Jeopardy, non-public information, and insider trading around SEC 10-K and 10-Q filings

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Journal of Accounting and Economics 43 (2007) 3–36 www.elsevier.com/locate/jae

Jeopardy, non-public information, and insider trading around SEC 10-K and 10-Q filings$ Steven Huddarta,, Bin Kea, Charles Shib a

Pennsylvania State University, USA University of California, Irvine, USA

b

Received 7 March 2005; received in revised form 19 June 2006; accepted 27 June 2006 Available online 7 September 2006

Abstract Evidence contrasting U.S. insider trades in high- and low-jeopardy periods and across firms at high and low risk for 10b-5 litigation indicates that insiders condition their trades on foreknowledge of price-relevant public disclosures, but avoid profitable trades when the jeopardy associated with such trades is high, such as immediately before earnings announcements. Insiders avoid profitable trades before quarterly earnings are announced and sell (buy) after good (bad) news earnings announcements. Insiders trade most heavily after earnings announcements and profit from foreknowledge of price-relevant information in the forthcoming Form 10-K or 10-Q filing. r 2006 Elsevier B.V. All rights reserved. JEL classification: J33; K22; M12 Keywords: Accounting standards; Government regulation; Insider trading; Litigation risk; Stock-based compensation

$ Seminar participants at the 2005 Canadian Academic Accounting Association meetings, the 2005 Hong Kong University of Science and Technology summer symposium, Monash University, the Pennsylvania State University, Rice University, the University of California–Berkeley, the University of Hong Kong, the University of Queensland, and Yale University provided many useful comments. We thank Franc- ois Brochet, Sandra Chamberlain, Thomas Lys (the editor), Gans Narayanamoorthy, Karen Nelson, Adam Pritchard, Alan Ramsay, Louis-Philippe Sirois, Jake Thomas, Mark Vargus, Serena Shuo Wu, and an anonymous referee for many helpful suggestions. Maya Atanasova, Karen Hennes, and Santhosh Ramalingegowda provided able research assistance. We especially thank Karen Nelson for sharing data on litigation risk with us. Part of this research was completed while Steven Huddart was a visiting fellow at the University of Queensland. Corresponding author. Tel.: +1 814 865 3271; fax: +1 814 863 8393. E-mail address: [email protected] (S. Huddart). URL: http://www.smeal.psu.edu/faculty/huddart.

0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2006.06.003

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1. Introduction We examine and contrast how the frequency and value of insider trades in the United States are associated with two significant information releases that occur in every fiscal quarter: the earnings announcement, which is a summary measure of firm performance that is highly price-relevant, and the subsequent Form 10-K or 10-Q filing, which contains more detailed financial results and also represents price-relevant information. We replicate earlier findings of a weak association between insider trades shortly before the earnings announcement and the subsequent earnings announcement.1 We provide new evidence that insider trades before earnings announcements are relatively infrequent and occur when the magnitude of the earnings announcement abnormal return is small. In sharp contrast, insiders trade relatively heavily after the earnings announcement and these trades are significantly associated with the stock’s returns over narrow windows around both the forthcoming 10-K or 10-Q filing and the preceding earnings announcement.2 Returns over these windows are proxies for the price-relevant information released to the market by the disclosure that occurs within the window. The pattern of associations is consistent with the interpretation that variation in jeopardy over a fiscal quarter (i.e., the combined risks of unfavorable publicity, civil liability, and criminal prosecution) restrains insiders seeking to profit from foreknowledge of corporate disclosures more before earnings announcements than before 10-K and 10-Q filings. Buttressing this interpretation, we present evidence that variation in insider trading across firms is associated with firm-specific variation in the ex ante risk of 10b-5 litigation. Collectively, these findings are consistent with insiders conditioning their trades on foreknowledge of price-relevant public disclosures but limiting their trades to periods when the jeopardy they face due to trade is low. Since it does not seem possible to elicit from insiders directly and unbiasedly the motives behind their trades, evidence on the litigation avoidance hypothesis necessarily is circumstantial. This paper offers evidence drawn from two related settings that plausibly differ in the seriousness of the jeopardy. Trade that shortly precedes and is conditioned upon a forthcoming earnings announcement has resulted in prosecutions and so is risky.3 Legal advice that insiders should avoid trading in the period immediately before an earnings announcement is widespread. Many corporations stipulate blackout periods that cover the preannouncement period and during which insiders may not trade. In contrast, we know of no complaint filed against an insider for trading improperly on foreknowledge

1

The results of studies that have examined the relationship between insider trades and corporate news released within the next three months are mixed. Givoly and Palmon (1985) find little association between insider trades and subsequent Wall Street Journal reports, a sample composed mainly of earnings announcements. Sivakumar and Waymire (1994) find trading by insiders in one quarter is not correlated with errors in analysts’ forecasts of next quarter’s earnings. Noe (1999) finds that increases in insider trades in the 20 days prior to disclosure of management forecasts are not correlated with management earnings forecast errors. Other studies, however, find evidence of an association between insider trades and the next earnings announcement. Lustgarten and Mande (1995) present evidence that insiders purchase undervalued stocks (but no evidence that insiders sell overvalued stocks) in the 30 days before earnings announcements. Roulstone (2004) documents a statistically significant but economically small association between insider trades in the two months before an earnings announcement and the abnormal return at the earnings announcement. 2 Insiders’ trades after the 10-K or 10-Q filing are significantly associated with the stock’s returns over narrow windows around both the preceding announcement and filing. 3 A relevant case in this area is SEC v. Lipson, No. 97-CV-2661, 129 F. Supp. 2d 1148.

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of the contents of a 10-K or 10-Q.4 Relatedly, Bettis et al. (2000) document that blackout periods typically end on the second trading day after the earnings announcement, so corporate policy typically permits trades in this period. This suggests that the risk stemming from trade after the earnings announcement are lower than the risks from trade before the announcement. According to Kelson and Allen (2004, p. 13): ‘‘A well-designed insider trading policy that is properly followed creates an effective prophylactic against inadvertent insider trading, and provides a defense for a company’s insiders against any allegation that such trading has occurred. Adoption and enforcement of a written insider trading policy also provide a method for the corporation to demonstrate that ‘appropriate steps’ have been taken to prevent insider trading violations, and to assert a defense against ‘controlling person’ liability for trades made by its insiders under Sections 20A, 20(a), and 21A of the Securities Exchange Act of 1934 (Exchange Act).’’ They further point out that only a minority of companies keep trading windows closed (or blackout periods in place) until after the filing of their 10-Qs and 10-Ks. Neither legislation nor SEC rules require firms to restrict insider trades to particular periods or circumstances. Thus, firm policies that prohibit or discourage trade at specific times are an endogenous and voluntary response by firms (and their managers and shareholders) to the more fundamental risks that insiders and the corporation face. We term these risks ‘‘jeopardy’’. Jeopardy arises from the formal surveillance and policing activities of the exchanges and the SEC; the resulting enforcement actions and precedents; and the less formal disciplinary roles of the business press, who publicizes certain insider trades, and the plaintiffs’ bar, who launches 10b-5 class action lawsuits. Given that the jeopardy an insider faces from trade varies over the fiscal quarter, and, in particular, jeopardy is higher before the earnings announcement than in the period between the announcement and the 10-K or 10-Q filing, it is interesting to ask whether insider trade clusters in low-jeopardy periods and whether such trades are profitable to insiders. Prior research has examined the connection between insider trading and a variety of information releases.5 We believe our study is the first to examine insider trading around the filing of 10-Ks and 10-Qs. As such, it provides evidence on the specific nature of the private information related to proximate financial disclosures that insiders possess and use in making their trading decisions. The filing of a 10-K or 10-Q is an important and interesting informational event because (i) it occurs frequently and regularly, (ii) the magnitude of the stock price response is sometimes large—for 5% of the observations, the 4

No centralized database of securities law complaints exists—these documents are filed in courthouses around the country—so it is not feasible to conduct an exhaustive search. However, a variety of keyword searches uncovered no document alleging improper trade related to any of over 1,000 securities for which documents are available at the Securities Class Action Clearinghouse (http://securities.stanford.edu). Furthermore, a keyword search of the Lexis/Nexis file ‘‘SEC Litigation releases, Administrative Releases, and AAERs’’ using the search string ‘‘insider trading’’ w/50 ‘‘10-K’’ or ‘‘10-Q’’ yields 21 documents, none of which relate to an allegation of improper trade shortly before the filing of a 10-K or 10-K. This suggests the SEC has never pursued an insider for trading on foreknowledge of information contained in a 10-K or 10-Q. 5 Among these studies are examinations of insider trades around earnings forecasts (Penman, 1982 and Noe, 1999), news announcements in the Wall Street Journal (Givoly and Palmon, 1985), declarations of bankruptcy (Seyhun and Bradley, 1997), dividend initiations (John and Lang, 1991), seasoned equity offerings (Karpoff and Lee, 1991), stock repurchases (Lee et al., 1992), and takeover bids (Seyhun, 1990). Hillier and Marshall (2002) document the abnormal returns associated with insider trading before and after the two-month long trading ban preceding earnings announcements that applies to companies listed in the United Kingdom.

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abnormal return at the filing is less than 9:78%, and for 5% of the observations, it is more than 9.77% (as we explain in more detail below)—and (iii) compared to informed trade before an earnings announcement, there are reasons to believe the jeopardy due to trade before the filing is lower. Johnson et al. (2004) examine whether insider trading is a determinant of subsequent securities litigation. They find that plaintiffs’ lawyers’ filings and allegations point to the level of insider stock sales as evidence of management’s fraudulent intent. Our research question is different. Rather than asking if insider trading contributes to litigation, we ask how the combined threats of SEC scrutiny, litigation, and adverse publicity (i.e., jeopardy) may discipline or limit insider trading. We do this by contrasting insider trading decisions in firm- and time-specific situations where jeopardy is either high or low. Jagolinzer and Roulstone (2004) examine the evolution of the distribution of insider trades around earnings announcements in the years 1984–2000. Over this 17-year period, they find that insider trades in the month after the earnings announcement, as a fraction of all insider trades, has increased. Their evidence also suggests a shift of insider trades to the period after the earnings announcement. The shift is more pronounced at firms that have certain characteristics: small market capitalizations, low analyst following, low institutional ownership, more volatile earnings surprises, and more volatile returns. Given a trend over time towards greater jeopardy for improper trade and assuming greater jeopardy at firms with those certain characteristics, their time-series analysis complements this study in identifying how jeopardy influences insiders’ trades. Corporate insiders profit from foreknowledge of price-relevant information disclosures by selling before the disclosure of bad news or after the disclosure of good news. Some argue that instead of altering the time of trade to profit from information releases, insiders may alter the time of the disclosure or the content of the disclosure.6 Along these lines, Beneish et al. (2001) examine whether earnings management precedes or follows insiders’ trades. In our setting, the time of disclosure of the 10-K or 10-Q is fixed within narrow limits by regulation. Moreover, many firms voluntarily disclose the date on which they plan to announce earnings. The evidence in Bagnoli et al. (2002) is that, by and large, firms do announce earnings on the planned-and-disclosed date.7 This suggests that earnings announcement and filing dates are known in advance and sticky. Also, the scope to modify the content of the disclosure likely is limited by the facts that earnings are reported after either a review by public accountants in the case of 10-Qs, an audit in the case of 10-Ks. As a consequence, the components of earnings have been fixed. Further, consistency over time of the principles used in the preparation of financial reports is required by reporting standards, filing is mandatory, and deadlines are prescribed, so the setting we examine is one in which insiders have discretion to choose the time and quantity of their trades, but are limited in their ability to alter the content or timing of their disclosures. For investors, our findings indicate that the informativeness of insider trades depends, in part, on when during the fiscal quarter the trade takes place and characteristics of the firm 6 Aboody and Kasznik (2000) present evidence that CEOs adjust the timing of voluntary disclosures around fixed stock option award dates, so as to expedite disclosure of bad news and delay disclosure of good news, thereby increasing the value of options granted at the money. Bartov and Mohanram (2004) present evidence that is consistent with executives reporting inflated earnings prior to option exercises, followed by a pattern of lowerthan-expected earnings after exercise, which represents a reversal of the earlier inflation. 7 Delaying the announcement is associated with a significant price drop, which is personally costly to insiders holding long positions in the stock.

