish the trades made by different insider groups. Insider groups are described in Fig. 1. VALUE Natural logarithm of one plus the absolute value of insiders’ net trades (transaction price*#shares purchased – transaction price*#shares sold) in thousands. The sign of net trades (net purchase = positive, net sale = negative) is added back. _EXEC, _NONEXEC, _EPAR, _NONEPAR, _TEPAR, _NONTEPAR are added to the variable names to distinguish the trades made by different insider groups. Insider groups are described in Fig. 1. Stock Performance Measures BHAR (0, 20) 20 trading day size-adjusted buy-and-hold abnormal returns of the spun-off firm commencing from the spin-off distribution date. BHAR (0, 254) 254 trading day size-adjusted buy-and-hold abnormal returns of the spun-off firm commencing from the spin-off distribution date.

Spin-off prospectus

Spin-off prospectus Parent company’s 10-K

Thomson Reuters Insider trading database

Thomson Reuters Insider trading database

CRSP CRSP

Controls ROAt-1 SG SIZE_SUB

SIZE_PAR

Operating income/Total Assets of the subsidiary during the last fiscal year prior to the spin-off Sales growth, defined as percentage change in total sales of the subsidiary during the last fiscal year prior to the spin-off relative to the previous year. Price * shares outstanding of the spun-off subsidiary at the end of the spin-off distribution month (LSIZE, the natural logarithm of SIZE_SUB, is used in the main analyses). Price * shares outstanding of the spun-off subsidiary at the last month end prior to the

Spin-off prospectus Spin-off prospectus CRSP

CRSP

(continued on next page)

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Appendix A (continued)

Controls RELSIZE ROAt CFOt EARNVOL NSEG LOSS RET_PAR

RETVOL_PAR BTM FOCUS INSTOWN_PAR INSTOWN_SUB

DINSTOWN

spin-off distribution. SIZE_SUB/SIZE_PAR Operating income/Total Assets of the subsidiary during the first fiscal year following the spin-off Operating cash flow/Total Assets of the subsidiary during the first fiscal year following the spin-off The standard deviation of ROA of the subsidiary calculated using data from the last five years Number of segments of the subsidiary at the end of the first fiscal year following the spin-off. Indicator variable that is equal to one if ROAt-1 is less than zero and is equal to zero otherwise. 12 month size-adjusted buy-and-hold abnormal returns of the parent. The holding period is from the first prospectus filing month - 13 to the first prospectus filing month - 1. The stock return volatility calculated using 12 months of monthly abnormal return data before the first prospectus filing month. Book-to-market ratio of the subsidiary at the end of the first fiscal year following the spin-off. Indicator variable that is equal to one if the spun-off subsidiary’s 2-digit SIC code is different to the parent’s 2-digit SIC code and is equal to zero otherwise. The percentage of parent shares held by institutional investors at the parent’s most recent fiscal quarter end prior to the spin-off The percentage of subsidiary shares held by institutional investors at the subsidiary’s first fiscal quarter end following the spin-off INSTOWN_SUB - INSTOWN_PAR

Compustat Compustat Spin-off prospectus Compustat Spin-off prospectus CRSP

CRSP Compustat Compustat Thomson Reuters Thomson Reuters

Appendix B. Expected tone model Variables

TONE

TONE_PAR

Parent (t-1)

ROAt-1

Subsidiary (t-1)

SG

Subsidiary (t-2 to t-1)

LSIZE

Subsidiary (t-1)

ROAt

Subsidiary (t)

EARNVOL

Subsidiary (t-5 to t-1)

NSEG

Subsidiary (t)

LOSS

Subsidiary (t-1)

RET_PAR

Parent (t-1)

RETVOL_PAR

Parent (t-1)

Constant Spin-off Industry & Year FE

0.289*** (4.837) 0.0350 (0.237) 0.0634 (1.634) 0.00425 (0.147) 0.174 (1.127) 0.130*** (2.892) 0.0238 (0.889) 0.160** (2.838) 0.219** (2.339) 0.118 (0.106) 0.159 (0.459) Yes

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W. Choi / J. Account. Public Policy xxx (xxxx) xxx Appendix B (continued)

Variables

TONE

SE Clustered by Year Observations Adjusted R2

Yes 230 0.387

This table presents the results of the regression estimating spin-off prospectus tone: TONE = a + b1TONE_PAR + b2ROAt-1 + b3SG + b4LSIZE + b5ROAt + b6EARNVOL + b7NSEG + b8LOSS + b9RET_PAR + b10RETVOL_PAR + Spin-off Industry & Year Dummies + e. TONE_PAR, RET_PAR, RETVOL_PAR are variables measured at the parent company level, and all other control variables are measured at the subsidiary level. NTONE is the predicted value and ABTONE is the residual of the regression. All variables are described in the Appendix A. ***, ** and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. T-statistics are reported in parentheses.

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