In the paper, Corporate Governance and the Information Content of Insider Trades, forthcoming in the Journal of Accounting Research, we examine the impact of the firm’s internal control process – specifically, actions taken by the general counsel (GC) – on addressing one specific governance issue, namely mitigating the level of informed trade. In order to investigate the effectiveness of the governance provisions in the insider trade policy (ITP) at mitigating informed trade, we examine the trades made by Section 16 insiders where we know the precise terms of the firm’s ITP. It is illegal for insiders to trade while in possession of material nonpublic information (Securities and Exchange Acts of 1933 and 1934; Insider Trading Sanctions Act of 1984 (ITSA); Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)). However, prior research finds that insiders do appear to place, and profit from, trades based on superior information (e.g., Aboody and Lev, 2000; Ke et al. 2003; Piotroski and Roulstone, 2005; Huddart et al., 2007; Ravina and Sapienza, 2010). Building on these studies, we test the effectiveness of governance provisions in the ITP by examining whether such provisions are associated with (decreased) insider trading profits and the ability of insiders’ trades to predict future operating performance.
Our analysis focuses on elements of firms’ ITPs that allow us to infer the degree of GC control over the trading environment. Specifically, we focus on the terms of the firm’s restricted trading window and whether the ITP states that GC approval is required for any insider transaction. We find that 80% of our sample firms require trades to be pre-approved by the general counsel, and the average length of restricted trading windows is 48 days (46 days before and 1 day after an information event). Interestingly, and in contrast to prior literature (e.g., Bettis et al., 2000), we find that about 24% of all insider trades occur within restricted trade windows.
We find that active monitoring by the general counsel is associated with a substantial reduction in informed trading by insiders and the extent to which insiders use their private information to extract rents from shareholders. On average we find that insider trades that do not require GC approval earn risk-adjusted returns of 0.03% per day, but when general counsel is required such trades earn –0.01% per day, a difference of 0.04% or 7.20% over the 180 days following the trade. Additionally, and consistent with prior work, we find that net purchases of insiders positively predict future earnings surprises. However, consistent with the GC reducing the level of informed trade, we find that only those trades not approved by the GC predict the future earnings surprises.
Our results suggest that restricted trading windows, by themselves, are not effective at reducing informed trading. Rather, the results suggest that the effectiveness of restricted trade windows depends on whether individual transactions require GC approval. Specifically, we find that trades inside restricted windows earn risk-adjusted returns of 0.06% per day, 0.04% more than trades outside windows, but that trades inside restricted windows approved by GC earn -0.01%, a difference of 0.07% per day or 12.6% over the 180 days following the trade. This is in contrast to Bettis et al. (2000) who find that restricted trading windows are associated with decreased trading profits from 1992 to 1997. In additional analyses, we examine the Bettis et al. (2000) time period (and other time periods that precede recent regulatory changes), and effectively replicate their inferences that restricted trade windows are associated with lower insider trading profits. Importantly, this suggests that the primary tool used by firms to mitigate informed trade in prior periods is not especially effective in the current regulatory environment, which is perhaps an unintended consequence of recent regulations and what may be motivating an increased role of the GC in corporate governance.
Several additional analyses support the inference that our findings are attributable to active governance by the GC rather than alternative explanations. One potential alternative explanation, for example, is that the GC approval requirement is found in firms that have lower ex ante information rents available to insiders (i.e. less information asymmetry that can be exploited by insiders). If this were true, it would not be surprising to observe less profitable trades at firms that require GC approval. However, we find that the GC approval requirement occurs more frequently in firms with greater information asymmetry (and therefore greater ex ante information rents) and that GC approval is associated with a significant reduction in insider trading profits even when firms are matched based on measures of ex ante information rents. Additionally, we find firms that require GC approval of insider trades during our sample period do not have lower trading profits in prior periods, suggesting that the GC requirement itself, rather than some unobserved characteristic of the firm, is responsible for a decrease in trading profits. Overall, we interpret our findings as suggesting that the general counsel can effectively mitigate informed trade and that the choice of corporate governance directly affects the extent to which insiders use their private information to extract rents from shareholders.
The full paper is available for download here.