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including the risk of litigation that the firm faces. The link between jeopardy and the timing of insider trades may interest jurists studying how individuals’ actions change in response to statute, case law, and regulation. These findings also have implications for regulatory choices. For regulators seeking to limit the information rents gathered by informed insider traders, an important question is how to balance the trading needs of top executives who receive substantial stock-based compensation against the profitable trading opportunities created when insiders have private information and substantial trading discretion. We provide a measure of insider trading profits attributable to foreknowledge of the contents of 10-K and 10-Q filings. The paper is organized as follows. Section 2 describes key features of the setting and the data. Section 3 describes our empirical methods and presents our analysis of the distribution of insider trades over the fiscal quarter. Section 4 documents how insider trades vary across firms in response to the risk of litigation the firm faces. Section 5 concludes. 2. Data and institutional background In this section, we describe the data, the strategies insiders may use to profit from private information about corporate disclosures, and the timeline relating the disclosures to the trading periods we examine in each firm-quarter. Next, we define active and passive trading, describe the construction of the variables used in the analysis, and present descriptive statistics on these variables. 2.1. Data The data used in this study come from three sources. The 10-K and 10-Q filing dates are from the SEC’s Edgar online database. Stock returns and financial information come from the CRSP and Compustat files. Insider trading data are from First Call/Thomson Financial Insider Research Services Historical Files. These data are the transactions of persons subject to the disclosure requirements of Section 16(a) of the Securities and Exchange Act of 1934 reported on Forms 4 and 5. Because our objective is to examine trading by insiders motivated by foreknowledge of company disclosures, the transactions included in the study are limited to open market purchases and sales by officers and directors. Non-open market transactions, including, e.g., option grants and exercises, transactions related to dividend reinvestment plans, stock transfers between spouses, and certain pension and other benefit program transactions are excluded. Also, transactions that are reportable solely because the transacting entity is a large shareholder are excluded. Since the requirement to file 10-Ks or 10-Qs through Edgar online became effective on January 1, 1996, our sample includes only calendar years 1996–2002. The SEC requires that 10-Qs be filed within 45 days after the fiscal quarter’s end and 10-Ks be filed within 90 days after the fiscal year end.8 In our sample, 95% of the 10-Q (10-K) filings are made within 47 days (92 days) of the fiscal quarter’s end (fiscal year’s end). Our research 8

For most companies, the deadlines for filing 10-Qs and 10-Ks are being shortened gradually to 35 and 60 days, respectively, by SEC Release No. 33-8128 (issued September 5, 2002 and effective November 15, 2002). The SEC subsequently proposed to delay by one year the implementation of this rule change. See SEC Release No. 33-8507 (issued November 17, 2004 and effective December 23, 2004).

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questions are best addressed by studying situations where the timing of disclosures is fixed in advance and the content of disclosures is privately known to insiders. Accordingly, we exclude instances where announcements and filings are greatly delayed. Specifically, we require (i) the quarterly earnings reporting date to be no later than 45 days after the fiscal quarter’s end, (ii) the 10-Q filing date to be no later than 47 days after the fiscal quarter’s end, (iii) the annual earnings reporting date to be no later than 90 days after the fiscal quarter’s end, (iv) the 10-K filing date to be no later than 92 days after the fiscal quarter’s end. We impose these data restrictions because a delayed filing or announcement likely indicates that the disclosure is not finalized timely. Also, delays generally signal bad news, which Bagnoli et al. (2002) show leaks out in advance of the announcement. Finally, delays may indicate that the disclosure is contentious or lacks representational faithfulness. Situations where either insiders do not know the content of the disclosure, insiders lateadjust the content of the disclosure, the content of the disclosure is leaked, or the disclosure is misleading are inconsistent with the experimental setting we seek to explore.9 The final sample contains 110,305 firm-quarter observations, representing 7,791 unique firms. We count as an observation each of the three periods of the firm-quarters meeting the data requirements, including quarters in which there are no insider trades. The sample sizes for some regression specifications are smaller due to missing values for certain independent variables. 2.2. Opportunity to profit from foreknowledge of disclosures Consider how an insider may profit from short-lived private information about the contents of a forthcoming public disclosure. When the disclosure contains good (bad) news the insider ought to buy (sell) before the disclosure. Further, when the insider must sell stock for such reasons as personal liquidity needs, but he nevertheless has some discretion over when to trade, the insider benefits from postponing the sale until after good news is released. Likewise, when the insider must purchase stock for such reasons as achieving a stock ownership target established by his compensation contract, the insider benefits by postponing the purchase until after bad news is released. The insider’s opportunity to profit from the price impact of a public disclosure ends when the disclosure is made, since at that point the insider has either traded or postponed his intended trade. However, if the insider strategically delays purchases (sales) until after bad (good) news is released, then trades will be correlated with past stock returns. Our tests for an association between insider trades before and after the earnings announcement and 10-K and 10-Q filings with the short-window stock returns around those events are tests of whether and how insiders exploit specific pieces of short-lived private information, namely foreknowledge of the contents of the announcements and filings. Assuming that insiders know in advance the contents of the disclosure and can predict the price reaction that will occur when the disclosure is made, larger absolute returns imply a larger potential profit to insiders from conditioning their trades on the disclosure.10 To 9

Note, however, that qualitatively similar results obtain if we relax the data requirements so that the 10-Q is filed no later than 60 days after the quarter’s end and the 10-K is filed no more than 180 days after year’s end. 10 This seems a reasonable assumption since there is a long line of research documenting stock price reactions to the unexpected component of these announcements—beginning with Ball and Brown (1968), who study price movements around earnings announcements; and including Balsam et al. (2002), who study price movements around 10-Q filings.

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assess whether the profit opportunity before the announcement is comparable to the profit opportunity before the filing, Table 1 presents summary statistics on the distributions of the raw, market-adjusted, and the absolute value of market-adjusted stock returns around the earnings announcement and the subsequent SEC filing. We choose the 10-Q and 10-K event windows to be brief periods of concentrated price reaction associated with these disclosures. In a study of 10-K and 10-Q reports filed electronically with the SEC using the EDGAR system, Griffin (2003, p. 435) observes that the ‘‘EDGAR document will normally reside in the public domain at zero or low cost within one or two business days following the filing date’’. Using the absolute excess stock return as a measure of investor response to the filing, he finds that the response is concentrated on the day of and the two days after the filing date. Accordingly, we define RET_FD to be the return over days 0 to þ2 relative to the filing and call these days the Filing Window. We choose an earnings announcement window that is the same length as the Filing Window, namely three trading days. Since Morse (1981) finds that the price response to earnings announcements (measured as the median absolute return residual) is largest on days 1 to þ1 relative to the announcement, accordingly we define RET_EA to be the return over days 1 to þ1 relative to the announcement and call these days the Announcement Window. ARET_EA and ARET_FD are the corresponding abnormal returns computed as the difference between the buy-and-hold raw returns and buy-andhold value-weighted market index. Not surprisingly, the mean and median values of these returns are near zero. The active component of an insider’s trading gain from a stock purchase is the product of the value of the shares he buys and the subsequent abnormal return. Likewise, the trading loss an insider avoids from a stock sale equals the value of shares he sells times the subsequent abnormal return. To assess the frequency with which insiders are faced with the opportunity to receive a gain by buying or avoid a loss by selling, and to make potential gains comparable to potential losses, in Table 1 we also report the absolute value of returns. Comparing the magnitude of the trading opportunity insiders face before the Table 1 Value and absolute value of abnormal returns over the earnings Announcement and Filing Windowsa Variable

Mean

Panel A: Event window returns RET_EA 0.0078 RET_FD 0.0027 ARET_EA 0.0058 ARET_FD 0.0025

Standard deviation

5%

Median

95%

0.1033 0.0724 0.1017 0.0708

0.1378 0.0950 0.1366 0.0978

0.0000 0.0000 0.0017 0.0047

0.1650 0.1059 0.1584 0.0977

0.0033 0.0025

0.0396 0.0280

0.2029 0.1361

Panel B: Absolute value of abnormal event window returns abs(ARET_EA) 0.0640 0.0793 abs(ARET_FD) 0.0438 0.0557

a Panel A reports returns over the Announcement Window and Filing Window for 110,305 firm-quarters in the period 1996:1 to 2002:4 with available data. RET_EA is the return over days 1 to þ1 relative to the earnings announcement date. RET_FD is the return over days 0 to þ2 relative to the 10-K or 10-Q filing date. ARET_EA and ARET_FD are the corresponding abnormal returns, computed as the difference between the buy-and-hold raw return and the buy-and-hold value-weighted market index. The absolute value of abnormal returns over the earnings Announcement and Filing Windows are abs(ARET_EA) and abs(ARET_FD), respectively.

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announcement with the opportunity they face before the filing, observe that the absolute value of the market-adjusted return over the earnings announcement, abs(ARET_EA), has a mean of 6.40% and a median of 3.96%, while the absolute value of the return over days 0 to þ2 relative to the 10-K or 10-Q filing, abs(ARET_FD), has a mean of 4.38% and a median of 2.80%. Comparing the ratio of either the means or medians, it is apparent that the average or typical profit opportunity at the filing is about 70% of the profit opportunity at the announcement. The smaller magnitude of the return at the filing implies that, all else equal, insiders’ incentive to trade on foreknowledge of the filing is smaller than the incentive to trade on foreknowledge of the announcement. This makes it less likely that our test will detect an association between insider trades and the return at the filing than at the announcement. Nevertheless, large returns at the filing are frequent: For 5% of the observations, the abnormal return at the filing is less than 9:78%, and for 5% of the observations, it is more than 9.77%. The magnitude of these returns implies that insiders’ potential gains from well-timed trade are significant. It is useful to compare the profit opportunity at these events with the opportunities at other events. Jensen and Ruback (1983) point out that the abnormal return of target firms subject to a merger or acquisition is more than 20% over the month leading up to the announcement. Case law establishes a clear obligation for insiders to avoid trade in this period. Seyhun and Bradley (1997) point out that the abnormal return experienced by a firm in the year leading up to a bankruptcy filing is about 50% and that insider selling during this period is abnormally high. Ke et al. (2003) document increased insider selling before breaks in a string of consecutive earnings increases; the average abnormal return over the 32 days before and including this event is 4:29%, which is comparable to the means of abs(ARET_EA) and abs(ARET_FD) measured over only three trading days. Thus, the announcements around which we study insider trades are associated with price movements that in many cases are as large as those associated with major corporate events like mergers, bankruptcy filings, and extreme earnings surprises. Therefore, these events should be large enough to prompt insiders to trade. Moreover, the events we study occur four times each year for every public company. Given a difference in jeopardy and economically significant profit opportunities from private information, a test of the litigation avoidance hypothesis is therefore possible by comparing the strength of the associations between (i) insider trades preceding the announcement with the announcement return and (ii) insider trades between the announcement and the filing with the filing return. 2.3. Timeline In our experimental design, we focus on insider trading in three non-overlapping periods within every fiscal quarter. The first period is the 20 calendar days ending two days before a quarterly earnings announcement. The second period, begins on the second trading day after the announcement date and ends on the earlier of (i) the 20th calendar day after this day and (ii) the calendar day before corresponding 10-K or 10-Q is filed. The third period is the 20 calendar days beginning on the third day after the 10-K or 10-Q filing date. Because the stock market reaction to earnings announcements typically occurs on the three days centered on the earnings announcement date while the market reaction to SEC filings occurs on the three days beginning on the filing date, we construct Periods 1, 2, and 3 so that they surround the Announcement and Filing Windows, but not overlap them. To

