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Timing, profitability and information content of abnormal insider sales Francois Brochet Stern School of Business – NYU 44 West 4 th Street – Suite 10-99F New York, NY 10012 (212) 998 0024 [email protected] November 2005 ** Preliminary – do not quote/distribute ** When corporate insiders sell their stock in quantities that deviate from firm-specific trends, their trades are more likely to precede bad news over a horizon of several months, but not in the short run. This is consistent with insiders avoiding “suspicious timing” when engaging into “suspicious amounts” of trading, the combination of which would likely result in Rule 10b-5 securities lawsuits. Furthermore, the occurrence of abnormal sales is negatively associated with the ex-ante litigation faced by the firm. I also find that patterns of discretionary accruals and unmanaged earnings are indicative of managers using accruals to avoid reporting a loss after their abnormal trades and delay the report of earnings decreases two quarters away from their abnormal sales. In terms of stock returns, there is a smaller amount of good news following abnormal trades that are contemporaneous to loss-avoiding discretionary accruals, which is consistent with managers timing their trades and accruals to maximize their proceeds. By contrast, there is a greater amount of positive returns following trades during quarters where accruals offset an earnings decrease, which suggests managers delay the recognition of bad economic news to avoid litigation. More generally, trades in firm-years subject to high litigation cost precede greater positive stock returns, even if they eventually predict bad news. Finally, abnormal returns and trading volume around SEC filing dates of insider sales indicate that the market reacts to insider sales disclosure after the implementation of Section 403 of the Sarbanes-Oxley Act, which stipulates that insiders must report their trades within two business days. In particular, returns around those filings are associated with the probability that a trade is not motivated by liquidity needs. I would like to thank Joshua Ronen for his help and support. Discussions with Yonca Ertimur, Lucile Faurel, William Greene, Steve Huddart, Sarah McVay and Steve Ryan have also proved helpful.

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Page 1: Timing, profitability and information content of abnormal insider …w4.stern.nyu.edu/accounting/docs/speaker_papers/fall2005... · 2005-11-28 · Timing, profitability and information

Timing, profitability and information content of abnormal insider sales

Francois Brochet Stern School of Business – NYU 44 West 4th Street – Suite 10-99F

New York, NY 10012 (212) 998 0024

[email protected]

November 2005

** Preliminary – do not quote/distribute **

When corporate insiders sell their stock in quantities that deviate from firm-specific trends, their trades are more likely to precede bad news over a horizon of several months, but not in the short run. This is consistent with insiders avoiding “suspicious timing” when engaging into “suspicious amounts” of trading, the combination of which would likely result in Rule 10b-5 securities lawsuits. Furthermore, the occurrence of abnormal sales is negatively associated with the ex-ante litigation faced by the firm. I also find that patterns of discretionary accruals and unmanaged earnings are indicative of managers using accruals to avoid reporting a loss after their abnormal trades and delay the report of earnings decreases two quarters away from their abnormal sales. In terms of stock returns, there is a smaller amount of good news following abnormal trades that are contemporaneous to loss-avoiding discretionary accruals, which is consistent with managers timing their trades and accruals to maximize their proceeds. By contrast, there is a greater amount of positive returns following trades during quarters where accruals offset an earnings decrease, which suggests managers delay the recognition of bad economic news to avoid litigation. More generally, trades in firm-years subject to high litigation cost precede greater positive stock returns, even if they eventually predict bad news. Finally, abnormal returns and trading volume around SEC filing dates of insider sales indicate that the market reacts to insider sales disclosure after the implementation of Section 403 of the Sarbanes-Oxley Act, which stipulates that insiders must report their trades within two business days. In particular, returns around those filings are associated with the probability that a trade is not motivated by liquidity needs. I would like to thank Joshua Ronen for his help and support. Discussions with Yonca Ertimur, Lucile Faurel, William Greene, Steve Huddart, Sarah McVay and Steve Ryan have also proved helpful.

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1. Introduction

In a corporate environment where stock-based compensation has become

increasingly relied upon to align managers’ interests with those of shareholders, corporate

insiders routinely trade their own company’s shares in order to satisfy their consumption

and portfolio rebalancing needs. Yet, they are endowed with private information that

enables them to trade profitably, i.e. buy or sell at a price that does not reflect

forthcoming good or bad news that they only are privy to. However, executives trading in

their company’s stock while in possession of material nonpublic information can be

prosecuted, since it constitutes a violation of Rule 10b-5 of the US Securities and

Exchange Act of 1934.

This raises several questions. If we can sort out from the pool of insider sales

those that appear as liquidity-driven vs. private-information motivated, how is each type

of sale associated with future news? Can we gain insight into the nature of insiders’

private information that is driving the magnitude and timing of this news? Since insider

sales become observable to the public when filed with the SEC, do investors react to their

disclosure?

Some of these questions have been addressed to a certain extent in prior literature.

Several studies have found that – on average - insider sales have limited or no

explanatory power when it comes to predicting future returns or forthcoming disclosure,

despite the alleged existence of private information-motivated transactions, and conclude

that the combined effects of liquidity sales and litigation threat probably explain the weak

association1. Numerous papers have been dedicated to identifying the link between

insider trading activity and selected subsequent news announcements. A strand of this

literature focuses on earnings (announcements) and has produced mixed evidence.

Sivakumar and Waymire (1994) find no association between insider trading and next

quarterly earnings announcement surprise. Ke et al. (2003) show that insiders increase

their sales two to nine quarters prior to a break in earnings increases, but not within two

quarters, which the authors attribute to litigation concern. Managers have also been 1 Such studies include Lakonishok and Lee (2001), Huddart and Ke (2005) for abnormal returns, Noe (1999) and Cheng and Lo (2005) for management forecasts. The tendency of researchers to aggregate insider purchases and sales into net purchases measures probably contributes to understating the relative inability of insider sales to predict future returns compared to insider purchases.

1

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shown to use their discretion over accounting accruals in order to manipulate reported

earnings, and consequently stock price. However, conflicting theories have emerged to

explain the link between managerial trading incentives and accrual manipulation. Bartov

and Mohanram (2004) argue that insiders inflate earnings to increase their proceeds from

option exercise, while Beneish et al. (2005) posit that they resort to income-increasing

accruals so as to delay the revelation of bad news to the market, and thus decrease their

exposure to litigation threat.

The studies mentioned above partially address the questions that I raise, but some

are left unanswered, such as what subset of sales is more strongly associated with future

news or how accruals around insider sales affect contemporaneous stock returns. Beside,

the role of litigation with respect to these questions remains to be documented explicitly.

