Company insiders trade for a variety of reasons. While there has been empirical evidence suggesting that insiders buy their firm’s shares ahead of good news, in the case of insider sales, the evidence has been mixed. In particular, the academic literature has largely failed to distinguish genuine liquidity-motivated sales from information-based trades, thwarting efforts to uncover whether the average sale contains any information relevant to the value of the stock. In a new paper, I and my co-authors, Jonathan Faasse and Juliane Lotz, offer new evidence of what information insider sales convey, using voluntary disclosures in the footnotes of insider trading documents (Form 4) that executives have to file with the SEC within two business days of trading their company’s stock.
The SEC form contains identifying information of the firm and the insider as well as transaction information. The form may also contain footnotes in addition to the quantitative transaction details with descriptions about the nature of the transaction. By extracting and analysing the descriptions of the insider sales contained in these footnotes, we distinguish discretionary from non-discretionary insider sales. We find that discretionary insider sales are highly informative to investors: They portend bad news.
On the one hand, insiders might sell shares for liquidity reasons, to cover, for example, taxes or personal expenses. This is particularly true for executives and directors, whose compensation packages often include large blocks of company stock that tie their wealth to the fortunes of their firms. On the other hand, given an insider’s access to company information, a sale might signal an insider’s knowledge of future bad news about the firm. However, outside investors often don’t know why insiders sell stock, complicating efforts to determine the significance or meaning of such sales.
Moreover, insiders are currently not required to disclose any clarifying explanations giving the reasons of their stock sale, and, even if they do, they can still exploit outside investors’ difficulty in distinguishing between sales merely for diversification or liquidity purposes and those that may also convey valuable information. This is because insiders might have considerable discretion over the timing or amount of liquidity-based trades, might bundle liquidity-based and information-based sales, or might disguise information-based sales as trades for liquidity reasons.
In our paper, we examine whether and what information insiders disclose about the reasons for their trades on SEC Form 4 and, more specifically, in the footnotes to Form 4. These footnotes might mention that stock is being sold for personal reasons, to cover, say, divorce settlements or tuition fees for children, or, by contrast, that the sale is executed by the company as part of automated trades under a deferred compensation plan or to cover taxes that fall due with the exercise of stock options. At face value, all of these descriptions seem to convey to outside investors that the stock sale occurred for liquidity reasons, yet they tell us something about the insider’s discretion over the timing or amount of the stock sale – the key distinguishing factors we use to discriminate between discretionary and non-discretionary sales.
We also exploit the fact that some insider sales do not come with any footnote description. Insider sales are generally viewed suspiciously by outside investors, which is why insiders have an incentive to credibly convey to investors that the sale occurred solely for liquidity reasons; that is, they have an incentive to include a footnote with clarifying information. Thus, the mere fact that a sale is not accompanied with clarifying information should also be informative to investors.
Our study addresses two questions: whether footnote disclosures on the Form 4 that accompanies insider sales are informative to investors and whether these voluntary disclosures enable investors to distinguish between discretionary liquidity sales that reveal information from non-discretionary liquidity sales that reveal no useful information.
We find that discretionary sales – those sales that contain no explanation and those for which we classify the explanation as discretionary – are informative to investors. Such sales by the top executives of the 7,000 companies involved in the over 2 million open market transactions we studied led on average to a 1.31 percent decline in the value of that company’s stock on announcement of the sale.
Our findings suggest that investors react negatively to discretionary insider sales. However, more interesting, sales classified as discretionary are also powerful predictors of future negative stock returns, suggesting that investors tend to underreact to the negative signal that these footnotes convey. We found companies that report discretionary insider sales in a given month tend to underperform over the subsequent twelve months.
To assess whether the drop in stock value after discretionary insider sales is due to the revelation of negative news subsequent to the sale, we examined the association of discretionary sales with future analyst downgrades, disappointing earnings, the filing of lawsuits and other negative news. We found that firms whose insiders sold shares for discretionary reasons in a given month are significantly more likely to be downgraded and to miss their earnings targets in future months than firms whose insiders engaged in non-discretionary sales. The former firms are also more likely to be sued by shareholders after the discretionary sale.
Our findings demonstrate that footnotes in SEC Form 4 disclosures can be highly informative to investors. They can allow us to distinguish between informative and uninformative insider sales and show that insiders can use these footnote disclosures to disguise information-based sales. Our study will therefore benefit investors, market regulators, and other market participants who aim to understand the information content of insider sales and identify those sales that are potentially based on material non-public information.
This post comes to us from Professor Amir Amel-Zadeh at the University of Oxford’s Said Business School. It is based on his recent article, co-authored with Jonathan Faasse and Juliane Lotz, “Are All Insiders Created Equal? New Evidence from Form 4 Footnote Disclosures,” available here.