The Effects of Regulation on the Volume, Timing, and Profitability of Insider Trading

Transcription

1 The Effects of Regulation on the Volume, Timing, and Profitability of Insider Trading Inmoo Lee National University of Singapore Michael Lemmon University of Utah Yan Li National University of Singapore and John M. Sequeira Singapore Management University November 2008 Abstract In this paper, we investigate how changes in the regulatory environment have affected the volume, timing, and profitability of insider trading over the period Consistent with increased regulatory scrutiny, we find that there has been a steady increase over time in the proportion of trades by insiders that occur right after quarterly earnings announcements, and that more and more firms appear to adopt policies to restrict their insider trading. Despite these changes in the timing of insider transactions, however, we find no evidence that the overall volume or informativeness of insider trading has decreased over time. The results suggest that the information advantage of insiders in general does not arise from superior knowledge of near term earnings, but instead reflects the longer term prospects of the firm. Authors thank seminar participants at Korea University and National University of Singapore for useful comments. Inmoo Lee and John Sequeira also acknowledge financial support by the Ministry of Education, Singapore through the Academic Research Fund (grant # R ). * Corresponding author: David Eccles School of Business, University of Utah, 1645 E Campus Center Drive Rm 109, Salt Lake City, Utah 84112; Tel: (801) ; Fax: (801) ; michael.lemmon@business.utah.edu. Corresponding author: David Eccles School of Business, University of Utah, 1645 E Campus Center Drive Rm 109, Salt Lake City, Utah 84112; Tel: (801) ; Fax: (801) ; michael.lemmon@business.utah.edu.

2 The Effects of Regulation on the Volume, Timing, and Profitability of Insider Trading Abstract In this paper, we investigate how changes in the regulatory environment have affected the volume, timing, and profitability of insider trading over the period Consistent with increased regulatory scrutiny, we find that there has been a steady increase over time in the proportion of trades by insiders that occur right after quarterly earnings announcements, and that more and more firms appear to adopt policies to restrict their insider trading. Despite these changes in the timing of insider transactions, however, we find no evidence that the overall volume or informativeness of insider trading has decreased over time. The results suggest that the information advantage of insiders in general does not arise from superior knowledge of near term earnings, but instead reflects the longer term prospects of the firm.

3 The Effects of Regulation on the Volume, Timing, and Profitability of Insider Trading 1. Introduction Insiders are not allowed to trade based on material inside information according to Section 10(b) of the Securities Exchange Act of Nevertheless, many studies have documented that insider trading is informative (for example, Seyhun, 1986, 1992; Meulbroek, 1992; Lakonishok and Lee, 2001; Rozeff and Zaman, 1998; Lin and Howe, 1990; Pascutti, 1996). Over the past twenty years or so, there has been a series of changes in the regulatory environment that potentially affect both the timing and profitability of insider trading. The Insider Trading and Securities Fraud Enforcement Act (ITSFEA) passed by Congress on November 19, 1988 and the Stock Enforcement Remedies and Penny Stock Reform Act (SERPSRA) passed in 1990 in effect, make top management in a company responsible for employees illegal trading. 3 Bettis, Coles, and Lemmon (2000), and Jeng (1998) find that many firms responded to this increased regulatory scrutiny by adopting explicit policies that restrict insider trading, particularly around earnings announcements. Bettis et al. (2000), for example, find that over 92% of firms that responded to their survey conducted in 1996 have some type of policy regarding insider trading, while 78% have explicit black-out periods during which the company prohibits trading by insiders. The typical blackout period restricts insiders to trade (without gaining explicit permission from corporate counsel) only during a short period following quarterly earnings announcements. More recently, Regulation Fair Disclosure, which was adopted in August 2000, has changed both the timing and content of earnings news information releases by companies. A 3 Garfinkel (1997) finds that insider trades around earnings announcements after the passage of ITSFEA, become less informed with respect to the news in the announcement. 1