The first goal of this study is to extract from the pool of insider sales - using firm-

specific patterns of trades - those that appear as potentially driven by foreknowledge of

bad news because of their suspicious amount and investigate their association with future

news, in terms of stock returns in the days and months following insider sales, as well as

around specific events such as earnings announcements. Using a measure of litigation

cost based on filings of Rule 10b-5 securities lawsuits, I investigate how ex-ante litigation

impacts the incidence of abnormally large sales and the timing of insider sales with

respect to bad news. I then revisit the literature pertaining to the association between

insider sales and accrual manipulation by looking at patterns of quarterly earnings

components around individual insider sales. I also attempt to distinguish empirically

between the proceeds-maximizing story and the litigation avoidance explanation for

income-increasing discretionary accruals contemporaneous to insider sales by looking at

the timing of negative returns after the sales.

Section 403 of the Sarbanes-Oxley Act (thereafter SOX) amends Section 16 of the

Exchange Act of 1934 by requiring insiders to report their trades to the SEC within two

business days. I investigate whether there is a market reaction to insider sales, if yes

whether it differs for trades that are more likely to be private information-based vs.

others, and whether the accelerated filing introduced under SOX modified the nature of

the reaction to insider sale disclosure.

2

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I hypothesize and find that the sales that deviate from firm-specific patterns and

hence identified as “abnormal” are more likely to precede bad news than other insider

sales, but not in the days immediately following the transaction. Those bad news

materialize, among other time periods, around subsequent earnings announcements, but

not the closest one. Both sets of results are consistent with the argument that abnormal

trades are not timed shortly before bad news, in order to avoid legal scrutiny. Because

lawyers do track firm-level insider selling activity, I hypothesize that managers are more

likely to engage in abnormal equity selling activity when their firm’s ex-ante litigation

cost is low. The results are consistent with this hypothesis, although they also show that

ex post, firm with abnormal sales face a higher litigation cost. With respect to earnings

components, I expect managers to be more (less) likely to use income increasing

(decreasing) accruals that exceed negative (positive) pre-managed earnings in the

quarters around their abnormal sales. The results hold in terms of levels of positive and

negative accruals, and negative changes in accruals. Further empirical analysis shows that

abnormal trades, when contemporaneous to income increasing discretionary accruals that

offset a loss, are timed ahead of smaller amounts of positive stock returns, which suggests

that managers use discretionary accruals to inflate earnings and stock price to maximize

their proceeds. By contrast, managers are less likely to use accruals to offset an earnings

decrease around their abnormal sales, and when they do so, their trades are followed by

greater positive stock returns, which supports the contention that managers tend to delay

the revelation of bad economic news after their suspicious trades using discretionary

accruals in this specific scenario.

Given the observed returns and trading volume around filing dates of SEC Forms

4 and their association with insider trades characteristics, I document that the market

reacts to Form 4 filings and conditions its reaction on the probability that a trade is

abnormal. The distinction between pre- and post-SOX trades reveals that the market

reacts to trade filings only after SOX, insofar as my proxies capture information relevant

to investors. Taken together, the findings of this study show that simple monitoring of

firm-specific trading patterns helps identify trades that are more likely to precede bad

news, that those trades are generally not timed immediately ahead of bad news, and that

managers use their discretion over reported earnings to manipulate the timing of bad

3

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accounting and economic news after their large trades. In addition, I find that market

participants react to insider trade disclosure. In particular, when such disclosure becomes

significantly more timely because of Section 403 of SOX, their reaction is associated

with the level of suspicion of a trade.

This study contributes to the literature by showing that insider trades that deviate

from firm-specific average levels - as detected using methods inspired from legal practice

– are a subset of the population of insider sales which are a better predictor of future bad

news. Furthermore, by looking at individual trades separately, I am able to document how

insider sales are timed with respect to future news. Also, I provide direct evidence of how

litigation affects managers’ trading decisions. I find that high litigation risk generally

preempts large insider selling activity and induces managers to time their trades

immediately before good news. Building on a strand of literature that focuses on the

relation between accounting information and managerial equity transactions, I show how

abnormal insider sales are timed with respect to accrual patterns and find evidence

supportive of the contention that managers delay bad accounting news with income

increasing accruals around their abnormal sales. In addition, I show that depending on

whether they use discretionary accruals to offset a loss or an earnings decrease, managers

time their trade so as to maximize their proceeds or delay the reflection of bad news in

stock price. However, since managers are generally less likely to resort to increases in

discretionary accruals after their suspicious sales, the evidence in this paper gives only

limited support to the role of discretionary accruals in avoiding litigation in the presence

of high insider selling activity. Finally, I contribute to the literature that explores the role

of insider trading in incorporating information into stock prices. To the best of my

knowledge, this is the first study to examine the impact of Section 403 of SOX on insider

trading informativeness. Except for Aboody and Lev (2000) in the case of R&D, and

Lakonishok and Lee (2001) for size and book-to-market ratio, no study has explored the

determinants of the returns around SEC filing dates of insider trades.

The remainder of the paper is organized as follows: Section 2 reviews the relevant

literature. Section 3 develops the hypotheses. Section 4 delineates the research design.

Section 5 describes the sample and presents the results. Finally, Section 6 concludes. In

addition, the appendix provides information on variable constructs.

4

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2. Background and literature

There are numerous studies – in the finance and accounting literature -

investigating the association between insider trading and the information dissemination

process on capital markets, and whether the former contributes to the latter.

It is well established that trades by insiders are followed by abnormal returns.

Papers documenting this result include Jaffe [1974], Finnerty [1976], Seyhun [1986,

1992], Rozeff and Zaman [1988], Lakonishok and Lee [2001]. While insiders trade

routinely in their own stock for liquidity and portfolio rebalancing purposes, the findings

in the studies aforementioned are indicative of their trades being motivated by

information not impounded into stock price at the time of the transaction. When it comes

to identifying the nature of the information that managers trade upon, insider trading

around earnings announcements has received a great deal of attention in the past

literature. For instance, Sivakumar and Waymire (1994) find that, although post-earnings

announcement insider trades earn significant abnormal returns, they are not consistent

with the subsequent one-quarter-ahead earnings surprise. Ke et al. (2003) document that

insiders modify their trading activity in response to upcoming breaks in strings of

earnings increases as early as two years in advance, but not within two months, which

they interpret as avoidance of legal scrutiny. Managers may also have more of an

information advantage about earnings components that are estimate-based rather than

factual. Beneish and Vargus (2002) find that accruals are less persistent when preceded

by abnormally large insider selling activity, which they partly attribute to opportunistic

earnings management. Beneish et al. (2005), in a sample of firms experiencing default,

find that managers sell their stock prior to managing earnings upward, which they

interpret as an attempt by insiders to delay bad news in order to reduce their exposure to

litigation. Looking at option exercises, Bartov and Mohanram (2004) find that during

years of abnormally high level of exercise, firms report positive discretionary accruals,

that reverse in the subsequent year. All three papers provide evidence consistent with

managers resorting to income manipulation in response to their trading incentives.

