The U.S. Securities and Exchange Commission (SEC) has a three-part mission: to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. SEC investigations and enforcement actions play a critical role in carrying out each of these objectives. One of the hallmarks of the investigative process is that it is shrouded in secrecy: The SEC explicitly seeks to protect the identity of those under investigation (SEC, 2017; SEC, 2019). With respect to corporate malfeasance, only SEC staff, senior managers of the company being investigated, and outside counsel are aware of active investigations. While some companies choose to disclose active investigations, they are not required to do so – even in the extreme case when an enforcement action is likely.[1]

Thus, although a key purpose of SEC investigations is to safeguard investors and instill confidence in the integrity of markets, because the courts have ruled that disclosing these investigations is not mandatory, an unintended consequence of the investigative process is that it potentially endows corporate insiders with a significant information advantage. In some cases, senior managers and counsel will be aware of the investigation well in advance of shareholders; and in most cases, shareholders will never be aware of the investigation. In a new study, we examine whether corporate insiders exploit this information advantage and trade based on private information about ongoing investigations.

We obtain novel data on the subject of all formal SEC investigations closed between 2000 and 2017 – data that was heretofore non-public. The data cover 12,861 formal investigations and provide useful and novel insights into the breadth and scope of the SEC’s investigative process.

We find that 10 percent of publicly-listed firms are under investigation in the average year and that the industry distribution of investigations largely mirrors that of the universe of publicly listed firms, suggesting that no one industry is unduly targeted by the SEC. In contrast, 20 percent (6 percent) of investigations pertain to the largest (smallest) 10 percent of firms. This suggests a tendency by the SEC to investigate large firms: potentially those violations that have the largest scope of malfeasance and victims, but also those firms most capable of mounting a well-resourced defense.

In terms of firm performance, we find that these investigations portend economically meaningful declines in firm performance and increased volatility. Consistent with the confidential nature of the investigation, these declines are marked by a persistent downward drift, and are not quickly impounded into prices. For example, the median market-adjusted return one year (two years) after the opening of a formal investigation is –5.73 percent (–9.35 percent).  Despite these substantial declines in performance, only 19 percent of firms subject to an investigation disclose the investigation at its outset, and 44 percent disclose the investigation by its conclusion.

The undisclosed nature of the vast majority of these investigations, coupled with material, long-lived declines in performance, suggest insiders privy to the details of the investigation have a substantial information advantage.  We examine whether corporate insiders exploit this information advantage using a standard short-window event study around the investigation open date. The open date signifies the official start of the formal investigation and serves as a crude proxy for when senior managers are made aware of the investigation through subpoenas or other official correspondence.[2] This does not imply senior managers are not trading on private information about the investigation at other times – e.g., as the investigation progresses and potentially escalates – merely that the open date is unambiguously an important date in the lifecycle of the investigation and is readily identifiable for all SEC investigations in our sample. We focus our event-study analysis on those firms that had not disclosed the investigation prior to, or during, the window we use to measure trading activity. Evidence of a change in insider trading activity in a short window after the start of the investigation – when the investigation is known to insiders but not to the market – suggests insiders are trading based on private information about the investigation itself.

We find no evidence of abnormal trading around the opening of an SEC investigation for the average (non-disclosing) firm. However, we find a pronounced spike in insider selling activity among those (non-disclosing) firms with extreme negative outcomes (e.g., firms that would subsequently restate their financials due to fraud or experience a significant stock price crash during the investigation). Moreover, we find that the abnormal trading activity in these firms is attributable to corporate officers, and no evidence of abnormal trading among independent directors in these firms.

Highlighting the non-public nature of the information around the investigation open date, we find no evidence of a capital market reaction around this date – suggesting our results are not attributable to confounding disclosures or other corporate news. The absence of a capital market reaction, in conjunction with a spike in insider trading activity, is consistent with a significant internal information event occurring around the open of the SEC investigation – and insiders trading based on this event.

Finally, we find that abnormal selling activity at the outset of the investigation allows insiders to avoid significant losses. Those executives with abnormal trading activity at the outset of the investigation earn significant abnormal returns – whether measured relative the trading of their industry peers or their own historical trading returns. Collectively, our results suggest that (i) a substantial number of SEC investigations of publicly traded firms are not disclosed, (ii) many of these investigations are economically material, and (iii) the absence of disclosure, coupled with economic materiality, provides insiders with a considerable information advantage, which many insiders appear to exploit for personal gain.

Our research question and findings should be of interest to regulators, boards, and academics.

With respect to regulators, our results provide novel evidence that insiders exploit their information advantage regarding confidential regulatory investigations. We encourage regulators to scrutinize securities trading during the investigative process, even when the investigations themselves are not related to securities trading. In addition, we encourage the SEC to consider issuing guidance on whether and when a regulatory investigation should be considered sufficiently “material” that it would trigger mandatory disclosure. In the absence of such rules, our evidence suggests insiders are not disclosing the investigation and are simultaneously exploiting their information advantage for personal gain.

With respect to boards, our results suggest the “disclose or abstain” rule that governs officers’ and directors’ fiduciary duty is not being consistently applied as it relates to active regulatory investigations. Our results suggest that as soon as the general counsel is aware of an investigation, either the investigation should be disclosed, or those officers and directors with knowledge of the investigation should be precluded from trading. Our findings highlight the need for insider trading policies that restrict the trades of key personnel during ongoing investigations.

With respect to academics, our results provide novel insights into the scope of SEC investigations and their consequences. For instance, our results appear to highlight an exception to the materiality threshold that typically governs mandatory disclosure – namely, that firms do not have to disclose SEC investigations – and suggest that this exception has important consequences. We encourage regulators, boards, and academics to closely scrutinize insider trades placed during ongoing SEC investigations.

ENDNOTES

[1] For example, on January 22, 2016, the Southern District of New York ruled, In re Lions Gate Entertainment, that corporations are under no obligation to disclose SEC investigations or the receipt of a Wells Notice: “[T]he defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities laws do not impose an obligation on a company to predict the outcome of investigations. There is no duty to disclose litigation that is not ‘substantially certain to occur.’”

[2] Measurement error in this date will bias against finding a spike in trading.

This post comes to us from professors Terrence Blackburne at Oregon State University, John D. Kepler at Stanford University, Phillip J. Quinn at the University of Washington, and Daniel J. Taylor at the University of Pennsylvania’s Wharton School. It is based on their recent paper, “Undisclosed SEC Investigations,” available here. Please contact Professor Taylor (dtayl@wharton.upenn.edu) with any questions about the study or data.