In a new study, we examine restricted-stock vesting events, through which directors and high-level executives (“insiders”) receive stock but face fewer reporting requirements and selling restrictions than if the stock had been purchased on the open market. Using a detailed dataset that tracks restricted stock vesting schedules from Equilar, we find that insiders realize gains by retaining vested stock. A trading strategy that mimics insiders’ trading patterns by buying on the vesting date and selling on the subsequent open-market sales date yields positive abnormal returns.

The vast majority of previous insider-trading literature focuses on open-market transactions, but insiders acquire significantly more shares in the form of vested restricted stock than through open-market purchases. We view restricted-stock vesting events as similar to open-market purchases, in the sense that insiders’ stock holdings effectively increase on the vesting date. Unlike open-market purchases, however, increases in stock holdings due to vesting of restricted stock can be difficult to discern because they are not subject to a Form 4 filing. Only certain tax payments associated with the vesting trigger disclosure. A Form 4 filing is required when an insider has a portion of the vested shares withheld or sold to satisfy tax obligations. Thus, in most cases, any Form 4 filing associated with vesting events would paradoxically only show the disposition of shares, when in fact the insiders’ holdings of (unrestricted) shares increase. If an insider pays taxes out of pocket, no Form 4 is filed and therefore no disclosure is made on the vesting date. Restricted-stock vesting events can for this reason be viewed as “silent purchases.”

Furthermore, if the stock were acquired through open-market purchases, insiders would be prohibited from realizing gains by the short-swing profit rule in Section 16(b) of the Securities Exchange Act. This is another difference between open-market purchases and the vesting of restricted stock. Insiders can hold vested restricted stock for a short period and sell at a profit due to an exemption in Securities and Exchange Commission Rule 16b-3. The SEC’s rationale for the exemption is to reduce the bias towards cash compensation, which is unrestricted, and the lack of potential for insiders to profit. However, we suggest vesting of restricted stock as an unintended opportunity to profit from inside information not covered by the short-swing profit rule.

Unlike previous literature, we find that insiders more often than not retain vested stock after vesting. Excluding tax-related dispositions at vesting date, insiders sell stock gradually over time. Those insiders who do sell stock within 180 days of the vesting date—43 percent of the observations in our sample—realize significant gains between the vesting date and the selling date. Based on this observation, we devise a trading strategy that mimics insiders’ change in holdings of inside stock related to vestings, and also controls for known risk-factors. Specifically, when an insider’s restricted stock vests, we include that stock in our portfolio and hold it until he or she sells on the open market. In contrast to most insider-trading literature on open-market purchases, which relies on hypothetical return windows, usually 180 days, to measure gains we observe insiders’ actual holding periods, from the restricted stock vesting event to the first subsequent open-market sale. Our trading strategy yields annualized four-factor abnormal returns of 4.9 percent to 6.4 percent.

We further show that abnormal returns are larger when basing the trading strategy solely on insiders who are allowed to, and do, exercise discretion over what tax-payment method to use, consistent with an informed holding explanation. Using a similar line of reasoning, in J.D. Jordan v. Robert C. Flexton et al., a shareholder of Dynegy accused company insiders of violating the short-swing profit rule in disposing restricted stock upon vesting, which occurred with  six months of open-market purchases. The plaintiff argued that the exemption for executive compensation did not apply because the insider had discretion on whether to pay cash or have shares withheld. The case was dismissed by the U.S. District Court for the Southern District of Texas on April 2017 but is on appeal to the Fifth Circuit as of October 2017. In response to this case, law firms have advised companies to review tax withholding practices.

Finally, we assume that our trading strategy has not been arbitraged away, in part because the scant information in Form 4 would make such arbitrage very difficult. Mimicking insiders’ holding of vested stock requires careful tracking of filings. An arbitrageur would have to determine from the footnotes of grant filings the vesting date, which may change without notice, and follow up on the vesting date, on which there may or may not be a filing, depending on how taxes are paid. Adding to the complexity, filings made on the vesting date only reflect the disposition of shares to pay taxes, when in fact the insider’s holding increases.

This post comes to us from Erik Johannesson, a doctoral candidate at Columbia Business School, and Seil Kim, an assistant professor of accounting at Baruch College, City University of New York. It is based on their recent paper, “Invested in Vested Stock: Abnormal Returns on Silently Retained Equity,” available here.