Altogether, the evidence so far on the effect of accruals on insider trading timing and

5

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profitability is limited, as most studies aggregate insider transactions and accruals on a

yearly basis.

Many studies come to the conclusion that their results are consistent with

managers considering litigation threat in their trading decisions. However, very few do

actually implement tests of the effect of litigation on insider trading. Exceptions include

Ke et al. (2005), who show that insiders in firms facing high litigation risk shift their

trades to lower “jeopardy” periods (from right before to right after earnings

announcements) and their trades exhibit a stronger association with the recent earnings

announcement news, which is allegedly a low-risk strategy, since insiders can only be

sued for trading on non-public material information. Jagolinzer (2004) estimates the

litigation cost faced by individuals and how it affects their decision to elect for trades

scheduled within Rule 10b-5-1.

While those studies cover post PSLRA sample periods, federal regulation has

changed over time since the Exchange Act of 1934. Bainbridge (2001) provides a

comprehensive review of the pre-Sarbanes Oxley insider trading law in the US. The basis

of federal regulation on insider trading is Section 10(b) of the Securities Exchange Act of

1934, and more particularly Rule 10b-5. Another aspect of insider trading regulation of

potential importance to investors is the reporting requirements that insiders are subject to,

as defined under Section 16 of the Exchange Act until 2002, and Section 403 of SOX

subsequently. Under the previous rules, directors, officers and 10% or greater

stockholders were required to report most changes in their beneficial ownership every

month on a Form 4, to be filed within 10 days after the close of the calendar month in

which the transaction occurred. Section 403 amended this provision of Section 16 of the

Exchange Act by accelerating Form 4 filings. As of August 29, 2002, insiders are

required to file Form 4 with the SEC and the appropriate stock exchange within two

business days of the transaction date. As before, the report must include the insider’s

ownership as of the filing date. Additionally, starting July 30, 2003, insiders must file

Form 4 electronically. The SEC, as well as issuers maintaining websites, is required to

post those forms on a publicly available website within one business day of the filing.

Two studies have looked at returns around Form 4 filing dates in pre-SOX sample

6

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periods. Aboody and Lev (2000) find that raw returns around trade disclosures to the

SEC are significantly positive (negative) for purchases (sales), especially for firms with

R&D expenses. By contrast, Lakonishok and Lee (2001) find no economically significant

abnormal returns around transaction and SEC filing dates of insider open market

purchases and sales from 1975 to 1995. Other studies drawing conclusions on the

information content of insider trades include Damodaran and Liu (1993), who find that

insider trades elicit a market reaction in the context of appraisals of Real Estate

Investment Trusts (REITs), and Givoly and Palmon (1985), who infer from the observed

abnormal returns following insider transactions and the low disclosure incidence

following them that insider trades themselves generate abnormal returns, although they

do not refer to Form 4 filing dates. From a different angle, Piotroski and Roulstone

(2005b) show that insider trading activity is positively associated with the incorporation

of firm-specific information in stock prices. To my knowledge, no study, to date, has

investigated the impact of Section 403 of SOX on insider trading.

3. Hypothesis development

1) Timing and profitability of insider sales

Insider sales constitute the primary focus of this paper. Prior research has

consistently attributed a greater predictive ability for future returns to insider purchases2,

and often found that insider sales have – on average – little predictive power (see, e.g.,

Lakonishok and Lee [2001]) and are not profitable (Huddart and Ke [2005]). This result

is usually explained in the literature by two non-mutually exclusive hypotheses.

First, insider sales are subject to greater litigation risk than purchases. This is

assumed to be the by-product of an asymmetry in expected legal costs associated with

good and bad news. Consistently across studies that analyze a sample of securities-related

lawsuits, it appears that most cases are related to large stock price declines (Francis et al.

[1993], O’Brien and Hodges [1991]). Skinner (1994) suggests that “the legal reasons for

2 Studies documenting this regularity include Jaffe (1974), Finnerty (1976), Seyhun (1986, 1988), Noe (1999)

7

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this asymmetry appear to relate to proof of damages and the need to show a sufficient

causal connection between the plaintiff’s injury and the wrongful conduct.” In the case of

good news, one suffers an opportunity loss rather than an out-of-pocket cost, and proving

that they would not have sold if the information was available in due time, in order to

show causation, remains a difficult task. The connection with insider trading comes from

the fact that insider selling is recognized by courts as a mechanism to establish that the

defendants acted with scienter in securities fraud allegations, which plaintiffs ought to

prove for their lawsuit to prevail under Rule 10b-5. Hence, plaintiffs resort to insider

selling allegations to substantiate many cases. This has become particularly prevalent

after the enactment of the PSLRA of 1995, which further shifts the burden of proof to the

plaintiffs’ side3.

Insider sales are also driven by liquidity needs. Stock holdings are part of

managers’ compensation packages, and with the increasing tendency of firms to resort to

non-cash compensation devices, it is implicit that some or all of (restricted) stock and

option grants may be converted to cash for managers’ consumption needs. Trades that

respond to liquidity needs further weaken the predictive ability of private information-

based insider sales and provide an additional explanation for the lack of profitability of

insider sales4.

The first part of this paper is aimed at identifying insider sales of suspicious

amounts and investigating their association with future news. Given the importance of

litigation costs in insider trading decisions, I choose techniques observed in legal practice

as guidelines to identify abnormal trades. Lawyers, on behalf of investors, track insider

sales to detect any suspicious activity and include insider selling allegations in securities

fraud lawsuit filings (cite article). However, under the increased pleading standards for

scienter introduced by the PSLRA, courts have developed rules of thumbs to facilitate

their decision making process on motions to dismiss. Sale (2002) provides a review of the

heuristics used by judges to reject fraud-based allegations invoking insider selling to

3 Johnson et al. (2002) and Pritchard and Sale (2003) find in their samples that a majority of post-PSLRA lawsuits include insider trading allegations. 4 By contrast, I assume throughout the study that insider purchases are not motivated by liquidity needs. Since managers have undiversified portfolios with greater exposure to their company’s stock than optimal (from their point of view as an investor), they should only make open market purchases when expecting good news that will materialize in positive abnormal returns.