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Announcement Window

20 days

Filing Window Period 2

Period 1 –1

+1

11

up to 20 days

Period 3 0

+2

20 days

0

Announcement Date

Filing Date

Fig. 1. Definition of stock return windows and trading periods. Periods 1, 2, and 3 are measured in calendar days. The Announcement Window and Filing Window are measured in trading days. Firm-quarters in which the filing date is 0, 1, or 2 trading days after the announcement date are excluded from the analysis. Period 1 is the 20 calendar days before the start of the Announcement Window. Period 2 begins on the second trading day after the announcement date and ends on the earlier of (i) the 20th calendar day after this day and (ii) the calendar day before the filing date. Period 3 is the 20 calendar days after the end of the Filing Window.

facilitate the comparison of coefficient estimates across regressions based on observations from different periods, we construct the periods so that they are as close in length as possible. In the variable definitions introduced below, the index p 2 f1; 2; 3g denotes the period. Fig. 1 plots each of the periods on a timeline representing a typical firm-quarter. Because of variation in the time between the announcement date and filing date, Period 2 is less than 20 calendar days for some firm-quarters.11 In other firm-quarters, the Filing Window begins more than 20 calendar days after the Announcement Window ends, so the last days before the filing are excluded from Period 2. As a robustness check, we repeated the analysis reported below after redefining Period 2 to include all the days between the end of the Announcement Window and the beginning of the Filing Window. Results are qualitatively unchanged. 2.4. Active and passive trading If a trade is driven by the insider’s desire to profit from a particular disclosure, the direction and magnitude of insider trades both before and after the event may be correlated with the price reaction to the disclosure because the insider may engage in both active and passive trading strategies. The definitions of active and passive trading below parallel those in Seyhun (1998, p. 50). Take first the case of stock sales. To profit from foreknowledge of a public announcement of bad news, an insider may trade actively: anticipating the stock price fall after the bad news is disclosed, the insider may sell before the announcement, receiving an active return from his action. Empirically, active returns are indicated by 11

Firm-quarters in which the filing date is 0, 1, or 2 trading days after the announcement date are excluded from the analysis. Period 2 does not exist in such cases because there is no interval between the Announcement Window and the Filing Window, which represent 12% of firm-quarters. This situation arises, e.g., if a firm does not formally announce its earnings in press release that precedes the filing of a 10-K or 10-Q.

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more-than-expected sales transactions and more-than-expected sales value before bad news. To profit from foreknowledge of a public announcement of good news, an insider may also capture a passive profit: anticipating that the stock price will rise after the good news is disclosed, the insider may delay selling until after the announcement, receiving a passive return from postponing action. Empirically, passive returns are indicated by morethan-expected sales transactions and more-than-expected sales value after good news. Correspondingly in the case of stock purchases, active returns are indicated by morethan-expected purchase transactions and higher-than-expected purchase value before good news, while passive returns are indicated by more-than-expected purchase transactions and more-than-expected purchase value after bad news. Combining these observations, a positive association between net purchase transactions or net purchase value and future abnormal returns indicates active trading, while a negative association with past abnormal returns is consistent with passive trading. This interpretation is offered, e.g., by Seyhun (1986). It is possible, however, that the association between net purchase transactions and past returns is not driven by private information that prompts insiders to delay trading. Instead, it may be that insiders make contrarian trades in response to recent stock returns. Lakonishok and Lee (2001) and Cheng and Lo (2005) present evidence that insiders buy (sell) when the abnormal stock return is negative (positive) over the previous three to six months. In examining the relation between insider trade and abnormal returns in narrow windows surrounding the announcement and filing, we include as a regressor the stock’s return over a six-month window preceding these disclosures. Despite this, our tests do not allow us to rule out either contrarian tendencies or private information as drivers of the association between insider trades and abnormal returns at prior disclosures. 2.5. Definition of test variables The principal dependent variables in our analyses are the signed frequency and the signed value of net insider trading in the three specified periods of each firm-quarter. So that the measures of trade reflect the net direction, frequency, and value of trade in a given period when some insiders may be selling while others are buying, trade frequency and trade value in a firm-quarter-period are defined as follows: FREQpfq is the number of purchase transactions minus the number of sale transactions in Period p at firm f in quarter q. VALUEpfq is the value, in millions of dollars, of purchase transactions minus the value of sale transactions in Period p at firm f in quarter q.12 In over half the periods we examine, there are no insider trades. In these cases, FREQp and VALUEp are set to zero. In a smaller number of cases FREQp (respectively, VALUEp) is zero when the number (respectively, value) of purchase transactions in a firm-quarter-period equals the number (respectively, value) of sales transactions. Overall, FREQp and VALUEp are zero for 91% of Period 1 observations, 71% of Period 2 observations, and 77% of Period 3 observations. Panel A of Table 2 presents descriptive statistics on the dependent variables. Because sales transactions exceed purchase transactions in number and value and because sales transactions are coded as negative values, the mean values of FREQp and VALUEp are 12

Results are similar if FREQpfq and VALUEpfq are scaled by the number of insiders at that firm who trade in that period.

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Table 2 Descriptive statistics on insider trade and independent variablesa Variable

N

Panel A: Measures of insider trade FREQ1 110,305 FREQ2 110,305 FREQ3 110,305 VALUE1 110,305 VALUE2 110,305 VALUE3 110,305 Panel B: Independent PRIOR_RET1 PRIOR_RET2 PRIOR_RET3 MV BM

variables 106,291 106,842 107,418 110,305 110,305

Mean

Standard deviation

5%

Median

95%

0.0239 0.5743 0.3256 0.0840 0.8638 0.6763

2.0263 6.4797 4.2983 4.1484 26.6586 74.4262

0.0000 5.0000 3.0000 0.0000 1.4178 0.5688

0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

0.0000 2.0000 1.0000 0.0000 0.0488 0.0230

0.0797 0.0778 0.0769 2.3920 0.6165

0.5599 0.5512 0.5905 13.4163 0.5542

0.5398 0.5513 0.5543 0.0177 0.0745

0.0294 0.0239 0.0253 0.2542 0.4959

0.8077 0.8246 0.8110 8.0530 1.6209

a Panel A reports firm-quarter descriptive statistics on insider trade measured in three non-overlapping periods within each firm-quarter in the period 1996:1 to 2002:4 with available data. The first period is the 20 days ending two days before a quarterly earnings announcement. The second period, which may be up to 20 days long, begins on the second day after a quarterly earnings announcement and ends no later than the day before the corresponding 10-K or 10-Q is filed. The third period is the 20 days beginning on the third day after the 10-K or 10-Q filing date. These periods correspond to the periods depicted in Fig. 1 and are denoted p ¼ 1, p ¼ 2, and p ¼ 3, respectively. FREQp is the number of insider purchase transactions less the number of sale transactions in Period p. VALUEp is the value, in millions of dollars, of insider purchase transactions less the value of insider sales transactions in Period p. If there were no insider trades in the firm-quarter-period, then FREQp and VALUEp are set to 0. Panel B describes the independent variables additional to the test variables described in panel A. PRIOR_RETp is the buy-and-hold return for the six-month period ending on the last day of: for Period 1, the second month prior to the month of the earnings announcement; for Period 2, the month prior to the month of the earnings announcement; for Period 3, the month prior to the month of the filing. MV is the market value of equity, in billions of dollars. BM is the ratio of book value to the market value of equity. MV and BM are computed as of the end of the quarter to which the announcement and filing relate.

negative. The large standard deviations of these variables are driven by the small number of quarters where insiders trade heavily. For instance, the smallest and largest values of FREQ2 are 986 and 218, meaning that in one firm-quarter there are 986 stock sale transactions (net of stock purchase transactions) in that firm-quarter during Period 2 while in another there are 218 stock purchase transactions (net of stock sale transactions) in that firm-quarter during Period 2. The first and 99th percentiles of these FREQ2 are only 16 and 7. Similarly, the smallest and largest values of VALUE2 are far from zero, although the 1st and 99th percentiles of these variables, 11:500 and 0.400, respectively, are much closer to zero. The distributions of both FREQp and VALUEp are highly leptokurtic. Because of the potential for extreme values of the dependent variable to be highly influential in the regression analysis, in the reported regression results we eliminate outliers using Cook’s (1977) distance statistic. As well, in untabulated supplemental analyses, we perform rank regressions. The results of the rank regressions are qualitatively similar to the reported results. It is also useful to consider how much trade takes place in the three 20-calendar-day periods we consider and what fraction of all trades takes place in these periods rather than

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at other times in the quarter. Our analysis is based on 406,357 trades that take place over 110,305 firm-quarters, which implies that the average number of trades, both purchases and sales, is 3.68 trades per firm-quarter. The percentages of these trades that occur in Periods 1, 2, and 3, respectively, are 7.8%, 37.1%, and 24.6%, for a total of 69.5%. Thus, about two-thirds of trades occur in the three periods we examine, which represent 60 of the 91 calendar days in a typical quarter. It is notable that insider trades are unevenly distributed across periods. The number of trades in Period 2 is more than four times the number of trades in Period 1. 2.6. Definition of other independent variables Other independent variables used in the basic regression are: PRIOR_RETpfq , the buyand-hold return for the six calendar months before the beginning of the period; MVfq , the market value of equity, in billions of dollars; and BMfq , the ratio of the book value to the market value of equity. MV and BM are computed as of the end of the fiscal quarter to which the announcement and filing relate. Prior returns are included because insiders tend to be contrarian (i.e., insider buying is greater after low stock returns and lower after high stock returns), as documented by Rozeff and Zaman (1998) and Lakonishok and Lee (2001). Based on this research, the coefficient estimate on PRIOR_RETp is predicted to be negative in all periods. The firm’s market value is included as a control because Seyhun (1986) reports that insider trading varies cross-sectionally with firm size.13 Additionally, portfolio rebalancing for reasons unrelated to private information is often cited by executives as a reason for trading stock. For this reason, larger stock trades, both purchases and sales, are likely to be associated with larger insider stock and stock option positions. Hence, a positive relation between holdings and trade size would be expected. Insider stock and option holdings are available in machine-readable form on Execucomp for only a small number of firms. Since executive compensation and the value of executive stock and option holdings are strongly positively correlated with firm size, firm size could be used in place of insider stockholdings as a measure of non-information based motives for trade. To preserve sample size, we adopt this approach. Findings in prior research also suggest that the coefficient estimate on MV should be negative in all periods because insiders purchase less stock at large firms. For this reason, we expect that MV is negatively related to FREQp and VALUEp in each period. The book-to-market ratio controls for the effect documented by Rozeff and Zaman (1998) that insider buying climbs as stocks change from growth to value categories. Accordingly, the coefficient estimate on BM is predicted to be positive. Panel B of Table 2 presents descriptive statistics on the explanatory variables. The distributions of PRIOR_RET1, PRIOR_RET2, and PRIOR_RET3 are very similar because they are computed over similar periods. Our data are drawn from the years 1996–2002. From the beginning of this period until the third quarter of 2000, prices generally rose. In the following period, prices generally fell. Despite the retreat that began in 2000, from June 1995 to December 2002, the period over which prior returns are computed, the S&P 500 Index and the NAS/NMS Composite Index both rose by more 13

Specifically, Seyhun (1986, Table 3) documents that the absolute value of stock trades by insiders (scaled by the value of all stock trades) is negatively related to firm size.