4 number of researchers have documented that earnings announcements have become more informative in the period following the introduction of regulation FD, suggesting that the regulation has increased the degree of information asymmetry between insiders and outsiders around periodic earnings announcements (e.g., Bailey, Li, Mao and Zhong (2003)). Finally, the Sarbanes Oxley Act, which took effect in August 2002, has also increased the scrutiny associated with insider trading by tightening the reporting requirements associated with insider transactions. Previous studies based on survey results indicate that self-imposed insider trading restrictions affect the profitability of insider trading. Using insider transactions of 163 restricted firms and 97 unrestricted firms during 1992 and 1993, Jeng (1998) finds that a portfolio of insider purchasing firms without black-out periods earns abnormal profits, but finds no significant abnormal returns for a portfolio of insider purchasing firms with insider trading restrictions. Moreover, Bettis et al. (2000) also find that 5-day abnormal returns to trades made during the black-out periods are significantly lower than the returns to trades during allowed trading windows. Both studies suggest that firms may have successfully reduced informed trading by using their policies to restrict insider trading. Other studies, however, present evidence that regulations and self restrictions on insider trading do not eliminate abnormal profits earned by insiders from their trading. For example, in the U.K., insiders are not allowed to trade before earnings announcements under the London Stock Exchange s Model Code. Hillier and Marshall (2002) test the effectiveness of Model Code 4 (London Stock Exchange, 1977) on directors trades and conclude that directors could consistently earn abnormal returns even with trading time restrictions. In their study, company 4 The Model Code (London Stock Exchange, 1977) is a voluntary code of practice that specifies a prohibited period (called the close period) prior to periodic announcements in which company insiders should not trade. Under the Model Code, insiders are also required to receive clearance to trade from the chairman of the board of directors (or a designated director for this purpose). The Model Code was implemented so that insiders do not abuse or place themselves under suspicion of abusing price sensitive information, especially earnings announcements. 2

5 directors do not even appear to suffer any opportunity costs when trading immediately after the end of the trading ban. Similar results are reported in Sivakumar and Waymire (1994), who find that restrictions on trading prior to earnings announcements do not impose significant opportunity costs on insiders. Recently, Fidrmuc et al. (2006) also find that even though insiders in the U.K. are not allowed to trade before earnings announcements, insiders still earn significant abnormal returns from their trades. They conclude that insiders seem to trade on additional information relative to that contained in earnings announcements and that the existence of trading bans does not appear to curtail the value of the signal arising from director trades. Seyhun (1992), in fact, suggests that with more stringent regulation, insiders are more likely to exploit their private information by trading larger volumes over time. Consistent with this, Bris (2005) finds that insider trading enforcement increases the profitability of insider trading around takeover transactions using 4,541 acquisition events from 52 countries. These studies highlight the importance of corporate restrictions on insider trading but show that insider trading restrictions seem not to effectively eliminate informed trading. In this paper, we provide an assessment of how changes in the regulatory environment over the last twenty years have affected insider trading in the United States. Our objectives are primarily to examine whether increased regulatory scrutiny has: (1) resulted in changes in the timing of insider transactions in relation to earnings announcements; and (2) affected the overall profitability of insider trading. If firms react to the regulatory changes by strengthening their internal policies regarding insider trading or if insiders themselves alter their behavior in response to the increased scrutiny, we conjecture that the proportion of insider transactions that occur in time periods immediately following earnings announcements is likely to increase over time. To the extent that the 3

6 regulatory changes effectively raise the penalties for insider trading or reduce the informational advantage of insiders, we expect the overall profitability of insider trading to decline over time. Alternatively, it is possible that the changes in the regulatory environment may inadvertently create a safe harbor, that allows insiders to exploit their information advantage while minimizing their legal risk. If an insider has a piece of inside information that is not related to an imminent earnings announcement, but instead to the long-term prospects of the firm, then he or she will be able to exploit the opportunity by simply trading after the announcement of earnings. In such a case, we expect that changes in the regulatory environment will alter the timing of insider trades, but will have little effect on the overall profits earned by insiders. Distinguishing between these views is important for better understanding the type of information possessed by insiders and for informing the design of policies regarding insider trading. Using the comprehensive U.S. insider trading data from 1986 to 2004, we show that there has been a steady increase over time in the proportion of trades by insiders that occur right after quarterly earnings announcements. For example, before the adoption of ITSFEA in 1988, approximately 35% of insider trades occurred in the month immediately following an earnings announcement. After 2002, over 50% of all trades occur in the month following earnings announcements. Despite the significant shift in trading activity, however, we find little evidence that the profitability of insider trading has declined over time. Based on the findings in previous studies (Bettis et al, 2000; Jeng, 1998) that most firms adopt black-out periods in relation to earnings announcements, we classify our sample firms into restricted versus unrestricted firms based on the proportion of insider trading that occurs during the first sub-period following earnings announcements after dividing the period between two consecutive earnings announcements into three equal intervals. Since insiders of firms with 4