8

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establish scienter. Broadly speaking, plaintiffs must substantiate their allegations by

providing evidence that the trades are suspicious, with respect to their timing and

amount5. Hence, I follow courts’ approach to assess the probability that trades are

indicative of scienter to separate normal/liquidity from suspicious/abnormal trades. My

dichotomy is based solely on trading amount criteria, which enables me to test whether

abnormally large insider sales are timed opportunistically. I argue that managers, because

of the expected legal costs associated with selling their stock ahead of bad news, will

avoid large trades shortly before the release of bad news. However, relying on the timing

heuristics used by courts, whereby judges dismiss fraud allegations if trades are not timed

in a manner that univocally indicates fraud, I posit that summary judgments are more

likely to be granted to defendants if bad news is revealed gradually to the market or in the

months following the trades. Therefore, managers are hypothesized to deviate from their

liquidity-based trading pattern only if they anticipate bad news over a horizon longer than

what would be considered imminent. By contrast, liquidity trades should not – on average

– presage bad news. To summarize the short-term and medium-term distinction between

returns following normal and abnormal trades, the first hypothesis states:

H1: abnormally large insider sales are more likely to precede bad news than

those in line with past trading activity from the same firm’s insiders. Because of legal

jeopardy, bad news following abnormal sales do not materialize shortly after the trades

occur.

2) Insider sales and litigation

Conditional upon the rejection of the null of the first hypothesis, i.e. assuming that

abnormally large insider sales are, indeed, profitable, they should be subject to legal

scrutiny. In particular, because those trades are identified using techniques inspired by

legal practice, they constitute – in conjunction with bad news - a primary target for

securities lawsuits pursuant to Rule 10b-5. In the presence of forthcoming bad news, why

then would managers’ best response consist of trading in a way that is precisely what

5 I will review the heuristics in more detail in the research design section, where I articulate the different criteria of my distinction between normal and suspicious trades.

9

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investors consider as suspicious? I argue in Hypothesis 1 that insiders time their trades

sufficiently ahead of bad news to increase the difficulty for plaintiffs to prove the

connection between their trades and subsequent disclosure. Moreover, I argue that an

additional parameter in the decision to trade is the ex-ante litigation cost. If facing, ex-

ante, a low litigation risk, insiders are more likely to consider that the total benefit from a

large dollar amount of sales exceeds the expected litigation out-of-pocket cost. The

benefit accruing to an insider upon an abnormal stock sale is considered to be the sum of

two components. The first one is simply the proceeds from the sale, while the second one

is the loss avoided by trading before a benchmark date. By deviating from consumption-

driven trading patterns, abnormal sales are assumed to accelerate sales that would have

been timed in the next year(s) otherwise. Since I assume that litigation threat is

decreasing in distance to bad news, I argue that symmetrically, managers time their trades

further away from bad news as they face a higher ex-ante litigation risk. By doing so,

however, they are more likely to realize lower proceeds to the extent that more good

news is to be reflected in stock price after the trades are completed. In summary, the

second set of hypotheses is stated in alternative form:

H2: a) In years of abnormal insider sales, firms face lower ex-ante than firms

with no abnormal trading.

b) The amount of good news following an insider sale is increasing in the ex-

ante litigation faced by the firm.

3) Insider sales and accruals

The hypotheses so far are silent about the nature of the private information that

insiders trade upon. Previous research has shown that managers use their information and

discretion about future earnings reports to increase their profits from stock-based

transactions. Bartov and Mohanram (2004) find that in years of abnormally high option

exercise, managers resort to income increasing accruals in order to inflate earnings and

potentially stock price on exercise date. In the year following abnormal exercise, they

report disappointing earnings that result from the reversal of the prior year’s accruals. In

a concurrent study, Beneish et al. (2005) document similar findings using insider sales in

10

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a sample of firms experiencing technical default, but interpret the earnings management

in the year of abnormal insider sales as a deferral of bad news in order to avoid litigation.

The aggregation of trades or option exercises and accruals at the firm-year level in the

studies aforementioned make it difficult to sort out between a proceeds-maximizing

scenario, whereby managers would inflate stock price through income increasing accruals

and sell at a peak vs. the litigation hypothesis, which suggests that managers resort to

positive abnormal accruals after their sales in order to delay bad news and conceal its

connection with their abnormally large selling activity. The litigation scenario is

consistent with findings in the literature, such as the increase in insider sales two to nine

quarters prior to a break in earnings increases documented by Ke, Huddart and Petroni

(2003). The absence of association between the occurrence of the break and insider

selling in the two preceding quarters is attributed to litigation avoidance. Likewise, if

income increasing accruals persist in the quarters subsequent to insider sales, it would be

provide additional support for the litigation interpretation. In addition, stock returns

following insider sales contemporaneous to high unexpected accruals should be

informative about managers’ use of accruals for proceeds-increasing or litigation-

avoidance purposes. For example, the joint occurrence of opportunistic accrual

manipulation and insider sales puts managers at risk with respect to litigation if plaintiffs

can prove that price was inflated at the time of the sales. Therefore, to the extent that the

litigation avoidance argument holds, I would expect – ceteris paribus – more good news

to follow insider sales when contemporaneous to positive accruals. To summarize the

role of accounting discretion in the timing and profitability of insider sales, H3 a) is

stated in its alternative form, whereas H3 b) is stated in its null form, since the distinction

between the price-maximizing and litigation avoidance hypotheses is left as an empirical

question:

H3: a) abnormal sales are more likely to be immediately followed by positive

discretionary accruals and negative pre-discretionary accruals earnings (or change

thereof) than normal sales,

b) The positive stock returns following abnormal sales executed during a quarter

where managers use discretionary accruals to avoid reporting a loss or an earnings

decrease are not different from those following other sales.

11

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4) Information content of insider sales

The trades taken into consideration in this empirical study become eventually

observable because they are subject to filing requirements with the SEC, which releases

them through the EDGAR system. Insofar as it does not occur after the news that insiders

were anticipating, the disclosure of information about insider trades may be of interest to

market participants. However, there is no clear evidence in the literature as to whether the

market reacts upon the release of SEC Forms 4. Lakonishok and Lee (2001) find a

statistically but not economically significant average market-adjusted return around SEC

filing dates across a large sample of insider purchases and sales. Aboody and Lev (2000)

find that trades filed by insiders in firms that report R&D trigger larger (signed) raw

returns than no-R&D firms. They attribute this result to the greater information

asymmetry associated with R&D activity, which explains why investors pay greater

attention to trades in those firms. Following up on the previous hypotheses, I argue that

insider sales are not equally relevant to investors. Abnormal sales are more likely to

presage bad news, yet not in the short run, so that even if they are not immediately known

to the public, their disclosure may still trigger a negative market reaction. However, the

timeliness of the disclosure may have an impact on the nature and the magnitude of the

market reaction. My sample period is not homogeneous with regards to this dimension,

since Section 403 of the Sarbanes-Oxley Act, effective August 29, 2002, modifies the

disclosure requirements that corporate insiders are subject to with respect to their trades,

as previously defined by Rule 16b of the Exchange Act. Insiders are required to file their

trades with the SEC within two business days of the transaction, which drastically

reduces the delay that was allowed under the previous rule. To summarize the hypotheses

related to the market reaction to insider trade filings, H4 is stated in its alternative form:

H4: a) Abnormal returns around SEC filing dates of insider trades are negatively

associated with the probability that trades are motivated by insiders’ private information.

b) The nature of the reaction is different before vs. after Section 403 of the SOX

came to effect.