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15

than 40%, implying that the median six-month returns of between 2% and 3% reported in Table 2 are consistent with overall market movements. The median observation has a market value of common equity at the beginning of the fiscal year of $254.2 million and the mean MV is nearly 10 times greater. Because MV is highly skewed, we report regression results for ln(MV), which is the natural logarithm of MV. The book-to-market ratio, BM, over sample firm-quarters has mean and median values of 0.6165 and 0.4959, respectively. 3. Analysis of trade over time Finding that the net number of insider purchases, FREQp, is positively correlated with the abnormal return associated with a forthcoming announcement means that insiders are more likely to buy stock before good news is released and more likely to sell stock before bad news is released. For a given price reaction (i.e., abnormal return) to an announcement by a firm, insiders’ profits are proportional to the value of stock traded, VALUEp. Finding that the value of stock traded increases in the magnitude of the abnormal return at the announcement means the value of insider trades and, hence, insider trading profits increase when their information advantage (as proxied by the abnormal return) is greater.14 To test for these associations, we regress FREQp and VALUEp on the information content of the announcements and the filings, as proxied by the abnormal returns at these events, and the other independent variables: FREQpfq ¼ b0 þ b1 ARET_FDfq þ b2 ARET_EAfq þ b3 PRIOR_RETpfq þ b4 lnðMVfq Þ þ b5 BMfq þ fq

ð1Þ

and VALUEpfq ¼ b0 þ b1 ARET_FDfq þ b2 ARET_EAfq þ b3 PRIOR_RETpfq þ b4 lnðMVfq Þ þ b5 BMfq þ fq .

ð2Þ

Separate regressions are run for each of the periods, p 2 f1; 2; 3g. These regressions pool data across firms and quarters. The chief interests in these regressions are the coefficient estimates on ARET_FD and ARET_EA, i.e., b1 and b2 . Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Periods 1 and 3 are 20 days long in every case. Because some firms file 10-Ks or 10-Qs shortly after announcing earnings, Period 2 is less than 20 days in some cases.15 To control for the possibility that either FREQ2 or VALUE2 is correlated with the number of days in Period 2 (e.g., when Period 2 is less than 20 days there might be fewer insider trades simply 14

Relative to the value measure, the signed frequency measure equally weights the insider’s trading decisions. If high-value insider trades are more likely to be motivated by liquidity needs or a desire to diversify or are subject to greater scrutiny by regulators (as is suggested by Seyhun, 1998, p. 75), then an equal-weighting of trades may better capture the informed component of insider trade. 15 Over the first three fiscal quarters of the firm-year, the median, mean and minimum number of calendar days between the Announcement Window and the Filing Window are 17, 16 and 1 days, respectively. For 25% of the observations, there are 11 or fewer days between the Announcement Window and the Filing Window. For the fourth fiscal quarter, the gap between the earnings announcement date and the 10-K filing date is longer: the median, mean and minimum number of days between the Announcement Window and the Filing Window are 43, 41 and 1 days, respectively.

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because there are fewer days on which to trade), the set of explanatory variables for period 2 is augmented with indicator variables (coefficients not reported).16 We analyze interim and fourth quarter observations separately because it is possible that the relation between insider trade and the abnormal returns at the announcement and the filing may differ across quarters for at least four reasons. First, the time between an interim earnings announcements and the filing of the 10-Q is shorter than the time between the fourth quarter earnings announcement and the filing of the 10-K: on average the elapsed days between the Announcement Window and the Filing Window for these events are 16 and 41 calendar days, respectively.17 Second, Salamon and Stober (1994) find that the stock price response to earnings surprises is greater at interim earnings announcements than at fourth quarter announcements. Third, Griffin (2003) finds that the price response to 10-K filings is greater, on average, than the price response to 10-Q filings. Finally, for both announcements and filings, two-sample Wilcoxon rank-sum tests indicate significant differences (at better than the 0.001 level) in the distributions of absolute abnormal returns for the fourth quarter compared to interim quarters. These differences in price reactions and time between information events could lead insiders to adopt different trading strategies across interim and fourth quarter disclosures; however, the signs, magnitudes, and significance levels of coefficient estimates (reported below in Table 3) are quite consistent between the annual 10-K and the three quarterly 10-Qs. 3.1. Predicted associations of trade with announcement and filing returns If trades are prompted by an insider’s desire to actively exploit foreknowledge of the content of either the earnings announcement or the regulatory filing, then there should be a positive association between either the number or value of purchase transactions (net of the number or value of sales transactions) and the forthcoming information releases. If trades are prompted by an insider’s desire to passively exploit foreknowledge of the content of either the earnings announcement or the regulatory filing, then there should be a negative association between either the number or value of purchase transactions (net of the number or value of sales transactions) and a prior information release. Thus, if insiders trade actively to profit from private information in a period, then the coefficient estimate on the abnormal returns at a disclosure (i.e., either the announcement of earnings, or the filing of a 10-K or 10-Q) that follows the period should be positive. If insiders trade passively to profit from private information in a period, then the coefficient estimate on the abnormal returns at a disclosure that precedes the period should be negative. Prior research reports mixed evidence on the association between insider trades before the earnings announcement and the announcement return. Accordingly we predict no association between the trade measures (i.e., FREQ and VALUE) and ARET_EA in Period 1. Because jeopardy is high before the announcement, we further predict no association between the trade measures and ARET_FD in Period 1. Given the lower 16 Specifically, 19 indicator variables, Dn for n ¼ 1; . . . ; 19, are created. Let n be the length of Period 2 in calendar days. For an observation for firm f in quarter q where no20, the indicator variable Dnfq is equal to 1; otherwise, it is zero. 17 Recall that for the years we study, the SEC requires 10-Qs to be filed no later than 45 days after the end of the quarter, while 10-Ks must be filed no later than 90 days after the end of the quarter. In the sample, 10-Qs, on average, are filed 43 days after the quarter’s end, while 10-Ks are filed, on average, 84 days after the fiscal yearend.

Table 3 Regressions of signed frequency and signed value of insider trade on signed event returnsa Period 1: before the earnings announcement

Period 2: after the earnings announcement and before the filing

Period 3: after the filing

1

All quarters (1a)

Quarter 4 (1c)

All quarters (2a)

All quarters (3a)

Panel A: Dependent variable is the signed frequency of trade, FREQp ARET_FD 0 +  0.006 0.014 ARET_EA 0   0.039 0.044 PRIOR_RETp 0.013 0.014 ln(MV) 0.022 0.023 BM 0.017 0.018 Firm-quarters 104,687 78,621 0.004 0.004 R2

0.038 0.006 0.019 0.017 0.015 26,066 0.003

0.579 0.545 0.562 0.833 0.824 0.565 2.181 2.152 2.392 0.523 0.640 0.162 0.392 0.333 0.598 0.175 0.248 0.062 0.298 0.291 0.330 0.159 0.189 0.050 0.053 0.080 0.005 0.041 0.0433 0.039 105,428 79,191 26,237 105,481 78,858 26,623 0.036 0.035 0.043 0.022 0.024 0.009

Panel B: Dependent variable is the signed value of trade, VALUEp ARET_FD 0 +  0.018 0.013 ARET_EA 0   0.008 0.016 PRIOR_RETp 0.009 0.009 ln(MV) 0.011 0.010 BM 0.004 0.007 Firm-quarters 106,088 79,668 0.002 0.002 R2

0.035 0.031 0.010 0.013 0.004 26,420 0.002

0.290 0.201 0.266 0.602 0.470 0.325 1.389 1.243 1.828 0.412 0.482 0.072 0.276 0.248 0.425 0.158 0.240 0.052 0.368 0.314 0.542 0.241 0.297 0.085 0.136 0.100 0.265 0.083 0.120 0.013 106,673 80,107 26,566 107,341 80,474 26,867 0.017 0.016 0.025 0.010 0.012 0.003

2

3

Quarters 1–3 (1b)

Quarters 1–3 (2b)

Quarter 4 (2c)

Quarters 1–3 (3b)

Quarter 4 (3c)

a For the regressions in Panel A, the dependent variable is FREQp for the regressions corresponding to Period p; for the regressions in Panel B, the dependent variable is VALUEp for the regressions corresponding to Period p. All variables are as defined in Tables 1 and 2, except that ln(MV) is the natural logarithm of MV. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Cook’s (1977) distance statistic is used to eliminate influential observations. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

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Predicted coefficient sign by period

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Specification

17

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jeopardy insiders face for active trade after the earnings announcement, we predict (i) positive associations between the trade measures and ARET_FD in Period 2, (ii) negative associations between the trade measures and ARET_EA in Period 2, and (iii) negative associations between the trade measures and both ARET_EA and ARET_FD in Period 3. 3.2. Active and passive trading within Periods 1, 2, and 3 3.2.1. Main tests The first three columns of Table 3 lay out the predicted signs on the event return coefficient estimates that follow from the discussion above for each of the three periods. In Table 3, specifications (1a)–(1c) correspond to Period 1, (2a)–(2c) to Period 2, and (3a)–(3c) to Period 3. Thus, the dependent variable is FREQ1 in Panel A and VALUE1 in Panel B in specifications (1a)–(1c); it is FREQ2 in Panel A and VALUE2 in Panel B in specifications (2a)–(2c); and the dependent variable is FREQ3 in Panel A and VALUE3 in Panel B in specifications (3a)–(3c). In the (a) specifications, results are presented for all quarters pooled. In the (b) and (c) specifications, results are reported for the interim quarters and the fourth quarters separately. Regarding Period 1 (i.e., the period before the earnings announcement), Table 3 indicates that associations between insider trades and the forthcoming announcement and filing are insignificant, with the exception of a positive coefficient estimate on ARET_EA in specifications (1a) and (1b) of Panel A, where the coefficient estimate is significantly positive at the 5% level using a two-tailed test. Thus, there is some evidence that insiders buy (sell) more often before good (bad) news earnings announcements in quarters 1–3, but no evidence of this in quarter 4 and no evidence that the value of shares traded varies with the abnormal return at the announcement. The lack of any significant association with ARET_FD in Period 1 suggests that the value of insiders’ trades in Period 1 is not increased by the desire to profit from foreknowledge information in the filing not conveyed by the earnings announcement.18 The results for Period 2 are sharply different. The pattern of insider trades in this period suggests that insiders use their private information to derive both active and passive profits. Consistent with the realization of active profits, insider trades, measured in Panel A by the signed frequency of trade, is positively associated at better than the 5% level with the abnormal return of the forthcoming filing. Note from Panel A that the coefficient estimates for Period 2 on ARET_FD in specifications (2a), (2b), and (2c) are more than 10 times the coefficient on ARET_EA in specifications (1a), (1b), and (1c), which implies that for a given abnormal return at the disclosure, the effect on insider trades is more than 10 times greater in Period 2 compared to Period 1. The significantly positive coefficient estimate on ARET_FD in Period 2 implies that insiders buy before filings interpreted by the market as good news and sell before filings interpreted as bad news.19 We turn next to Panel B, where the dependent variable is the signed value of shares traded. When all quarters are pooled, the coefficient estimate on ARET_FD is significantly 18

Coefficient estimates and standard errors are very similar when market-adjusted returns are replaced with raw returns in this and subsequent regressions. 19 The positive coefficient on ARET_FD in Period 2 is not a result of insiders’ trading on the post earnings announcement drift because the coefficient on ARET_FD is unaffected by the inclusion of the earnings surprise in the immediately preceding earnings announcement, defined as the seasonal difference in earnings per share scaled by stock price at the end of fiscal quarter  4 relative to the observation quarter (results not reported).