7 black-out periods are more likely to trade right after earnings announcements, we use this empirical proxy as a way to identify firms with insider trading restrictions. A similar method is used by Roulstone (2003) who examines the relation between executive compensation and insider trading restrictions. Using this proxy, we find that even insiders of firms that are more likely to have trading restrictions still earn significant abnormal returns from their insider trading. 5 To better understand the source of insiders information advantage we net out the returns around subsequent earnings announcements from overall insider profits. In aggregate, we find little evidence that the informational advantage of insiders arises from information about immediate future earnings. Over a six month period following an insider trade, insiders earn abnormal returns of 4.7% relative to a size and book-to-market benchmark. Of this amount, only 0.13% is related to future earnings news. Segmenting the data into firms with and without trading restrictions, there is some evidence that insiders trade on future earnings news in firms without trading restrictions; however, the economic magnitude of the contribution of earnings news to overall insider profits remains small. We then examine purchases and sales separately. In aggregate, the average 6-month abnormal return following purchases is -0.38%, indicating that insiders do not earn abnormal returns following their purchases. However, the returns around earnings announcements during the measurement period are 1.11%, indicating that purchases precede positive earnings news. In contrast, insiders earn significant abnormal returns following insider sales. The average 6-month abnormal return following sales is -7.14%, and the average abnormal return around future 5 Similar to the conclusions in this paper, Jagonlinzer and Roustone (2006) examine the impact of insider trading regulation on firms risk environment and conclude that insider trading behavior is significantly affected by the firms litigation risk, but that insider trading profits do not seem to decline with increased trading regulation enactment. 5

8 earnings announcements is 0.34%, indicating that there is little evidence that future earnings news contributes to the profitability of insider sales. Overall, our findings suggest that although changes in regulation have significantly altered the timing of insider trades, they have had little effect on the profitability of insider trading. Moreover, we also find little evidence that insider profits arise from news contained in future earnings. Instead, insider profits appear to be driven by news regarding the long-term prospects of the firm that are not conveyed to the market through earnings announcements. The results suggest that restricting insiders to trade in the period immediately following an earnings announcement is an ineffective mechanism for reducing the profits from insider trading. The rest of the paper is as follows. In section 2, we present the data and methodology. In Section 3, we analyze the profitability of insider trading in restricted firms and the effect of black-out periods. We conclude the paper in Section Data & Methodology 2.1. Data The insider trading data used in our study covers the period from 1986 to 2004, and is based on the comprehensive insider trading data cleaned and distributed by Thomson Financial. Insiders are required to report their transactions to the Securities and Exchange Commission (SEC) according to Section 16(a) of the Securities and Exchange Act of Our sample includes companies in the insider trading data that are available on both the CRSP and Compustat databases. Insiders are classified into management, large shareholders and others who are required to report all trades to the SEC. Management refers to CEOs, CFOs, chairman of the board, directors, officers, presidents, and vice presidents. Large shareholders are shareholders who own more than 10% of shares in the firm, but are not management. Insider 6

9 transactions that we examine relate to open market or private purchase and sales of common stock, as well as the acquisition of stock through the exercise/conversion of options, warrants or convertible bonds. Option-related sales are further separated out from sales transactions. Optionrelated sales are defined as sales that occur within six months after the options are exercised, with the number of shares sold being less than or equal to the number of shares acquired through prior exercise of these options. 6 Since the Thomson Financial database started to classify some sales into option-related sales from 1993, for the sales transactions from 1993, we use the classification of the Thomson Financial instead of using our own classification for the optionrelated sales. After applying various filters, our insider trading data consist of a total of 132,280 firm-year observations. To control for the factors that are known to affect insider trading behavior, we follow Lakonishok and Lee (2001) and classify our sample firms into three size and book-to-market (B/M) groups. We use the cutoff points provided by Kenneth R. French in his web site to form size and B/M deciles. 7 As described on his web site, size cutoff points are based on the June market capitalization of NYSE listed firms and B/M cutoff points are based on the June market capitalization and book equity values in the prior fiscal year end of NYSE listed firms. We classify the bottom three size deciles as small firms, the top three deciles as large firms, and the remaining four deciles as medium firms. Similarly, we form three B/M groups, namely, low B/M firms, medium B/M firms and high B/M firms, based on the bottom 30%, middle 40% and top 6 As explained in Carpenter and Remmers (2001), before May 1991, insiders were required to hold shares acquired through exercises of options for at least six month to avoid the short-swing rule (Section 16(b) of the Securities and Exchange Act of 1934) under which insiders are required to return any profits made from a round-trip transaction of less than six months. Since May 1991, insiders have been free to immediately sell the shares acquired through option exercises

10 30% of B/M cutoff points. After merging insider trading data with CRSP and Compustat data, we obtain our final sample of 85,026 firm-year observations. We then collect earnings announcement data from the Compustat Industrial Quarterly file. For each insider transaction, we identify the two closest consecutive quarterly earnings announcements dates that contain the particular transaction date. Due to missing earnings announcement data, the final sample is further reduced to 69,312 firm years Summary Statistics of Insider Trades Table 1 shows the summary statistics for each firm-size group and insider type. The table reports the fraction of firms in each group with at least one insider trade (Fraction) per year, the average number of trades per company per year (# of trades), and the average ratio of the individual company s total insider trading dollar volume to the market capitalization of the corresponding company at the beginning of each year per year (% Mkt Cap). In addition, we report the average annual aggregate dollar trading volume for each insider type and each insider transaction type, and the average total insider transaction dollar volume (Total $). From the results, we see that managers (i.e., management ) are the most active insiders in terms of trading frequency. Generally, we find that managers are more active in larger firms. In all firm sizes across all insider types, we find that insider sales exceed purchases by a ratio of about three to one. Based on 2005 dollar value, management in aggregate, bought an average of $0.4 billion worth of their stocks through open market or private transactions and about $1.7 billion through the exercise/conversion of options, warrants, or convertible bonds in each year during our sample period. They directly sold $7.7 billion of their stocks and engaged in an additional $2.6 billion of option-related sales. 8

