Academic study shows increases in insider sales prior to public release of certain SEC comment letters

by Cydney Posner

Articles in Compliance Week and Forbes  report on a recent academic study showing unusually high levels of stock sales by insiders in the period prior to public release of SEC comment letters that addressed revenue recognition issues, a topic that can often spell trouble at many companies. The level of trading by insiders was even higher at companies with acute financial reporting quality and valuation issues, identified by significant short selling activities and high levels of accruals.

According to the articles, the study looked at thousands of SEC comment letters issued regarding annual reports on form 10-K filed during the period from 2006 through 2012. Because of the potentially critical impact of the issue and its significance to investors, the research focused on comment letters addressing revenue recognition issues (approximately 20% of letters in the period).The study then examined insider trading activity before and after the release of those comment letters. The SEC makes publicly available on EDGAR SEC comment and company response letters no earlier than 20 business days following resolution of the comment process.  As a result,  executives have information about the SEC comments and their resolution for at least 20 business days before investors could have access to the information.

According to Forbes, the researchers compared “insider sales before the release of a letter to trading on five randomly selected days 3-6 months before and after the release. They found $1.5 billion in total sales in the 10 days before the release of their subset of comment letters (average firm market cap: $4.6 billion) and a statistically significant $356,500 in abnormal selling per firm in the 5 trading days before release, or almost 70% higher than normal. The selling was even heavier at firms with a high short interest, where investors may have already detected accounting or business problems. Sales at those firms were $495,000, or 200% higher than normal.“ (emphasis added) Sales were 77% higher for companies with high levels of accruals. Compliance Week reports that “[o]ver the course of those five days, the value of shares dumped by insiders was about $360 million above what might be expected to occur randomly, the study says, with CEOs, CFOs, board members and other top executives all involved….” The study authors conclude that the study provides empirical evidence suggesting that “insiders take advantage of the SEC’s practice of delaying the disclosure of comment letter correspondence by timing their trades before the release date. “ In contrast, according to Forbes, there were apparently “no statistically significant increases in insider trading across the entire group of comment letters, nor did they find it during the ‘correspondence period’ when the SEC and target companies were still exchanging letters. The authors attribute this to the fact that insiders have no fear of their stock losing value during the typically secret process, but wait until the news is imminent to sell.”

The study also reports that the market did not respond quickly to the public disclosure of the comment letters. There was little evidence of a stock price response on the disclosure date; however, the study did find evidence of a delayed stock price response. The authors speculate that the delay may result from the possibility that investors are not paying much attention to comment letters. (By contrast, looking at download activity on EDGAR, the authors found that stock prices respond more quickly when comment letters have greater downloading activity.) In addition, the difficulty of promptly identifying comment letters for any particular firm may also contribute to the delay. As a result, the study found abnormal insider trading immediately after the release date: insiders were still able to profit from their trades because of the delayed stock price response to comment letter information.

What do the authors prescribe? They suggest that the SEC should encourage companies to implement black-out periods for insider sales during the comment letter review process (which could be painful if the process stretches over months, as sometimes happens).  In addition, the authors suggest that the SEC consider abbreviating the current 20-business day time lag and find a way to “’improve online access to comment letters….The current set-up is quite opaque unless you check daily, and it almost certainly contributes to the slow response of the market to disclosure.’” Whether or not a company decides to impose a formal black-out period, it may be advisable to evaluate SEC comments received to determine if any of them, especially any regarding revenue recognition, could have a market-moving impact if adversely determined from the company’s perspective, and if so, consider prohibiting sales until after public disclosure and dissemination of the information.

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