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19

positive at the 5% level using a two-tailed test. Thus, there is evidence that the value of shares purchased by insiders is higher before a good news filing (and lower before a bad news filing). When the observations for quarters 1–3 and quarter 4 are analyzed separately, the sign and magnitude of the coefficient estimates on ARET_FD is similar, but the relationship is insignificant. Consistent with the realization of passive profits, insider trades, measured either by the signed frequency or signed value of trade, is negatively associated at the 1% level with the abnormal return at the preceding announcement. The significantly negative coefficient estimate on ARET_EA in Period 2 is consistent with the notion that insiders sell after announcements interpreted by the market as good news and buy after announcements interpreted as bad news.20 For Period 3, the coefficient estimates on the abnormal returns at the preceding filing and announcement both are significantly negative (with the exception of ARET_EA for quarter 4 analyzed separately), which is consistent with trade in Period 3 being driven in part by insiders’ passive use of private information. Such an association with past news also could arise from a contrarian trading strategy under which insiders condition their trades on past stock price movements so that they buy after bad news events and sell after good news events. We control partially for the possibility of contrarian trading by including in the regressions PRIOR_RETp, the return over the six months before the beginning of Period p. Despite this, contrarian trading with respect to the past filing or earnings announcement cannot be ruled out. The coefficient estimates on ARET_EA and ARET_FD in specification (2a) of Table 3 have an economic interpretation. For instance, the coefficient estimate of 0.579 on ARET_FD in Panel A specification (2a) implies that an abnormal return of 10% at the filing increases the net number of insider purchases in Period 2 by an average of 0.0579. This coefficient implies that, if 17 (i.e., 1/0.0579) firms experience abnormal returns at the filing of 10%, at one of those firms there would be one more insider purchase (or one less sale) transaction than would be expected if those firms had experienced returns of 0% at the filing. This effect should be interpreted in light of the rarity of insider trades—in our data, insider trade occurs in only 53% of firm-quarters. Furthermore, trades are spread over the 90 days of the quarter, while Period 2 is 20 days at most. Turning to the coefficient estimate of 0.290 in Panel B specification (2a), an abnormal return of 10% at the filing implies that the value of stock purchased by insiders in that firm-quarter increases by $29,000, on average. From Table 2, the mean value of the net stock trades by firm insiders in Period 2 over all firm quarters is $863,800 sold. This implies that a 10% return at the filing is associated with an increase of 3.4% in the value of stock purchased by insiders. Thus, the associations documented in Table 3, while highly significant in a statistical sense, are less significant from an economic standpoint. A potential concern with these findings is that insiders might not learn earnings precisely until shortly before the earnings announcement, so that insiders are not informed about earnings until the latter part of Period 1. In contrast, at the start of Period 2, insiders likely know how the earnings figure was achieved although this information may not be publicly revealed until the filing date. Hence, insiders may know at the beginning of Period 2 20

To alleviate the concern of cross-sectional dependence of insider trades, we also run a Fama-MacBeth regression of specification (2a) of Table 3 by calendar year and draw similar inferences.

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whether there is likely some further reaction by investors around the filing date. To address this concern, we reperform the analysis in specifications (1a), (1b), (1c), (2a), (2b), and (2c) of Table 3 after shortening the periods over which we examine trades from 20 days to 10 days. The results reported in Table 3 are qualitatively unchanged when we focus on just the 10 days before and the 10 days after the Announcement Window. Also in Table 3, the coefficient estimates on the PRIOR_RETp and lnðMVÞ are consistent with prior findings in all periods. Consistent with Rozeff and Zaman (1998), the coefficient estimate on BM is positive in Panel A where the dependent variable is FREQp. In contrast, in Panel B, wherever the coefficient estimate is significantly different from zero, it is negative so the value of insider net purchases decreases in the book-to-market ratio. We note that Rozeff and Zaman’s (1998) evidence is based on the proportion of trades that are purchases, not on the value of trades. 3.2.2. Additional tests The generally insignificant relationships in Period 1 between insider trades and the earnings announcement documented in Table 3 may be due in part to the paucity of insider trades in Period 1. As noted earlier, 7.8% of all trades occur in Period 1 as compared to 37.1% and 24.6% of trades in Periods 2 and 3, respectively.21 Across firm-quarters, the mean values of total insider trades (i.e., the sum of insider stock purchases and sales) in Periods 1, 2, and 3 are $95,000, $741,000, and $388,000, respectively. One cause of the lower frequency and value of trades in Period 1 may be the higher jeopardy that attaches to trades in this period. However, another explanation for fewer insider trades in Period 1 than in other periods may be that all traders avoid trade in Period 1. To rule out alternative explanations for the relatively low amount of insider trades in Period 1, we consider reasons why particular groups of traders may avoid trade in Period 1 and trace out the implications. Applying the logic in Foster and Viswanathan’s (1990) model of variation in interday trading volume, Chae (2005) suggests that uninformed traders avoid the period before the earnings announcement because informed traders, who have advance knowledge of the announcement, seek to profit from their private information at the expense of uninformed traders. Anticipating a decrease in uninformed trade, market makers widen the bid–ask spread and the sensitivity of price to order flow increases so trading costs are higher. Despite the heightened price sensitivity, which is caused by the anticipation of informed trades, informed traders nevertheless can profit from their private information about earnings by trading before earnings are announced at the expense of uninformed traders who do not have discretion over the timing of their trades. Thus, if insiders were informed (and ignoring, temporarily, the effect of jeopardy on the pattern of insider trades), we might expect insiders to trade more intensely before the earnings are released than afterwards. This is because some of the insiders’ information is dissipated by the earnings announcement. On the other hand, if insiders were uninformed and traded only for liquidity reasons they might choose to trade after the earnings announcement when trading costs are lower for the same reasons and in the same proportion as traders in general. In this case, we might expect to see fewer insider trades in Period 1 and more insider trades in Period 2, but in proportion to total trading volume in Periods 1 and 2, respectively. 21

Park et al. (1995), who study insider trades drawn from 1986 and 1987, document a significant decrease in insider trading in the 10 days prior to an annual earnings announcements relative to the preceding 140 days.

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21

To summarize, we see no reason (other than jeopardy) for insider trading to be disproportionately greater in Period 2 than in Period 1. For Periods 1, 2, and 3, the mean values of insider trades in the firm-quarter-period as a fraction of all trade in that firmquarter-period are 0.44%, 1.67% and 1.19%, respectively. Thus, the fraction of trade that is due to insiders in Period 3 is more than twice the fraction in Period 1. The fraction of trade that is due to insiders in Period 2 is almost four times the fraction in Period 1. These results are more consistent with the jeopardy hypothesis than the alternative explanations described above. We use ARET_FD as a proxy for the private information contained in the SEC filing that insiders use for their stock trades in Period 2. However, formal models, including Huddart et al. (2001), predict that disclosures of insider trades that precede news releases preempt part of the information content of forthcoming news releases. Empirical evidence (including Damodaran and Liu, 1993; Udpa, 1996; and Roulstone, 2004) is consistent with this prediction. Preemption, by reducing the magnitude of abnormal return at the release, weakens the associations we seek to document. Despite this, we document a highly significant correlation between trade in Period 2 and the abnormal return at the filing. To check the potential impact of preemption on the association between insider trades and ARET_FD in Period 2, we rerun the regression specification (2a) of Table 3 on (i) the subset of observations that excludes firm-quarters for which the trade disclosure date is after the filing date for more than half of the trades in the quarter and (ii) the complementary subset of observations that excludes firm-quarters for which the trade disclosure date is before the filing date for more than half of the trades in the quarter. In the period we study, insider trades must be disclosed by the 10th day of the calendar month following the month of the trade. Although some preemption may be due to insider trades not disclosed before the news is released, preemption is likely to be stronger when insider trades are disclosed before the news is released. Thus, the above sample partitioning allows us to assess the impact of preemption on our inferences. Results reported in Table 4 reveal that coefficient estimates and significance levels computed for the subsets are very similar to each other and to the corresponding results reported in Table 3. We conclude that the location of the trade disclosure date in relation to the filing date does not appear to affect the relation between insider trades and the information in the filing. We argue that the positive coefficient on ARET_FD in specification (2a) of Table 3 reflects insiders’ trading response to the information in the SEC filing. However, because insider trades in Period 2 precede the measurement of ARET_FD in calendar time, it is possible that the positive coefficient on ARET_FD represents the market’s reaction to the insider trades in Period 2. To rule out this reverse causality, we estimate the regression specification (2a) using a two-stage least-squares regression approach. Bagnoli et al. (2002) find that the market reacts negatively if a firm does not report earnings on the expected earnings announcement date. Moreover, the market reaction at the actual earnings announcement date is more negative the later firms report their earnings, which they summarize as ‘‘a day late, a penny short’’. We conjecture the results in Bagnoli et al. should apply also to SEC filings. Accordingly, we use as an instrumental variable for ARET_FD a proxy for the lateness of the filing date relative to the expected filing date. A firm’s actual filing date is defined relative to the fiscal quarter end. Each firm’s expected filing date is the median filing date of the firm in our sample. Because firms

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Table 4 Regressions of signed frequency and signed value of insider trade on signed event returns in Period 2— observations partitioned by whether the trade was disclosed before the filing datesa Specification

Predicted sign

Trade disclosed before the filing (1)

Trade disclosed after the filing (2)

Panel A: Dependent variable is the signed frequency of trade, FREQ2 ARET_FD + 0.383 ARET_EA  1.402 PRIOR_RET2 0.264 ln(MV) 0.158 BM 0.007 Firm-quarters 88,361 0.024 R2

0.348 1.261 0.224 0.199 0.038 91,829 0.024

Panel B: Dependent variable is the signed value of trade, VALUE2 ARET_FD + 0.198 ARET_EA  0.991 PRIOR_RET2 0.183 ln(MV) 0.246 BM 0.113 Firm-quarters 88,928 0.014 R2

0.147 0.724 0.154 0.202 0.059 92,548 0.011

a In Panel A, the dependent variable is FREQ2. In Panel B, the dependent variable is VALUE2. The regression specification (2a) of Table 3 is re-estimated on (i) the subset of observations that excludes firm-quarters for which the trade disclosure date is after the filing date for more than half of the trades in the quarter and (ii) the subset of observations that excludes firm-quarters for which the trade disclosure date is before the filing date for more than half of the trades in the quarter. Firm-quarters in which there is no insider trade are included in both specifications. Firm-quarters where there are multiple trades are classified according to whether the majority of the trades are disclosed before or after the filing data. Cook’s (1977) distance statistic is used to eliminate influential observations. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

are allowed to have a longer time to file their annual filings than quarterly filings, the expected filing date is allowed to differ for the annual and quarterly filings. The instrumental variable is the difference between the actual filing date and the expected filing date. Consistent with Bagnoli et al., the instrument variable is significantly different from zero and negatively associated with ARET_FD in the first stage regression. In addition, we argue that the instrument should not be correlated with the error term in the regression specification (2a) because insiders should always trade on the filing information in Period 2 regardless of whether the SEC filing will be on time or late. Therefore, the instrument satisfies the two necessary conditions for being a valid instrument. Using the two-stage least-squares regression approach, we find the coefficients on ARET_FD for specification (2a) are larger than those in Table 3 and significant at the 1% two-tailed level (results not tabulated). The larger coefficients on ARET_FD are reasonable because we expect a portion of insiders’ private information to leak into stock prices before the SEC filing date, thus creating a downward bias in the OLS regression coefficients. The coefficients on the other variables have the same signs and similar significance levels to those reported in Table 3.