11 2.3. The Timing of Insider Trades and Corporate Restrictions on Insider Trading To examine the timing of insider trades in relation to earnings announcements, we divide the interval between two consecutive earnings announcements into ten equal sub-intervals and compute the proportion of insider transactions during the quarter that occur in each sub-interval. Each sub-interval represents about 9 calendar days. To see how regulatory changes have affected insider trading over time, we divide our sample period into four corresponding subperiods as follows: subperiod 1, from 1986 to 1988 before the ITSFEA; subperiod 2, from 1988 to 1990 after the ITSFEA but before the Securities Enforcement Remedies and Penny Stock Reform Act (SERPSRA) of 1990; subperiod 3, from 1990 to 2002 after the SERPSRA and before the change in reporting time in Section 16(a) of the Securities Exchange Act of 1934; subperiod 4, after the change in a reporting time regulation. 8 From Figure 1, we observe that the fraction of trades that occur within the one month following each quarterly earnings announcement has increased steadily over time and that the fraction of trading in the month prior to an earnings announcement has decreased. The results are consistent with the idea that increased regulation and stricter enforcement of insider trading has caused insiders to alter their trading behavior. 8 In 1984, U.S. Congress passed the Insider Trading Sanctions Act (ITSA), which gave the SEC the discretion to seek civil penalties up to three times the profit made or loss avoided, as well as increased criminal penalties from $10,000 to $100,000. Four years later, the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) was passed, which held top management liable for illegal trading of employees and increased the maximum criminal penalties tenfold to $1 million and doubled maximum prison sentences to 10 years for improper insider trading. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (SERPSRA) empowered the SEC to directly impose civil penalties to securities law violators, including illegal insider trading, and increased penalties and fines for delinquent filings of insider transactions. The most recent amendment to Section 16(a) of the Securities and Exchange Act of 1934 which was introduced in August 2002 forced insiders to report their trading within the 2 business days after trading. Before this regulation change, insiders were required to report to the SEC by the 10 th day after the end of the trading month. 9

12 Bettis et al. (2000) show that many firms responded to the increased regulation of ITSFEA and SERPSRA by adopting explicit blackout periods during which insiders are not allowed to trade without obtaining explicit permission from corporate counsel. Around 30% of respondents in their survey had a trading window from 3 through 12 trading days after earnings announcements, and another 43% had other trading windows defined in relation to earnings announcements. Out of 78% of the respondents with black-out periods in place, the majority define black-out periods in relation to earnings announcements. 9 Based on this, if firms have explicit black-out period restrictions, we expect to observe most of insider transactions occurring within a short period following an earnings announcement. To identify firms that are likely to have corporate restrictions that restrict trading to the period immediately following the earnings announcement we divide the period between two consecutive earnings announcements into three equal intervals, with the first interval defined as the unrestricted period. On average, this interval covers the one month period following an earnings announcement. 10 The remaining two intervals are defined as the restricted or black-out periods during which insiders are not permitted to trade. We then proceed to calculate the percentage of insider transactions within each interval. For example, the percentage of insider transactions for the first interval, denoted PEC1, is calculated as the number of insider transactions recorded in the first interval divided by the total number of transactions within the quarter following the earning announcement. Since PEC1 can be meaningless when there are small numbers of insider transactions in a quarter, we estimate PEC1 only for the quarters with 9 Bettis et al (2000) state that in rare cases, black-out periods are defined relative to dividend announcements, mergers, bankruptcy filings, board meetings, the end of the quarter, other important corporate events, or upon the possession of material nonpublic information. Jeng (1998) reports that the median number of annual trading days allowed for her sample firms with trading restrictions is 88 days (i.e., 22 days per quarter). 10 We also repeated the analyses using a different window. We divided each earnings announcement interval into nine equal time periods and defined the first period as the unrestricted period. Unreported results based on this alternative are qualitatively similar to the ones reported in the paper. 10