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4. Research design

1) Measures of normal/expected insider trading

The first stage of the analysis consists of identifying abnormally large insider

sales. Lack of consensus in prior research about the correct measure of insider trading

activity suggests the use of several alternative proxies. I choose to measure insider

trading with the number of shares traded, deflated by the number of shares outstanding on

the same day, as in Beneish and Vargus (2002), or by the number of shares held by the

reporting insider6. Next, I need to consider the level of aggregation of trades. There are

two dimensions for within-firm aggregation of insider trades: a temporal one, and the

type of insiders that are included in the aggregate measure. Most studies restrict their

analysis to directors and officers and exclude other persons subject to reporting

requirements of Section 16 of the Exchange Act, mainly large shareholders that hold 10%

or more of the shares outstanding. I choose to aggregate only trades from top

management team members (i.e. CEOs, CFOs, Chairmen of the Board, Presidents and

COOs as in Rogers [2004]) for my measures of expected trading. This choice is driven by

the assumption that those are the insiders whose access to non-public information about

the firm’s future operations is assumed to be most timely and accurate, and who are

assumed to exert influence on the disclosure policy of the firm. It is also motivated by

the “All-defendant” judging heuristic, which relies on the theory that if there was fraud,

the highest-ranking (“most knowledgeable”) managers must have taken part to the selling

activity (see Sale [2002] for example of cases where judges dismissed scienter inferences

based on the absence of trades by CEOs or CFOs). The “All-defendant” heuristic

reinforces the validity of monitoring insider trading at the firm-level. The time dimension

of insider trade aggregation is also subject to trade-offs between accuracy and data

6 Theoretically, deflating trades by insiders’ equity holdings is more appealing than using shares outstanding, because it better reflects the impact of trades on insiders’ portfolios, and patterns of trades as a percentage of insider holdings should provide a more accurate proxy for liquidity and portfolio rebalancing needs. However, when selling “conventional” stock, insiders report their holdings exclusive of options. By contrast, when selling options, they report only option holdings for a specific series, so total (option) holdings are generally not observable in Thomson Financial. Using other observations in the database (Such as holdings records with no associated transaction), I retrieve stock holdings data for insiders even in years when they do not trade and check for inconsistencies within years and from year to year.

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availability. Too large a window may introduce noise and decrease the detection power of

the model for abnormally large individual trades, while analyzing trades over small time

intervals potentially ignores the frequency with which liquidity trades occur. Another

factor that reduces trading frequency is the short-swing profit rule that entitles firms to

claim profits realized by insiders from round trip transactions within six months. Hence,

as a compromise, I aggregate trades over fiscal or calendar years as a base case for my

estimations of normal firm-level insider trading.

Abnormally large trades can be detected using either firm-specific time-series

patterns of trading or compared with other firms in the sample. Recent research has

attempted to distinguish between normal and abnormal levels of insider selling activity.

For example, Beneish et al. (2005) classify firm-years as abnormal sellers if their net

selling activity exceeds the median in the same size decile over the same calendar year

(cross-sectional approach) or if they sell more than the previous year (time-series

approach). As Bartov and Mohanram (2004) do for abnormally large option exercises, I

choose a time-series approach. Notwithstanding the difficulties to control for the

substantial cross-sectional differences among sample firms in terms of managerial

compensation (especially since my study is not restricted to Execucomp firms), liquidity

needs of managers are better assessed using their own past trading behavior rather than

contemporaneous trades by insiders in other firms. Furthermore, time-series detection of

abnormal sales akin to that in legal practice enables me to test the validity of court

heuristics. Yearly aggregate insider sales as a percentage of shares outstanding (and

shares held when available) are compared to their average over the past two to five years

for each firm. If the magnitude exceeds the historical average by more than three standard

deviations with respect to both measures, the firm-year is classified as abnormal (Abn=1)

with respect to insider sales, normal otherwise (Abn=0). If there is only one prior year of

data available, the firm-year is classified as abnormal if its level of sales exceeds the prior

year’s by more than 50%. The cutoffs are arbitrary and represent a trade-off between

sample size and noise7. To be consistent with the “Percentage heuristics”, whereby courts

have dismissed fraudulent insider trading allegations based on the premise that the

7 Sale (2002) reports that the courts rhetoric contains criteria such as trades being suspicious only if “drastically out of line with” past trades. Quantifying such wording necessarily requires a high degree of subjectivity. I try many different combinations of parameters to sensitize the abnormal trade definition.

14

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defendants sold only a fraction of their total stock holdings, even if the transaction

proceeds amounted to several millions of dollars, shares held by insiders should be used

as the primary deflator. The “Option-basis heuristic” includes option holdings in the

denominator. Because insiders’ total holdings are not available in Thomson Financial,

common shares outstanding are used as the primary deflator in my tests. For firm-years

with consistent data on insiders’ holdings, I also check whether the sales qualify as

abnormal as a weighted-average percentage of insiders’ holdings. Note that throughout

the study, I refer to shares sold divided by shares outstanding as Net_Shrout and divided

by shares held as Net_Hold. As long as a firm has return data available on CRSP during a

given year, it is accounted for in the measure of expected trading. Hence, many firm-

years are assigned a value of zero trading. The next step consists of examining individual

trades within each ‘suspicious’ year. Given that the “abnormal” flag is attributed at the

firm-year level, all trades within an abnormal firm-year are considered as abnormal,

regardless of their size.

H1 tests the timing and profitability of normal vs. abnormal sales. I use stock

returns as my primary measure of news. Under the filing requirements prior to Section

403, it was not unusual that insiders would trade on several days in a given month and

report all trades altogether on the same filing date8. I aggregate trades reported by the

same insider on the same date. Pre-trade returns (PreRet) are computed over the 10

trading days prior to the first transaction date, cumulating size-adjusted daily returns.

Post-trade returns (PostRet) are computed over a window starting from the last

transaction date until the SEC filing date. Since this window varies in length, cumulative

size-adjusted daily returns are scaled by the number of trading days in the post-trade

window. I choose the SEC filing date as the end date because presumably, over the post-

trade window defined as such, the identity of the trader is not public information, and

8 The split of trades into several transactions over several days probably represents an attempt by insiders to limit the impact on stock price of large transactions. It may also be due to pre-arranged terms. I assume that the choice of transaction dates is at the discretion of the insider. Intra-day timing is more likely to be attributable to the broker.