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3.3. Differential implications of trade on price reactions across periods If jeopardy is high in Period 1, then what type of trades take place in Period 1? One might naively suppose that firm policies that establish approved trading windows also prohibit trade by insiders in Period 1, yet the data indicate that in 9% of firm-quarters insiders trade in Period 1. Some firms do not have trading policies. Some firms that do have policies permit, but discourage, trade outside approved trading windows—see Jagolinzer and Roulstone (2004, p. 4) for an example. Trade in Period 1 may be desirable when the insider has a motive for trade (e.g., a desire for liquidity or diversification) other than the desire to profit from foreknowledge of the forthcoming earnings announcement. However, if he intends to buy (sell) and also believes the return at the earnings announcement will be positive (negative), jeopardy may prevent him from trading in Period 1. If the insider intends to buy (sell) but instead believes the return at the earnings announcement will be negative (positive), he benefits by delaying his trade until Period 2. Finally, assuming jeopardy is lower when subsequent stock price movement does not result in a profit to the insider, an insider may trade in Period 1 when he anticipates a price reaction to the forthcoming earnings announcement that is close to zero. Hence, trade frequency and value should be greater in Period 1 when the abnormal return at the earnings announcement, ARET_EA, is near zero. Since an insider also may be at risk from trading in Period 1 when the return at the filing is extreme, it follows that trade frequency and value are greater in Period 1 when the abnormal return at the filing date, ARET_FD, is near zero; however, because the time between the trade and the price reaction is greater, the effect should be weaker because establishing that trade was improper is harder to prove when the trading event and the price movement are separated by a greater interval of time. In Period 2, the opposite implication applies: given jeopardy is low, it follows that informed trade frequency and value are greater in Period 2 when the abnormal return at the forthcoming filing is extreme. Likewise, given jeopardy is lower in Period 2, trades motivated by liquidity or diversification needs are less likely to be impeded by the potential for an extreme return at the filing than in Period 1. Also, a consequence of avoiding trade in Period 1 when the magnitude of abnormal returns at the announcement is large may be to shift trades to Period 2. Hence, trade value and frequency should be greater in Period 2 when the abnormal return at the preceding announcement is extreme. Finally, to the extent insiders delay trades into Period 3, trade value and frequency in Period 3 should be greater when the returns at the filing and announcement are extreme. The following tobit regressions offer evidence on the hypothesized link between trade frequency and value and the magnitude of the price reaction at the announcement and filing: SUM_FREQpfq ¼ b0 þ b1 absðARET_FDfq Þ þ b2 absðARET_EAfq Þ þ b3 absðPRIOR_RETpfq Þ þ b4 lnðMVfq Þ þ b5 BMfq þ fq

ð3Þ

and SUM_VALUEpfq ¼ b0 þ b1 absðARET_FDfq Þ þ b2 absðARET_EAfq Þ þ b3 absðPRIOR_RETpfq Þ þ b4 lnðMVfq Þ þ b5 BMfq þ fq .

ð4Þ

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In these regressions, SUM_FREQp is the number of insider stock transactions (both purchases and sales) in the period-firm-quarter; SUM_VALUEp, defined as the total value of insider stock transactions (both purchases and sales) in the period-firm-quarter; and abs(ARET_EA) and abs(ARET_FD) are the absolute values of ARET_EA and ARET_FD, respectively. Regressions control for calendar year quarter and fiscal quarter fixed effects. The foregoing discussion suggests that higher jeopardy in Period 1 implies negative association in Period 1 between the frequency and value of insider trades (respectively, SUM_FREQ1 and SUM_VALUE1) and the magnitudes of the abnormal returns at the announcement and the filing, after controlling for variation in firms’ prior returns, market capitalizations, and book-to-market ratios. Conversely, lower jeopardy implies a positive association in Periods 2 and 3 between the frequency and value of insider trades and the magnitudes of the abnormal returns at the announcement and the filing. Results in Table 5 are consistent with our predictions except that in Panel B, the sign on abs(ARET_FD) in Period 2 and on abs(ARET_EA) in Period 3 are insignificantly different. Overall, the results support the notion that insider trading frequency and value are lower in periods of high jeopardy when the forthcoming news is extreme. This suggests that insiders eschew some, but not all, trades in periods of high jeopardy. Specifically, insiders proceed with trades when they foresee zero or small price responses to forthcoming announcements and avoid trades when they foresee large price movements. Thus, insider trades shortly before an earnings announcement are, on average, an indication that the price reaction at the announcement and filing will be small. 3.4. Effects of news type and past trading on insider trades In this section, we examine two questions regarding determinants of insider trades in Period 2: whether good and bad news have differential effects on trade and whether past insider trading affects current insider trading. To conduct these analyses, the basic regression for Period 2 from Table 3 pooling across all quarters (i.e., specification (2a)) is revised to more precisely identify the relationship between insider trades and the forthcoming filing. Results are reported in Table 6. 3.4.1. News type In specification (1) of Table 6, the abnormal return variable is decomposed into three parts so that the effects of forthcoming good news and bad news at the filing on insider trades in anticipation of that news can be examined separately. ARET_FD is replaced by: IND_ARET_FD, which is an indicator variable equal to 1 if the abnormal return at the filing is positive and zero otherwise; POS_ARET_FD, which is defined to be max(0,ARET_FD); and NEG_ARET_FD, which is defined to be min(0,ARET_FD). In Panel A, the coefficient on IND_ARET_FD, reflecting an intercept shift in FREQ2 across positive and negative returns, is positive and significant, implying that insiders buy more (or sell less) shares before good news disclosures than bad news disclosures. The coefficient estimate on POS_ARET_FD is significantly different from zero, indicating that more positive news at the filing implies more insider purchases. While the coefficient estimate on NEG_ARET_FD is not significantly different from zero, neither is it significantly different from the coefficient estimate on POS_ARET_FD. This indicates that the marginal effect of a more positive return at the filing is indistinguishable from the

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Table 5 Tobit regressions of unsigned frequency and unsigned value of insider trade on absolute event returnsa Specification

Predicated coefficient sign by period 1

2

3

Period 1: before the earnings announcement (1a)

Period 2: after the earnings announcement and before the filing (2a)

Period 3: after the filing (3a)

Panel A: Dependent variable is the absolute frequency of trade, SUM_FREQp 2.759 abs(ARET_FD)  + + 3.580 abs(ARET_EA)  + + 5.104 10.090 abs(PRIOR_RETp) 0.369 1.099 ln(MV) 0.285 1.327 BM 0.287 0.983 Constant 13.666 30.402 Firm-quarters 106,291 106,842

5.431 3.118 0.651 0.632 1.053 11.042 107,418

Panel B: Dependent variable is the absolute value of trade, SUM_VALUEp 0.382 abs(ARET_FD)  + + 3.906 abs(ARET_EA)  + + 9.252 28.260 abs(PRIOR_RETp) 0.132 3.215 ln(MV) 0.553 4.832 BM 0.308 2.182 Constant 23.153 130.018 Firm-quarters 106,291 106,842

31.386 19.049 2.747 3.806 5.413 88.082 107,418

a For the regressions in Panel A, the dependent variable is SUM_FREQp, defined as the number of insider stock transactions (both purchases and sales) in the period-firm-quarter; for the regressions in Panel B, the dependent variable is SUM_VALUEp, defined as the total value of insider stock transactions (both purchases and sales) in the period-firm-quarter. The absolute values of ARET_FD, ARET_EA, and PRIOR_RETp, are abs(ARET_ FD), abs(ARET_EA), and abs(PRIOR_RETp), respectively. Other variables are as defined in Table 2, except that ln(MV) is the natural logarithm of MV. Regressions control for calendar year quarter and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

marginal effect of a more negative return. In other words, the associations between insider trading and the subsequent filing return magnitude are comparable for good and bad news. In Panel B, the coefficient estimate on NEG_ARET_FD is significantly different from 0 at the 10% level (two-tailed test), but indistinguishable from the coefficient estimate on POS_ARET_FD. We conclude that there is no evidence that foreknowledge of good news has a larger or smaller marginal effect on insider trading than foreknowledge of bad news. 3.4.2. Past trading The next question we address is whether past insider trades affect current insider trades. Autocorrelation in insider trading may be induced by the short swing profit recovery rules of Section 16(b) of the Securities Exchange Act of 1934, which requires an insider to disgorge any profits received from any purchase and sale transactions that occur within the same six-month period. If an insider has purchased stock within the past six months and the price has increased, then he may purchase more stock without violating the rule, but a sale would trigger disgorgement. Another possibility is that insiders may trade repeatedly on the same long-lived private information as outlined by Huddart et al. (2001). To examine this potential serial dependence, we include in the regression LAG_FREQ. This

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Table 6 Regression of insider trade frequency and value in Period 2 on the abnormal return at the filing interacted with past insider trade frequencya Specification

Predicted sign

(1)

(2)

Panel A: Dependent variable is the signed frequency of trade, FREQ2 IND_ARET_FD + 0.041 POS_ARET_FD + 0.401 NEG_ARET_FD + 0.302 LAG_FREQ + ARET_FDLAG_FREQ + ARET_FD + ARET_EA  2.184 ARET_EALAG_FREQ + PRIOR_RET 0.398 ln(MV) 0.299 BM 0.049 Firm-quarters 105,425 0.036 R2

0.077 0.196 0.574 2.133 0.308 0.308 0.211 0.067 90,382 0.078

Panel B: Dependent variable is the signed value of trade, VALUE2 IND_ARET_FD + POS_ARET_FD + NEG_ARET_FD + LAG_VALUE + ARET_FDLAG_VALUE + ARET_FD + ARET_EA  ARET_EALAG_VALUE + PRIOR_RET ln(MV) BM Firm-quarters R2

0.062 0.321 0.567 1.267 0.110 0.229 0.314 0.118 91,576 0.048

0.009 0.259 0.435

1.387 0.276 0.365 0.135 106,674 0.017

a

In Panel A, the dependent variable is FREQ2. In Panel B, the dependent variable is VALUE2. Variables are defined as follows: IND_ARET_FD is an indicator variable that is 1 if ARET_FD40, and 0 otherwise. POS_ARET_FD is defined as max(0,ARET_FD) and NEG_ARET_FD is defined as min(0, ARET_FD). LAG_FREQ is computed like FREQp, except that the period over which LAG_FREQ is computed begins on the day after the earnings announcement date in the previous quarter and ends on the day before the earnings announcement date for the current quarter. LAG_VALUE is computed analogously. Other variables are defined in Tables 1 and 2, except that ln(MV) is the natural logarithm of MV. Cook’s (1977) distance statistic is used to eliminate influential observations. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two tests, are denoted by  ,  , and  , respectively.

variable is computed like FREQp, except that the period over which LAG_FREQ is computed begins on the day after the earnings announcement date in the previous quarter and ends on the day before the earnings announcement date for the current quarter. LAG_VALUE is defined analogously. To examine how the short swing rule affects the intensity of passive and active insider trades, we examine the coefficient estimates on the interactions of ARET_EA and ARET_FD with LAG_FREQ or LAG_VALUE. The short swing rule leads us to predict a positive coefficient on the interaction terms.