13 at least three insider transactions throughout the paper. 11 Figure 2 shows how we calculate PEC1. Similar to Roulstone (2003) who examines the relation between executive compensation and insider trading restrictions, we classify a firm as a restricted firm from the quarter when PEC1 is greater than or equal to 75%. We choose the 75% cutoff point based on the findings in Bettis et al. (2000). Bettis et al. (2000) show that insiders are three times more likely to trade in allowed trading windows than during black-out periods. Moreover, insiders in firms that adopt corporate restrictions typically confine insider trading to periods within the first interval following an earnings announcement. This means that PEC1 is likely to be higher in restricted firms. Because this classification is arbitrary, we try alternative ways to classify firms into the restricted group in Table Since a firm is not likely to drop the restriction policy after its adoption, we also require that PEC1 should be greater than or equal to 50% in subsequent quarters, where PEC1 is calculated based on all insider transactions in subsequent quarters. The second condition is used to reflect the fact that firms are not likely to drop their restriction policy once they adopt it. To check the validity of this method, we apply this method to the survey sample in Bettis et al. (2000) and find that in 71% of the cases, this method correctly classify firms into their corresponding groups Changes in Insider Trading Patterns Figure 3 presents values of PEC1 to PEC3 over the period 1986 to The three measures represent the proportion of insider transactions that occur within each of three equally spaced intervals between two quarterly earnings announcements. PEC1 captures the proportion 11 We do not impose this restriction when we calculate PEC1s based on each transaction type in Table We tried additional robustness checks using alternative requirements for PEC1s in subsequent quarters and found that the results are qualitatively similar. 11

14 of insider transactions that occur in the first interval immediately after the quarterly earnings announcement, while PEC2 and PEC3 are corresponding values in the second and third intervals, respectively. The lower right graph in Figure 3, which displays the total results for all sample firms, shows that PEC1 increases gradually over the sample period, while PEC3 exhibits a corresponding decrease over the same period. In fact, differences between PEC1 and PEC3 widen significantly until At the beginning of our data period in 1986, PEC1 and PEC3 are 36% and 25%, respectively. However, towards 2004, PEC1 increases to 57% while PEC3, on the other hand, falls to 15%. Unreported t-statistics for the test of differences in PEC1 and PEC3 for each calendar year show that the differences are significant at the 0.01 significance level and the significance has increased over time during our sample period. This result is consistent with an increasing number of firms over the sample period imposing corporate restrictions on insider trading which typically force insiders to trade in the first interval. Insiders seem to be prevented from trading during the period immediately prior to an earnings announcement and this is, in fact, captured by the fall in PEC3 over the sample period. The change in trading patterns might not only be due to explicit corporate restrictions, but also possibly to insiders of unrestricted firms being cognizant of potential legal troubles that may arise from trading right before earnings announcements and altering their trading behavior accordingly. Values of PEC1 are generally higher in larger firms as compared to smaller firms, while smaller firms have higher values of PEC3 over the sample period. In Figure 4, we present the percentage of firms classified as having adopted blackout restrictions for each year for three size groups. We observe an upward trend in the percentage of restricted firms over our sample period for all size groupings. The percentage of large firms 12

15 classified as restricted firms is consistently higher over the sample period. More generally, we find that the percentage of all firms classified as restricted firms increased dramatically from less than 10% in 1986 to more than 70% for medium and large firms. For small firms, the percentage of restricted firms is closer to 60%. The results indicate that larger firms are more likely to adopt restrictions that limit the timing of insider trades. Large firms may be more likely to adopt a policy restricting insider trading due to greater scrutiny from outsiders and larger potential costs arising from insiders illegal trading. Table 2 presents four measures to capture the level of insider trading activity before and after firms adopt trading restrictions, namely, the number of trades, dollar value of trades as a percentage of market capitalization, total dollar value of trades, and PEC1. Examining each of these measures for all four transaction types, we find that the number of trades for each type of insider transactions has increased significantly after the adoption of insider trading restrictions. For purchase transactions, on average, there are 4.05 purchases per year before the adoption of restrictions and 4.52 purchases thereafter, with the difference being statistically significant. However, the dollar trading volume as a percentage of market capitalization of purchase and sale transactions has not changed significantly even though total dollar sales volume in 2005 dollars increased significantly in the period after trading policies are adopted. We also observe significant increases in option-related transactions. Overall, the results in Table 2 indicate that trading restrictions do little to reduce the overall level of insider trading. Instead their main effect appears to be to alter the timing of insider transactions. 13

16 3. Profitability of Insider Trading In this section we examine the profitability of insider trading. Following prior work we focus on insider open market purchase and sale transactions and do not include option related transactions. On each transaction date with at least one insider purchase or sale, we count the numbers of purchase transactions and sales transactions and classify the date as a net purchase (sales) date if the number of purchases is greater (less) than the number of sales transactions. Any transaction date classified as either net purchase date or net sales date is used as an event date in our analyses. To measure profitability we adopt the event study methodology in Seyhun (1992) to compute expected returns for securities using the market model, and from these expected returns, we calculate daily abnormal returns. Using the CRSP equally-weighted index as a market portfolio proxy, we estimate the model parameters over the -300, -46 days prior to an event. As an additional benchmark, we also calculate daily abnormal returns using size and B/M benchmark portfolio returns. We use the size and B/M portfolio returns from Kenneth R. French s website to calculate daily abnormal returns. The daily abnormal returns are cumulated over five-day, three-month, and six-month, intervals following the transaction date. We multiply the abnormal returns of sales by minus one for net sales dates before we calculate average CARs. This allows us to compute aggregate abnormal returns across both purchases and sales Profitability of Insider Trading Over Time Table 3, compares the profitability of insider trading across the different regulatory regimes described above. As seen in the table, insiders earn significant abnormal returns in all time periods. Focusing on returns relative to the size and book-to-market benchmark, the 14