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information asymmetry between the corporate insider and outsiders is exacerbated (see

Aboody and Lev [2001] for a similar argument)9.

Insider trading profitability (more precisely loss avoided for sales) is measured

over a six-month period, following Huddart and Ke (2005). It is calculated as the product

of the number of shares traded times the reported transaction price times the abnormal

return computed over the six months following the trade, excluding the transaction date.

The abnormal return is adjusted for by a five-factor model, based on the Fama-French

(1993) three-factor model augmented for momentum as in Carhart (1997) and

information risk as in Aboody et al. (2005). Information risk is included in the pricing

model because of evidence in the literature that it is priced by investors (Easley et al.

[2002], Easley and O’Hara [2004], Francis et al. [2005]) and affects the profitability of

insider trades (Aboody and al. [2005]). The last factor is constructed using the return on a

mimicking portfolio that is long in low earnings quality firms and short in high earnings

quality firms. Consistent with Aboody et al. (2005), I use the cross-sectional modified

Jones model developed by Dechow et al. (1995) (see also Subramanyam [1996], Guay et

al. [1996], Bartov et al. [2000]) to measure abnormal accruals, whose absolute value

proxies for earnings quality. The following regression is run by Fama-French industry

and calendar year (using the most recent fiscal year for firms whose fiscal year-end is not

December), provided there are at least 20 observations with the required data available in

any given industry/year:

0 1 2 3( )i i i iTA Sales AR PPE ASSETi iγ γ γ γ= + ∆ −∆ + + +ε (1)

where TA is total accrual, Sales∆ is annual change in sales, AR∆ annual change

in accounts receivable, gross property, plant and equipment and beginning

of the year total assets. Since all variables are scaled by ,

PPE ASSET

ASSET 3γ is the intercept of the

regression. is measured as the difference between net income before extraordinary

income and operating cash flow adjusted for extraordinary items that affect cash flows

(Compustat annual Data124). To reduce the influence of outliers, all variables are

truncated at 1% each tail. Each regression produces firm-year specific error terms that are

TA

9 Because Section 403 reduces the transaction-filing date window to two days, I exclude trades executed after August 29, 2002 from this analysis. As a robustness check, I set the post-event window to ten trading days and include all trades in the sample period.

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labeled discretionary (or abnormal) accruals. For each fiscal year, firms are ranked by the

absolute value of their discretionary accrual component. Firms in the bottom (top)

quintile are classified as high (low) earnings quality. To ensure that the data used in

classifying firms into earnings quality quintiles is publicly available, the factor-

mimicking portfolios are based on the previous year earnings quality rankings.

Over the two years preceding the month during which the trade occurs, daily

stock returns are regressed on daily market excess return, size, book-to-market,

momentum and earnings quality factors, using the following firm-specific time-series

specification:

, , 1, , , 2, 3, 4, 5,( )i t f t i i m t f t i t i t i t i t i tR R R R SMB HML UMD EQ ,α β β β β β− = + − + + + + + ε (2)

Where ,i tR is firm i’s stock return, ,f tR the risk-free rate (one-month T-Bill rate),

,m tR the market rate (CRSP value weighted index), and the Fama-French

(1993) size and book-to-market factors, the Carhart (1997) momentum factor and

the earning quality factor (the t subscript stands for day t). The coefficient estimates

obtained from this first stage regression are subsequently used to fit expected daily

returns based on the five factors

tSMB tHML

tUMD

tEQ

10 and subtracted from actual returns to obtain daily

abnormal returns, summed over the six month period to obtain the desired cumulative

abnormal return FFRet. In turn, this six-month abnormal return multiplied by the trade

value (shares traded times transaction price) times (-1) is defined as Profit. Because of

the skewness of the trade value variable, I use its logarithm multiplied by the abnormal

return (times -1) to compute Ln_Profit.

To test H1, I first use univariate tests. Since the distinction between normal and

abnormal trades is performed at the firm-level, I compute firm-specific comparisons of

profits for normal and abnormal trades, at the firm-year and individual trade levels. For

the firm-year level test, insider trading profits (for 3-, 6- and 9-month horizons) are

summed for each calendar year, and the firm-specific difference between average yearly

profits for abnormal and normal years is computed. I then look at the distribution of this

difference across all sample firms that have at least one normal and one abnormal year of 10 The factor loadings are estimated using rolling windows, because they are not expected to be stationary over time. Also, consistent with the unrestricted approach undertaken in the empirical finance literature, the intercept α is included in the estimation of expected returns, although its theoretical value is zero.

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insider selling activity. In particular, I test whether the cross-sectional mean and median

are significantly positive. I run the same test at the individual trade level. As for the

aggregate analysis, the mean and median firm-specific difference between the average

abnormal and normal trade profits (and returns) are expected to be significantly positive.

By contrast, short-term returns differences are not expected to be significantly different

from zero. A similar test is performed cross-sectionally. Individual sales are ranked

across all firm-years by Net_Shrout into quartiles. Within each quartile, the mean and

median Net_Shrout, Profit and Ln_Profit are then computed separately for normal and

abnormal trades. Again, I expect the mean and median Ln_Profit and Profit to be

significantly greater for abnormal than for normal trades, within each quartile. Ideally,

there would be no significant difference in terms of Net_Shrout, which would indicate

that the quintile decomposition effectively controls for scaled trade size.

In order to test jointly the association between normal/abnormal trades and short-

term/long-term returns, I use a multivariate logit regression analysis. Logit appears to be

more appropriate than an OLS specification because there may not be a linear

relationship between insider trading and subsequent returns, and the primary question is

to see if normal and abnormal sales are characterized by different timing and profitability,

so the dependent variable takes only two values. The joint test of timing and profitability

is summarized by the following equation:

0 1 2 3

4 5 6

7 8 9

Pr( 1) ( *

* *

)j jj

Abn f PreGood PreRet PreGood PreRet

PostBad PostRet PostBad PostRetPosProfit FFRet PosProfit FFRet

Ctrl

β β β β

β β ββ β β

β ε

= = + + +

+ + ++ + +

+ +∑ (3)

H1 states that abnormal trades are more likely to be profitable on average. Hence,

the variable PosProfit equal to one if the six month abnormal return following a trade is

strictly negative, zero otherwise is expected to be significantly and positively associated

with the probability that a trade is abnormal. Additionally, this dummy variable is

interacted with Profit, to see if the likelihood of a trade being abnormal is increasing in

its profitability, given that it is profitable. In a similar fashion, the timing of insider sales

with respect to short-term returns is captured by PreRet, PostRet and dummy variables

PreGood, PostBad that equal 1 if PreRet is positive and PostRet negative. Regarding

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PreGood and PreRet, both abnormal and normal trades are expected to follow good

news, so these variables may not be significantly different from zero11. As for PostBad

and PostRet, according to H1, they should not be different from zero. Control variables

include Size (Log of market value as of the end of the most recent fiscal year) which is

expected to be negatively associated with Abn because large firms should have more

stable trading patterns, BM (Book to Market value of equity ratio, end of the most recent

fiscal year) which should exhibit a negative association with Abn because insiders tend to

be contrarians and sell more heavily when the market-to-book ratio is high (Rozeff and

Zaman [1998]), AllHi (variable equal to one if the price is an all-time high on the

transaction date, zero otherwise) should be positive because option exercise has been

shown to occur on all-time price days (Carpenter and Remmers [2001]). Lagged

performance measures (Lag∆ROA and LagRet) account for determinants of passive

trading that would not be captured by the short-term window over which PreRet is

measured, and should be positively associated with Abn if abnormal trades capture

passive trades.