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As predicted, the coefficient estimates on LAG_FREQ, ARET_FD*LAG_FREQ, ARET_EA*LAG_FREQ, LAG_VALUE, ARET_FD*LAG_VALUE, and ARET_ EA*LAG_VALUE are significantly positive in specification (2) of Table 6. Thus, insider purchases (sales) in the past quarter imply further purchases (sales) in the current quarter. Moreover, insider purchases (sales) in the current quarter for a given abnormal return at the filing or earnings announcement are increasing (decreasing) in the net number of purchases made in the prior quarter. Also notable is that the R2 of the regressions are more than double the values reported in specification (2a) of Table 3, suggesting that past insider trades are important predictors of current insider trades. Nearly identical results obtain if the period over which LAG_FREQ and LAG_VALUE are computed by aggregating transactions in the previous two quarters (i.e., the aggregation period begins on the day after the earnings announcement date in the second previous quarter and end on the day before the earnings announcement date for the current quarter). 3.5. Distribution of insider trades between the announcement and the filing We earlier noted that insider trades are distributed unevenly across Periods 1, 2, and 3. We now examine whether insider trades are distributed evenly over the interval between the announcement and the filing and how the intensity with which insiders make use of their private information varies over this period. Define Period 20 to be the days between the Announcement Window and the Filing Window. In general, two countervailing factors may affect insiders’ trades in relation to a forthcoming disclosure. First, as the disclosure approaches, the precision of insiders’ information about the content of the disclosure increases. An insider therefore may be expected to trade most intensely on his private information right before its release. If, as seems plausible, jeopardy increases as the time between the trade and the event becomes shorter, then the insider may refrain from trade immediately before the disclosure.22 Which of these two effects dominates is an empirical question, but we note that after the earnings announcement the insider is likely to have precise information about the content of the filing, so that the precision of the insiders’ information with respect to the filing may not increase much over the period. Jeopardy, on the other hand, would seem to increase as the filing date approaches. This leads us to conjecture that insider trades are concentrated early in Period 20 and that the intensity with which insiders trade on private information about the disclosure is highest early in Period 20 . Turning to the data, we note first that insider trades within Period 20 are concentrated early in the period, consistent with our conjecture. Recall that the median number of days between the end of the Announcement Window and the beginning of the Filing Window, in the case of an interim quarterly announcement, is 17 days. Over 75% of the trading activity in Period 20 occurs in the first 10 days of this period. There is a similar concentration of insider trades in the first part of the period following an annual earnings announcement: the median number of days between the end of the Announcement 22

The regulatory history of Rule 16b-3(e) supports the notion that the SEC supposes the informational advantage of insiders is low in the 10 days following an earnings announcement: Rule 16b-3(e) (since revised), stipulated that to avoid liability under y16(b) when exercising SARs, insiders should exercise them ‘‘during the period beginning on the third business day following the date of release of the financial data specified in paragraph (e)(1)(ii) of this section [i.e., quarterly and annual summary statements of sales and earnings] and ending on the twelfth business day following such date’’ (17 CFR 240.16b-3 1996). We thank Mark Vargus for this observation.

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Window and the beginning of the Filing Window is 43 days. Over 70% of all trading activity in Period 20 occurs in the first 20 days of this period. Across firm-quarters, the mean values of total insider trades (i.e., the sum of insider stock purchases and sales) in the first and second halves of Period 20 are $629,000 and $292,000, respectively. While lower jeopardy may drive the higher mean value of insider trades in the first half of Period 20 , it could also be that all traders avoid trade in second half of Period 20 . To address this possibility, we express insider trades in each half of Period 20 in each firm-quarter as a fraction of all stock trades in that half of Period 20 for the firmquarter. The mean values of insider trades as a fraction of all trade in the first and second halves of Period 20 are 1.06% and 0.80%, respectively. Thus, relative to shares traded by all market participants, trade by insiders is disproportionately concentrated in the first half of Period 20 , which is consistent with the explanation that lower jeopardy in the first half of Period 20 serves to concentrate insider trading there. Panel A of Table 7 reports the results of regressions identical to those reported in specification (2a) of Table 3 except that the dependent variable (either FREQ or VALUE) is redefined. In specification (1), the dependent variable is measured over the first half of Period 20 . In specification (2), the dependent variable is measured over the second half of Period 20 . That is, for each firm-quarter, Period 20 is divided into two sub-periods of equal

Table 7 Regression of signed insider trade frequency and value in the first and second halves of Period 20 on the announcement and filing date abnormal returnsa Specification

(1) First half of Period 20

(2) Second half of Period 20

Panel A: Dependent variable is the half-period signed frequency of trade, FREQ20 ARET_FD 0.368 0.187  ARET_EA 1.620 0.621 PRIOR_RET2 0.257 0.112  ln(MV) 0.237 0.106 BM 0.017 0.038 Firm-quarters 103,562 103,153 0.032 0.019 R2 Panel B: Dependent variable is the half-period signed value of trade, VALUE20 ARET_FD 0.267 ARET_EA 0.981 PRIOR_RET2 0.197 ln(MV) 0.272 BM 0.108 Firm-quarters 104,868 0.019 R2

0.049 0.484 0.101 0.180 0.074 105,138 0.011

a Period 20 is the period from the end of the Announcement Window to the beginning of the Filing Window. Period 20 is divided into two sub-periods of equal length. In specifications (1) and (2), the dependent variables FREQ20 (Panel A) and VALUE20 (Panel B) are computed like FREQ2 and VALUE2 in earlier tables except that they are based on trades occurring in the first and second halves of Period 20 , respectively. Other variables are defined in Tables 1 and 2, except that ln(MV) is the natural logarithm of MV. Cook’s (1977) distance statistic is used to eliminate influential observations. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

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duration. The dependent variables for each sub-period are recomputed over each subperiod, and regression (2a) of Table 3 is rerun for each sub-period. The signs and significance levels of the coefficient estimates in Table 7 are consistent with the corresponding regressions in Table 3 except that the coefficient estimate on ARET_FD in Panel B for the latter part of Period 20 is indistinguishable from zero. Notably, the coefficient estimates on ARET_FD are greater for the first half regression than for the second half regression, for both FREQ and VALUE. Again, this is consistent with the conjecture that insider trading intensity is greater when jeopardy is lower. In Panels A and B, the coefficient estimates on ARET_EA for the first half of Period 20 are more than twice the corresponding estimate for the second half, consistent with the interpretation that some insiders postponed a sale (purchase) until just after the earnings announcement knowing that the earnings announcement contained good (bad) news. Alternatively, if insiders are contrarian, then the evidence indicates that the sensitivity of insider trading to the earnings window returns attenuates the longer the time since the earnings announcement. 4. Litigation risk In this section, we address two questions: First, how does litigation risk affect the timing of insider trades over a fiscal quarter? Second, how does litigation risk affect the intensity (as measured by either FREQ or VALUE) with which insiders trade on foreknowledge of 10-K or 10-Q filings? To answer these questions, we require a measure of the cross-firm variation in litigation risk, which we develop next. 4.1. Measuring litigation risk To assess whether and how insider trades vary in response to firm-specific litigation risk, we relate insider trades to an ex ante probability estimate of likelihood a firm will be the subject of 10b-5 litigation in the coming year. This probability is the predicted probability derived from a first-stage logit regression in which the dependent variable is an indicator variable that is 1 if the Securities Class Action Clearinghouse (http://securities.stanford. edu) reports the firm to have been sued in a given year, and the regressors are characteristics of the firm.23 The construction of these estimates closely follows the methodology described in Johnson et al. (2000). There are 1,062 firm-years in which securities class action lawsuits are filed over the 60,044 available firm-years in the period 1995–2001. The fitted predicted probability from the prior year is an ex ante estimate of the probability that the firm will be the subject of 10b-5 litigation in the current year. This estimate ranges from less than 0.01% to over 99%. Across the years for which the estimate is available, its mean and median values are 23

Specifically, the explanatory variables are the market value of common equity measured at the end of the year, firm beta relative to an equal-weighted market index, the stock return over the year, the minimum stock return over any consecutive 20-day trading period in the year, the skewness of raw daily returns for the year, stock turnover (measured as 1  ½1  TURNn ), where n is the number of trading days in the year and TURN is average daily trading volume divided by shares outstanding), and industry indicator variables for biotech, computer hardware, electronics, retailers, and computer software (SIC codes in the ranges of 2833–2836, 3570–3577, 3600–3674, 5200–5961, and 7371–7379, respectively). We are grateful to Karen Nelson for providing us with these data.

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2.2% and 0.6%, respectively, while the 75th percentile is 2.0%. To examine whether insider trades are associated with litigation risk, we partition sample observations into two groups, depending on whether the estimated risk is above the 75th percentile. We define the indicator variable HIGH_LITif to be 1 if the ex ante risk of litigation is more than 2.0% for firm f in the year in which the quarter q earnings announcement falls. HIGH_LITif is 0 otherwise. 4.2. Timing of trade In this section, we examine how litigation risk, which is a component of jeopardy, affects the timing of insider trades within a quarter. We first construct measures of the insider trades that takes place in each firm-quarter-period as a fraction of all the insider trades that take place in that firm-quarter. We define F_FREQp to be the sum of insider purchases and sales frequencies over Period p divided by the sum of insider purchases and sales frequencies between the two earnings announcement dates in which Period p falls. F_VALUEp is defined similarly using dollar values. Firm quarters with zero insider trades between the two earnings announcement dates or missing HIGH_LIT are excluded. Next, we examine whether the fraction of insider trades in each period is greater or lower when litigation risk is high, by regressing F_FREQp and F_VALUEp, respectively, on HIGH_LIT for p 2 f1; 2; 3g. Table 8 presents the results of these regressions.24 Note that, for both dependent variables, the coefficient estimates on HIGH_LIT are significantly negative in Period 1. This is evidence that insiders at high litigation risk firms undertake a smaller fraction their trades in the period before the earnings announcement than insiders at low litigation risk firms. Conversely, in Period 2, the coefficient estimate on HIGH_LIT is strongly positive, which indicates that insiders at high litigation risk firms undertake a higher fraction of their total trades in Period 2. The coefficient estimate on HIGH_LIT is insignificant in Period 3. The coefficient estimate on HIGH_LIT is larger in Period 2 than in Period 3, which is consistent with the interpretation that, at high litigation risk firms, insiders concentrate their trades more in Period 2 where jeopardy is plausibly least.25 4.3. Intensity of trade The last question we address is how litigation risk affects the intensity with which insiders trade on foreknowledge of 10-K or 10-Q filings in Period 2. To study the role of firm-specific litigation risk on insider trades, we include three additional regressors in the basic regression developed earlier and reported in specifications (2a), (2b) and (2c) of Table 3: HIGH_LIT, and the interactions of HIGH_LIT with ARET_FD, ARET_EA. Including HIGH_LIT and its interactions should not alter the basic relationship between insider trades and either past or forthcoming disclosures, so the sign of the coefficient estimate on ARET_FD should be positive, while the sign of the coefficient 24 To ensure the results in Table 8 are not merely a size effect, we include ln(MV) as a control and obtain similar inferences. 25 We also regress the sum of insider purchases and sales frequencies over the first half of Period 20 divided by the sum of all insider purchases and sales frequencies over Period 20 on HIGH_LIT and find a significantly positive coefficient on HIGH_LIT. Thus, insiders at high litigation risk firms execute a greater portion of all their trades in Period 20 immediately after the earnings announcement than insiders at low risk firms. This result is consistent with the argument above that litigation risk is lower early in Period 20 than later in the period.