17 aggregate abnormal returns across both purchases and sales are positive and statistically different from zero across all return horizons. There is some evidence that abnormal returns are slightly lower in the last subperiod relative to other subperiods when measured over 3-month and 6- month horizons. Examining purchases and sales separately, however, it appears that the decline in profitability during the last subperiod is driven by returns following insider sales. Insider purchases have actually become more informative in the last subperiod, while sales have become less so. Next, to more formally assess the profitability of insider trading over time, Table 4 presents regression analysis of insider trading profits that controls for a number of factors shown in prior literature to affect insider trading profits. As seen in the table, short-term (5-day) abnormal returns were slightly lower in the first and second periods following the implementation of ITSFEA, but were actually larger compared to the pre-itsfea period during the most recent time frame. In contrast, for longer-term profits (3-month and 6-month), abnormal returns to insiders are lower in the first period immediately following the adoption of ITSFEA (compared to the pre-itsfea period), but then are no different or are higher in the latter subperiods. In sum, despite the fact that the timing of insider trades have changed over time to be concentrated in the period immediately following earnings announcements, there is little evidence that this change in timing has affect the profits earned by insiders. One possible reason for this finding is that insider trading restrictions defined in relation to earnings announcements are ineffective at limiting insiders information advantage. We explore this idea further in the next section Profitability of Insider Trading and Insider Trading Restrictions 15

18 Next, in Table 5, we compare the profitability of insider trades in restricted firms against trades in unrestricted firms. When the market model is used to calculate CARs, the results reported on the left hand side of Table 5, show that CARs are significantly positive for both restricted and unrestricted firms in all firm size and B/M portfolios over five-day, three-month, and six-month horizons, with the exception of the five-day CARs for large, mid B/M firms with trading restrictions. More importantly, we find that abnormal returns are generally higher in firms with trading restrictions, especially at longer horizons the exception being large growth firms. Moreover, the difference in CARs between restricted and unrestricted firms is economically meaningful. For example, the three-month CARs in restricted firms tend to be about 1% larger than those in unrestricted firms. When a size and B/M benchmark is used to calculate CARs, the results are in general consistent with the results based on the market model, except that the magnitude of the difference in CARs between restricted and unrestricted firms tends to be reduced, and the presence of insider trading restrictions seems to reduce profitability for firms with low B/M in all size groups. Moreover, short-term CARs of restricted firms become insignificant or negative in medium and large stocks. For example, insiders of large growth firms with trading restrictions earn, on average, a marginally significant -0.05% CAR over the five-day horizon when size and B/M benchmarks are used to calculate abnormal returns. However, for three-month or longer horizons, all CARs earned by insiders of restricted firms are significantly positive at the 0.01 significance level, even when size and B/M benchmarks are used. In sum, the results in Table 5 show that even though relative magnitudes of profitability of unrestricted vs. restricted firms are sensitive to the benchmark used, especially for growth firms, insiders seem to consistently profit 16

19 from their trading, at least over longer horizons, even in firms where insider trading is concentrated in the period immediately following earnings announcements. The results suggest that the information advantage of insiders in general does not arise from superior knowledge of near term earnings, but instead reflects the longer term prospects of the firm Profitability of Insider Trading in Restricted and Unrestricted Periods To assess whether insider trading restrictions affect the profitability of insider trading, Table 6 compares the profitability of insider trading in restricted firms in both the allowed trading window and black-out periods, sorted according to firm size and B/M, to examine whether the abnormal profits earned by insiders in restricted firms depend on when they trade. In general, we find that abnormal returns to insiders of restricted firms in the unrestricted period are higher than or indifferent to the restricted period. For example, at the three-month horizon when the market model is used to calculate CARs, insiders of large growth firms experience a significant 3.26% CAR when they trade during unrestricted periods and they still experience a significant 2.70% CAR even when they trade during black-out periods. The difference in CARs is significant at the 0.01 level. Since insiders are generally required to obtain permission from their companies to trade during a restricted period, the likelihood of insider trading during a restricted period being motivated by inside information is smaller compared to the insider trading during an unrestricted period. The results are consistent with this. When the size and B/M benchmark is used to calculate abnormal returns, the general pattern that trading during the unrestricted period is associated with higher profits compared to trades during the restricted period continues to hold, but similar to the findings in Table 3, the magnitudes of the differences are generally reduced. The one exception is large value stocks at 17

