In 1961, shortly after becoming chair of the Securities and Exchange Commission, William Cary ruled it illegal to make trades based on “material, nonpublic information.” Though ambiguity remains about what, precisely, this phrase means, the basic idea is that corporate insiders shouldn’t profit from information unavailable to the public. If they know something, they should either disclose it or abstain from trading.
Estimates nonetheless suggest that insiders make more than $6 billion in illicit trades every year. As Cary noted with Shakespearian flourish, “It might be said of fraud that age cannot wither, nor custom stale its infinite variety.”
Two new papers by John Kepler, assistant professor of accounting at Stanford GSB, expose two specific varieties within this infinitude — standard practices in the corporate world that appear to make insider trading both easy and systemic. The papers also provide potential fixes, if partial.
“The evidence from these papers is compelling enough to warrant serious consideration of the issue,” Kepler says. “Regulators at the SEC, corporate boards, and general counsels need to be aware of what’s going on.”
The Audit Advantage?
About three months after the end of every fiscal year, companies file a comprehensive and public report on their financial performance, the 10-K, with the Securities and Exchange Commission. A third-party audit report designed to corroborate the financial statements is filed alongside the 10-K.
Prior to the filing of the 10-K, auditors brief the board and executives of a company on what they found, detailing, among other things, whether the company’s internal controls over financial reporting practices are sufficient, as well as whether the financial statements themselves require modification. These private discussions often include “material, nonpublic information.”
Could people involved in the briefings be benefiting from these insider discussions? To find out, Kepler and his coauthors analyzed how often briefings coincided with internal trades.
By matching SEC and stock exchange records, “we find a pronounced spike in internal trading volume around the audit report date for firms that need to make modifications,” Kepler says. The probability of an insider sale on any given day is estimated at 3.8%; after an auditor’s briefing, this probability rises to roughly 8% for firms with modified audit reports.
Stock Movement Amid Investigations
Kepler’s second paper pursues a similar approach — a lag in, or complete lack of, information sharing — involving SEC investigations. A company isn’t required to disclose if it is under investigation to shareholders. This confidentiality is afforded following the same rationale that maintains people’s innocence until proven otherwise: A company should not be punished for malfeasance that it has not definitively committed. (When last November the Wall Street Journal revealed an SEC investigation of Under Armour, shares fell nearly 20% over the course of a day.)
Through a FOIA request made to the SEC, Kepler and three coauthors gathered information on every formal SEC investigation closed between January 1, 2000, and August 2, 2017. They then looked for suspicious trades around the time that the SEC announced to a firm that it was under investigation. They found a 64% surge in insider trades at firms where the conduct under investigation was egregious. Corporate officers and C-suite executives, it seems, understand when a ship is going down and they bail.
Kepler noted an important additional insight from this second study. Prior research into the prevalence of SEC investigations has relied on publicized enforcement actions and lawsuits — an unknown fraction of overall investigations. This leads to “the conventional wisdom among academics and practitioners that the SEC is rather resource-constrained and thus tends to be selective when it comes to which firms or individuals to investigate,” Kepler says.
The dataset gathered from the FOIA request provided Kepler and his colleagues the revelation that, in fact, 10% of public firms are under investigation at any given time. “Until now, we’ve had no idea of that magnitude.”
The findings from these papers provide a few straightforward patches for the problem of insider trading, Kepler says.
First, companies ought to consider extending what’s known as the blackout window. This window typically covers the lead-up to an earnings call, when insiders, given what they know, are forbidden from trading personal shares. The audit process, however, continues well after these calls, and can significantly alter a company’s financial standing depending on its conclusions.
“One thing boards can do is ensure that trading blackout windows don’t just extend to the earnings announcement, but to the filing of the 10-K,” Kepler says, at which point audit information becomes public.
Similar trading restrictions could be applied to company officers who have knowledge of ongoing SEC investigations.
On the regulatory side, the findings could help the SEC see insider trading “hotspots” — where activity is likely — and better monitor those areas with very simple tweaks to standing internal procedures.
Regardless of the specifics, though, Kepler says the issue of insider trading deserves more scrutiny.
“I would say, based on these results, it’s more common across U.S. capital markets than initially thought,” he says. “And in the particular cases we study, the trading occurs precisely as a result of institutions that were first put in place to protect shareholders.”