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Table 8 Tobit regression of the fraction of insider trade occurring in the period on a litigation risk indicator variablea Specification

(1) Period 1: before the earnings announcement

(2) Period 2: between the announcement and filing

(3) Period 3: after the filing

Panel A: Dependent variable is the fraction of insider trades by frequency, F_FREQp 0.126 HIGH_LIT 0.215 Constant 1.177 0.124 Firm-quarters 45,605 45,041

0.003 0.162 45,041

Panel B: Dependent variable is the fraction of insider trades by value, F_VALUEp 0.129 HIGH_LIT 0.217 Constant 1.188 0.121 Firm-quarters 45,605 45,041

0.006 0.179 45,041

a Dependent variables are defined as follows. F_FREQp is the sum of insider purchases and sales frequencies over Period p divided by the sum of insider purchases and sales frequencies between the two earnings announcement dates in which Period p falls. F_VALUEp is defined similarly using dollar values. HIGH_LITfq is an indicator variable that is 1 if the risk of litigation is more than 2.0% for firm f in the year in which quarter q’s earnings announcement falls and zero otherwise. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

estimate on ARET_EA should be negative. To the extent that insider trades at high litigation risk firms are shifted from periods of high jeopardy to periods of low jeopardy, we expect a stronger negative correlation between insider trades in Period 2 and the information that is made public before the Period 2. This is an implication of the hypothesis that at high litigation risk firms, insiders are less likely to engage in active trading before earnings announcements—instead, they engage in passive trading after earnings announcements. For this reason, we predict a negative sign on the coefficient estimates of ARET_EA*HIGH_LIT. As we explain next, there are counteracting forces at work on the other variables. Since the relative importance of these forces is unknown we make no predictions on the signs of the coefficients on either HIGH_LIT or ARET_FD*HIGH_LIT. Insiders at firms at high risk for class-action lawsuits have at least many reasons as insiders at other firms to avoid trading on private information when there is an established legal jeopardy. This implies that insiders at firms where litigation risk is high should be expected to avoid certain trades (like trades that actively exploit foreknowledge of earnings announcements or takeovers) because such trades clearly are proscribed. Whether insiders at high litigation-risk firms are less likely to trade on the foreknowledge of the forthcoming 10-K or 10-Q disclosure is less clear since there may be no jeopardy associated with such trades. Therefore, we make no prediction on the coefficient estimate on ARET_FD*HIGH_LIT in Period 2. We are also hesitant to predict the sign of the coefficient estimate on HIGH_LIT because on the one hand, we might expect insiders at high litigation risk firms to trade less overall. On the other hand, Table 8 indicates more of the trades at high litigation risk firms occur in Period 2. These counteracting effects lead to no clear prediction on whether the amount of trade should be higher or lower in Period 2. It is even less clear whether there should be more or less (net) purchase activity. Results are reported in Table 9. Turning first to the information variables ARET_FD, and ARET_EA, observe that coefficient estimates are consistent with predictions wherever

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Table 9 Regressions of signed frequency and value of insider trade in Period 2 on litigation risk, signed event returns, and interaction termsa Specification

Predicted coefficient sign

All quarters (1)

Quarters 1–3 (2)

Quarter 4 (3)

Panel A: Dependent variable is the signed frequency of trade, FREQ2 ARET_FDHIGH_LIT ? 0.484 ARET_EAHIGH_LIT  0.356 HIGH_LIT ? 0.237 ARET_FD + 0.429 ARET_EA  2.164 PRIOR_RET 0.379 ln(MV) 0.300 BM 0.035 Firm-quarters 84,189 0.040 R2

0.494 0.317 0.241 0.461 2.152 0.321 0.290 0.060 63,014 0.041

0.155 0.212 0.170 0.392 2.404 0.585 0.350 0.025 21,175 0.045

Panel B: Dependent variable is the signed value of trade, VALUE2 ARET_FDHIGH_LIT ? 0.253 ARET_EAHIGH_LIT  0.588 HIGH_LIT ? 0.241 ARET_FD + 0.164 ARET_EA  1.219 PRIOR_RET 0.268 ln(MV) 0.381 BM 0.143 Firm-quarters 85,121 0.018 R2

0.308 0.605 0.228 0.076 1.050 0.236 0.317 0.105 63,700 0.017

0.504 0.968 0.219 0.277 1.567 0.452 0.583 0.294 21,421 0.028

a

HIGH_LITfq is an indicator variable that is 1 if the risk of litigation is more than 2.0% for firm f in the year in which quarter q’s earnings announcement falls and zero otherwise. Other variables are as defined in Tables 1 and 2, except that ln(MV) is the natural logarithm of MV. Cook’s (1977) distance statistic is used to eliminate influential observations. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by  ,  , and  , respectively.

they are significantly different from zero. Next, consider the interaction variables. There is evidence that insiders at high litigation risk firms engage in more passive trading with respect to the previously announced earnings: where it is significant, the coefficient estimate on ARET_EA*HIGH_LIT is negative. The pattern of coefficient estimates on ARET_FD*HIGH_LIT is inconsistent with the conjecture that insiders at high litigation risk firms trade less aggressively in Period 2 on their private information about the forthcoming 10-K or 10-Q disclosures.26 Perhaps this is because (i) trades in Period 2 on average are positively correlated with the news in the forthcoming filing (as is indicated by 26 We perform a sensitivity check to demonstrate the robustness of the significant results in column (1) of Table 9. Because Huddart and Ke (2006) find that insiders trade more aggressively (both purchases and sales) when there is more variation in the order imbalance of uninformed traders, we include a measure of trading volume variability, SD_VOL, and its interactions with ARET_FD and ARET_EA. SD_VOL is the standard deviation of the ratio of the daily trading volume to the common shares outstanding over a 250-trading-day period ending 30 trading days before the observation quarter’s earnings announcement date. The coefficients on SD_VOL interacted with ARET_FD and ARET_EA are insignificant. More importantly, the coefficients on

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Table 3), (ii) the trades by insiders at high litigation risk firms cluster in Period 2 (as is indicated by Table 8), and (iii) high litigation risk imposes no differential jeopardy in Period 2 on insiders. Finally, the positive and significant coefficient estimates on HIGH_LIT across specifications in Table 9 indicates that the signed frequency of insider trades at high litigation risk firms is higher (indicating more purchases) in Period 2 than at low litigation risk firms. 5. Conclusion This study, which examines insider trades over narrow windows around disclosures of economically significant news, presents evidence complementary to studies of insider trades over long windows.27 Those studies cast light on whether insiders trade on foreknowledge of earnings but nevertheless avoid the risks of regulatory actions, shareholder class-action suits, and adverse publicity by making their trades several months before the information is made public. The combined evidence of those studies is that insider trades are associated with earnings the firm will report in the future, but the association between insider trades and earnings is strongest when the time between the insider trade and the earnings announcement is six months or longer. This study presents further evidence on how insiders condition their trades on their knowledge of upcoming firm disclosures. In contrast to earlier studies that focus on longlived private information, we focus on insider trading in short periods before and after firms make public disclosures. In the 20 days before a quarterly or annual earnings announcement, there is scant evidence of an association between insider trades and the announcement return. In striking contrast, insiders do appear to exploit a different piece of short-term news, namely the forthcoming 10-Q or 10-K: in the period following the earnings announcement and before the 10-Q or 10-K is filed, there is a strong statistical association between the frequency and value of insider trades and the filing return. This association suggests that insiders trade to profit from the information made public at the filing. There is also a negative association between insider trades in this period and the return at the preceding announcement. Although contrarian trading cannot be ruled out, this result is consistent with passive trading (i.e., private information prompting insiders to delay some trades). In line with another implication of passive trading, we document that there are fewer trades in Period 1 than in Period 2. Analysis of the magnitude of trade in relation to the magnitude of the abnormal return at the filing and the announcement suggests that trading intensity before the earnings announcement generally is decreasing in the magnitude of the abnormal return at the (footnote continued) ARET_FD*HIGH_LIT and ARET_EA*HIGH_LIT remain positive and negative, respectively, and both are significant at the 5% level. 27 Elliot et al. (1984) find an increase in insider sales prior to extreme earnings increases, but these transactions take place more than two quarters before the announcement. They conclude that most insider trading appears to be unrelated to the information events they consider. Ke et al. (2003) find little evidence of an association between earnings announcements that constitute a break in a string of quarterly earnings increases and insider trading in the preceding two quarters, although they do find an association between such announcements and insider trades more than two quarters before the break. Similarly, while Piotroski and Roulstone (2005) find only weak evidence of a significant correlation between insider trades and the innovation in that year’s annual earnings, they also find a highly significant relationship between insider trades in one year and the innovation in the next year’s annual earnings.

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announcement, consistent with the notion that small price movements imply lower risks to trade even in periods where jeopardy is high. Further analysis of trade in the period between the earnings announcement and the filing indicates that signed insider trading frequency and value are positively related to the net trade in the 90-day period ending at the earnings announcement. Moreover, net insider trading frequency and value are increasing in the interaction between the abnormal return at the filing and trade in the 90-day period ending at the earnings announcement, so that past trade intensifies insider trading in anticipation of the news in the filing. The insider trades that are most highly correlated with the price response at the filing occur shortly after the preceding earnings announcement, i.e., at the time when jeopardy is arguably lowest. There is no evidence that foreknowledge of good news has a different marginal effect on insider trading than foreknowledge of bad news. Lastly, cross-sectional variation in the risk of securities class action lawsuits is associated with the distribution of insider trades across Periods 1, 2, and 3. Insiders at high litigation risk firms trade more intensely on foreknowledge of the forthcoming filing in Period 2, perhaps because jeopardy is low in that period and their scope for trading in other periods is more limited than for insiders at low litigation risk firms. This paper offers evidence consistent with the notion that variation in the risks of legal action and adverse publicity attending trade affect the timing of trades in relation to periodic disclosures of financial information. In the setting we consider, insiders have little scope to alter the timing or content of disclosures, but have discretion over whether to trade. From several different perspectives, the observed trading pattern is consistent with the interpretation that insiders trade to avoid risks stemming from jeopardies established by past regulatory actions, shareholder class-action suits, and adverse publicity. Insiders nevertheless appear to profit actively and passively from their private information about proximate financial disclosures when jeopardy is low. These findings contribute to our understanding of the elements of firm financial information that are known in advance to insiders and the use they make of them for personal profit within the constraints of a regulatory framework mandating periodic disclosures and imposing jeopardies that plausibly vary over the fiscal quarter and across firms.

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