20 longer horizons, where average CARs from trading in unrestricted periods are significantly less than average CARs in black-out periods Robustness Since the classification criterion used for insider trading restriction policy is an arbitrary one, the results obtained so far might be due to misclassification of firms into the restricted group. To address this issue, we try alternative classification criteria in Table 7. First, we try three different cutoff points, at 60%, 75%, and 90%. In addition, for this table, we do not require that PEC1 should be high even in subsequent quarters to be classified as restricted firms. In other words, we classify firms into the restricted group in years when the average PEC1 for the four quarters in a year is greater than a cutoff point without looking at PEC1s of subsequent quarters. Therefore, a company can be classified as unrestricted even after it is classified as restricted in previous years. The results show that the findings in Table 3 are in general robust to the insider trading restriction criteria. In almost all size and B/M groups, CARs are significantly positive even for restricted firms, especially at longer horizons Insider Trading Profits and Earnings News The fact that insider trading remains profitable even though insiders have shifted their trades to periods following earnings announcements suggests that insiders trade on knowledge that is unrelated to current earnings. One possible explanation for this finding is that insiders trade on earnings news revealed in subsequent earnings announcements. To examine this issue, Table 8 reports the fraction of the 6-month abnormal returns to insider trades that can be attributed to news contained in subsequent earnings announcements. 18

21 Panel A shows that across both purchases and sales, over the six month period following an insider trade, insiders earn abnormal returns of 4.7% relative to a size and book-to-market benchmark. Of this amount, only 0.13% is related to future earnings news. Segmenting the data into firms with and without trading restrictions, there is some evidence that insiders trade on future earnings news in firms without trading restrictions, however, the economic magnitude of the contribution of earnings news to overall insider profits remains small. Separating purchases and sales in Panels B and C, the table shows that the average 6- month abnormal return following purchases is -0.38%, indicating that insiders do not earn abnormal profits following their purchases. However, the returns around earnings announcements during the measurement period are 1.11%, indicating that purchases precede positive earnings news. In contrast, insiders earn significant abnormal returns following insider sales. The average 6-month abnormal profits following insider sales is 7.14% (recall that we multiply the CAR s following sales by negative one), indicating that insiders avoid significant losses by selling. The average abnormal return around future earnings announcements is -0.34%, indicating that there is little evidence that future earnings news contributes to the profitability of insider sales. In fact, the evidence shows that future earnings news is slightly positive, on average, following insider selling. Finally, the table also separates firms with and without trading restrictions. Overall, the conclusions remain similar. There is little evidence that insider trading profits are mostly driven by news about immediate future earnings in either of the two groups of firms. Overall, our findings suggest that although changes in regulation have significantly altered the timing of insider trades, they have had little effect on the profitability of insider trading. Moreover, we also find little evidence that insider profits arise from news contained in 19

22 immediate future earnings. Instead, insider profits appear to be driven by news regarding the long-term prospects of the firm that are not conveyed to the market through earnings announcements. The results suggest that restricting insiders to trade in the period immediately following an earnings announcement is an ineffective mechanism for reducing the profits from insider trading. 4. Conclusions The regulatory environment surrounding insider trading has changed substantially over time. Consistent with these changes, Bettis et al. (2000) show that many companies have adopted policies to restrict insider trading, and that corporate restrictions significantly affect insiders trading behavior and abnormal returns earned by insiders from insider trading over shorthorizons. We explore changes in the patterns and profitability of insider trading using the entire insider trading database to examine how the use of corporate restrictions have changed over time, and whether insiders of the firms with restrictions are still making abnormal profits from their transactions, especially over longer horizons. Our results based on insider trading from 1986 to 2004, show that policies to restrict insider trading are widely used by our sample firms, and they significantly affect the timing of insider trading. Most insider trading in recent years occurs during a one-month period after quarterly earnings announcements. However, these restrictions have not reduced the level of insider trading nor do they appear to significantly reduce abnormal profits earned by insiders from their insider transactions. This indicates that insider trading is still informative, and can be used as a useful source of inside information both for academic research and in developing investment strategies. 20