In order to gain more insight into what private information insiders trade upon, I

investigate whether the profitability of abnormal sales materializes around specific

events. Earnings announcements are a natural candidate because they are associated with

returns of economic significance and there is mixed evidence in the literature as to

whether insiders engage into informed trading ahead of these events, so the

liquidity/informed trades distinction may shed light on this question. Furthermore, while

technically not mandatory, preliminary earnings announcements are very common and

relatively predictable in terms of timing, which partly mitigates concerns of endogeneity

between the timing of abnormal sales and that of earnings announcements. My primary

measure of earnings surprises is the 3-day abnormal return around the announcement

date. This measure circumvents the problem of unobservable market expectations and is

of greater interest in the case of insider trading because it measures directly a benefit (or

11 Alternatively, using the terminology introduced by Seyhun (198?), insiders may trade passively on their private information. Passive trading consists of delaying trades until after good news are released (in the case of insider sales) in order to maximize the proceeds. My abnormal trades may include large sales by insiders who want to capitalize on recent good news without consideration for future news.

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loss) to insiders’ equity sales. Since I assume that insiders have a horizon of about six

months when deciding to trade on private information, annual earnings surprises may be

too untimely. Hence, I focus on quarterly earnings announcements. In addition, insiders

are assumed to favor abnormal sales that will be revealed gradually to the market, so I

include up to three leading earnings announcements (two of which fall within the 6-

month window over which Profit is measured). I perform a univariate and logit analyses.

The univariate test simply computes the mean and median abnormal returns around the

three earnings announcements following insider sales, separately for normal and

abnormal sales, and tests whether they are significantly lower after abnormal sales. For

the logit, as in Model (3), I primarily test the association between the incidence of

abnormal insider sales and negative returns around earnings announcements, but also

include variables that account for the magnitude of the surprise. Following the argument

that litigation threat decreases in distance to news, I expect abnormal sales to be

associated with negative returns around the second next earnings announcement, and

possibly third if insiders’ horizon exceeds six months. The logit model is:

0 1 2 3 4 1

5 1 6 1 1 7 2 8

9 2 2

Pr( 1) ( *

*

* )

t t t t t

t t t t

t t j jj

Abn f PosEA CarEA PosEA CarEA PosEA

CarEA PosEA CarEA PosEA CarEA

PosEA CarEA Ctrl

β β β β β

β β β β

β β ε

+

+ + + +

+ +

= = + + + +

+ + + +

+ + +∑2t+ (4)

In light of the discussion above, since the t nPosEA + are set to 1 if the abnormal return

around the n+1th quarterly earnings announcement following an insider sale is strictly

positive (zero otherwise), 4β and 7β are expected to be significantly negative. Litigation

threat should deter large sales ahead of the closest earnings announcements, so 1β is not

expected to be significantly negative. Because of plausible contradicting hypotheses, I

make no predictions for the signs of the coefficients on magnitudes of the returns.

The second hypothesis posits that insiders are more likely to deviate from normal

selling patterns if their ex-ante litigation cost is low, so as to minimize their exposure to

legal jeopardy. During the year of abnormal trading and the subsequent one, litigation

cost should, by contrast, significantly increase above that of firms with no abnormal

trading activity. To test H2, I first calculate the fitted probability of a class action

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securities lawsuit being filed for a given firm-year using the model developed in Rogers

and Stocken (2005), similar to that in Johnson et al. (2000). I use the same variables as in

Rogers and Stocken (2005) but choose a logit specification on a yearly basis instead of

probit on a quarterly basis. More details are provided in the appendix. The second stage

consists of a univariate and a logit analyses as in the previous tests. For the univariate

analysis, all firm-years are ranked into quartiles based on aggregate Net_Shrout. The

mean and median ex-ante litigation costs are then calculated separately for normal and

abnormal sales within each quartile. I test whether the mean and median are significantly

lower for abnormal sales. Besides the ex-ante (lagged year) litigation cost measure, I

include the current (same year) and ex-post (next year) litigation fitted probability12. The

logit regression is as follows:

0 1 1 2 3 1Pr( 1) ( )t t t jj

Abn f Lawfit lawfit Lawfit Ctrl jβ β β β β− += = + + + + +ε∑ (5)

The main coefficient of interest is β1, which is expected to be negative, according

to H2. β3 is included to check whether the combination of abnormal insider sales and bad

news results in greater legal scrutiny.

The third set of hypotheses pertains to the role of accounting accruals with respect

to the timing and profitability of abnormal insider sales. To test H3, I need a measure of

discretionary accruals on a quarterly basis. I use a quarterly version of the annual model

described above for the EQ factor construct13. Unmanaged earnings are defined as the

difference between net income before extraordinary items and discretionary accruals. As

in the previous tests, I use a logit regression to test whether abnormal insider sales are

more likely to follow and precede patterns of discretionary accruals and unmanaged

earnings that are highly suggestive of earnings manipulation. I run the following two

tests:

12 H2 remains silent about the relation between ex-post litigation cost and abnormal sales. A predictably higher ex-post litigation cost may imply irrational expectations on behalf of managers. However, the joint occurrence of high insider selling activity and bad news will likely result in an increase in the litigation cost faced by the firm. Since the litigation cost is based upon filings of Rule 10b-5 lawsuits irrespective of whether they turn out to have merit or not, the higher ex-post litigation may be driven by lawsuits that will eventually be dismissed, which managers probably take into account in their trading decision problem. 13 All variables are the same except for net PPE instead of gross PPE, which has many missing observations on the quarterly tape. The caveat of switching to net PPE is the potential effect of managerial discretion on depreciation and amortization being attributed to non-discretionary accruals.