23 References Baily, Warren, Haitao Li, Connie X. Mao, and Rui Zhong. (2003). Regulation Fair Disclosure and earnings information: Market, analyst, and corporate responses. Journal of Finance 58, Bettis, J.C., Coles, J.L. and Lemmon, M.L. (2000). Corporate policies restricting trading by insiders. Journal of Financial Economics 57, Bris, Arturo, 2005, Do insider trading laws work?, European Financial Management 11, Carpenter, J. N., and Remmers, B. (2001). Executive stock option exercises and inside information. Journal of Business 74, Jeng, L. (1998). Insider trading and the window of opportunity. Unpublished working paper, Boston University. Fama, Eugene F., and French, Kenneth (1993). Common risk factors in the returns on bonds and stocks. Journal of Financial Economics, 33, Fama, Eugene F., and MacBeth, James D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81, Fidrmuc, J., M. Goergen, and L. Renneboog (2006). Insider Trading, News Releases and Ownership Concentration, forthcoming in Journal of Finance. Garfinkel, J. (1997). New evidence on the effects of federal regulations on insider trading: the Insider Trading and Securities Fraud Enforcement Act (ITSFEA). Journal of Corporate Finance 3,

24 Hillier, D. and Marshall, A.P. (2002). Are trading bans effective? Exchange regulation and corporate insider transactions around earnings announcements. Journal of Corporate Finance 8, Jagonlinzer, Alan D., and Darren T. Roulstone (2006). Litigation risk and the timing of insiders trades around earnings announcements. Working paper, University of Chicago. Lakonishok Josef., A. Shleifer and R. Vishny (1994). Contrarian Investment, Extrapolation and Risk. Journal of Finance Lakonishok, Josef. and Lee, Inmoo (2001). Are insider trades informative? Review of Financial Studies 14, Lin, Ji-Chai and John S. Howe (1990). Insider Trading in the OTC Market. Journal of Finance 45, Meulbroek, Lisa (1992). An Empirical Analysis of Illegal Insider Trading. Journal of Finance 47, Pascutti, Michael J. (1996). Inside Trading, Market Regimes and Information. Working Paper, Harvard University. Roulstone, D.T. (2003). The relation between insider-trading restrictions and executive compensation. Journal of Accounting Research 41, Rozeff M, and Zaman, M. (1998). Overreaction and insider trading: evidence from growth and value portfolios. Journal of Finance 53, Seyhun, N. (1986). Insiders profits, costs of trading, and market efficiency. Journal of Financial Economics 16, Seyhun, N. (1992). The effectiveness of the insider trading sanctions. Journal of Law and Economics 35,

25 Sivakumar, K. and Waymire, G. (1994). Insider trading following material news events: evidence from earnings. Financial Management 23,

26 Table 1: Summary Statistics Management Large shareholders Others Total Purchase Sales Ors Option Purchase Sales Ors Option Purchase Sales Ors Option Purchase Sales Ors Option Small firms Fraction # of trades %Mkt Cap 0.3% 1.0% 0.2% 0.2% 1.7% 3.6% 0.1% 0.4% 0.3% 0.7% 0.1% 0.1% 0.5% 1.2% 0.1% 0.2% Total $(m) 428 3, , , Medium firms Fraction # of trades %Mkt Cap 0.1% 0.8% 0.2% 0.1% 0.9% 4.0% 0.2% 0.2% 0.1% 0.5% 0.0% 0.1% 0.1% 0.9% 0.1% 0.1% Total $(m) 436 6,759 1,869 1,247 1,084 5, , , Large firms Fraction # of trades %Mkt Cap 0.0% 0.3% 0.1% 0.1% 0.7% 3.0% 0.1% 0.2% 0.0% 0.2% 0.0% 0.0% 0.0% 0.4% 0.1% 0.1% Total $(m) ,193 5,477 3, , , , ,453 2,532 1,576 Total firms Fraction # of trades %Mkt Cap 0.2% 0.8% 0.2% 0.2% 1.5% 3.6% 0.1% 0.4% 0.2% 0.6% 0.0% 0.1% 0.3% 1.0% 0.1% 0.2% Total $(m) 429 7,660 2,582 1, , , ,658 1, Table 1 presents summary statistics of insider trading data over the period from 1986 to 2004 based on the insider trading data cleaned and distributed by Thomson Financial. Management refers to CEOs, CFOs, chairman of the board, directors, officers, presidents, and vice presidents. Large shareholders refer to shareholders who own more than 10% of shares. Purchase and Sales refer to open market or private purchase and sales of common stocks. Option refers to the exercise/conversion of options, warrants, or convertible bonds. Ors are option-related sales, which refer to sales that occur within six months after options are exercised with the number of shares sold less than or equal to the number of shares acquired through prior exercise of options or that are indicated as option-related sales by Thomson Financial. Fraction is the average fraction of firms in our sample with at least one insider trade per year. # of trades is the average number of trades per company per year. % Mkt Cap is the average ratio of the individual company s total insider trading dollar volume to the market capitalization of the corresponding company at the beginning of each year per year. Total $ is the average aggregate total insider transaction dollar volume in 2005 million dollars per year. Firms are divided into three size groups using the cutoffs based on the market capitalization of NYSE listed firms at the end of June of each year. Bottom 30% and top 30% are classified as small and large firms, respectively. 24