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0 1 1 2 3 1 4 2 5 3

6 1 7 8 1 9 2 10

Pr( 1) (

)

t t t t

t t t t

j jj

Abn f Pump Pump Pump Pump Pump

Dump Dump Dump Pump PumpCtrl

β β β β β β

β β β β β

β ε

− + +

− + +

= = + + + + +

+ + + + +

+ +∑3

t

t

+

+

3

t

t

(6)

0 1 1 2 3 1 4 2 5 3

6 1 7 8 1 9 2 10

Pr( 1) (

)

t t t t

t t t t

j jj

Abn f Boost Boost Boost Boost Boost

Drag Drag Drag Drag DragCtrl

λ λ λ λ λ λ

λ λ λ λ λ

β ε

− + +

− + +

= = + + + + +

+ + + + +

+ +∑

+

+ (7)

Pump ( ) is set equal to 1 if the firm experiences an increase (decrease) in

discretionary accruals that more than offsets a decrease (increase) in unmanaged

earnings, zero otherwise. ( Drag ) is set equal to 1 if discretionary accruals are

positive (negative) and of greater magnitude than negative (positive) unmanaged

earnings. According to H3a, managers are expected, on average, to be more likely to

“pump” or “boost” earnings in the quarter during which they engage in abnormal sales to

postpone the revelation of poor future prospects to the market and/or inflate stock price to

increase their proceeds, so the coefficients on Pump

Dump

Boost

t and Boostt are expected to be

positive. Symmetrically, they are expected to be less likely to engage into abnormal

selling before a or scenario. The evidence in Ke et al. (2003) suggests that

insiders refrain from selling their stock within two quarters of a break in consecutive

earnings increases, but this result may not follow in terms of managed/unmanaged

earnings, therefore, while I expect a sign reversal for all sets of variables (e.g.

Dump Drag

1β (+) 2β (+) 3β (+) 4β (-) 5β (-)), I do not have specific predictions as to when they occur.

The further the reversal from the quarter during which the sale occurs, the more support

the evidence would give to the litigation avoidance hypothesis.

The fourth set of hypotheses relates to the potential market reaction to SEC filings

of insider sales. To test H4a and H4b, I use the following OLS regression model:

0 1 1 2 3 4

5 6 7

* *_

Abret PS Abnfit Abnfit PS PostRet PostRet PSBM Size R D

α α λ λ λ λλ λ λ ε

= + + + + +

+ + + + (8)

Model (8) tests the market reaction to SEC filings of insider sales using size-adjusted

returns measured over short-windows starting from the filing date and ending 2 to Abret

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4 trading days after. The 2-day post-filing minimum requirement accounts for potential

delays between the filing date and the availability of its content to the public (though the

electronic filing requirement - effective July 2003 - mitigates this issue), while the 4-day

upper limit is consistent with that in Lakonishok and Lee (2001). is a dummy

variable equal to 1 if the insider trade was executed after August 29, 2002, zero

otherwise. So far, abnormal trades have been detected on a firm-year basis, which is not

timely enough for investors to react to individual trades throughout the year. To alleviate

this problem,

PS

Abnfit is constructed using only publicly available data. Details about the

estimation of Abnfit are provided in Appendix B. Although Abn is determined at the

firm-level using time-series data, determinants of Abnfit are also measured cross-

sectionally. The parameters, such as ex-ante litigation risk, size, book-to-market ratio,

R&D, trade size or past trading activity are borrowed from previous tests in this study.

Another advantage of such method is to produce a continuous variable between 0 and 1

as opposed to a binary one. 1λ captures whether the market discounts pre-SOX insider

sales the more abnormal they are, and is expected to be negative as such. The increased

timeliness of post-SOX insider trade disclosure may result in a stronger market reaction

to abnormal sales: 2λ measures this potential incremental post-SOX reaction and is

expected to be negative as well. I include the average daily abnormal return PostRet from

the transaction date to the day before the SEC filing as an independent variable to control

for the amount of information impounded into stock price before the trade is known to

the public, whether through disclosure or informed trading. Since the window is

significantly longer for pre-SOX trade, PostRet may have different implications before

and after SOX, so I allow for separate coefficients 3λ and 3λ + 4λ depending on the

disclosure regime. Finally, the control variables include log of market value, book-to-

market ratio, an R&D indicator variable and dummies for insiders’ position within the

firm (CEO, CFO, COO, Board Chairman and President). In light of the results in Aboody

and Lev (2000), R_D is expected to exhibit a significantly negative association with

Abret.

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I test H2b and H3b in the same regression. Those two hypotheses predict the

effect of ex-ante litigation costs and discretionary accruals on the timing of insider sales

with respect to bad news. I run the following OLS regression for all profitable trades in

the sample (i.e. followed by six-month negative returns):

0 1 1 1 2 1 3 4

5 6 7 8 9

10

( ) * *

* *

*

t t t t

t t t t t

t j jj

Lostxprof Cumax Abn Lawfit Lawfit Abn Pump Pump Abn

Dump Dump Abn Boost Boost Abn Drag

Drag Abn Ctrl

α α β β β β

β β β β β

β β ε

− −= + + + + +

+ + + + +

+ + +∑

(9)

Lostxprof is defined as the proceeds from an insider sale times the cumulative abnormal

return Cumax (based on the 5-factor model used to compute Profit) from the transaction

date until the highest cumulative return is reached over a six-month window (zero if

cumulative abnormal returns are all negative) and can be interpreted as an opportunity

cost. Because Cumax is censored at zero by construction (hence so is Lostxprof), I also

use a Tobit specification (untabulated). According to H2b, 1β should be positive. Since I

already expect abnormal trades to be timed when 1tLawfit − is low (see H2a), the effect of

on 1tLawfit − Lostxprof may not be different for abnormal trades vs. normal trades, hence

there is no expected sign for 2β . The signs of 3β , 4β , 7β and 8β pertain to H3b. If

managers use discretionary accruals to inflate earnings and stock price and maximize

proceeds from their sale, they will trade closer to a peak in stock price before bad news

about future cash flows is revealed to the market, so these coefficients should be negative

(or only 4β and 8β if this holds exclusively for abnormal sales). By contrast, if managers

use positive (changes in) discretionary accruals to delay the recognition of bad news after

their suspicious sales, the positive returns following their sales should be greater, so those

coefficients should be positive, in particular 4β and 8β because of the higher litigation

concern associated with large sales. Dump and Drag are included for completeness,

although they are not of primary interest to this test. Other controls include size, book-to-

market and R&D.

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5. Results

1) Sample and descriptive statistics

The data employed for the main tests in this study is gathered from three sources:

1) CRSP for stock price and trading volume related variables, 2) Compustat for financial

information and 3) Thomson Financial insider trading database. Additional data was

retrieved from the Stanford Securities Class Action Clearinghouse for 10b-5 lawsuits

information. Sample size varies by test depending on data requirements.

Thomson Financial Insiders Data Feed contains trade information from directors,

officers and principal stockholders with holdings over 10% of the firm’s stock, all subject

to disclosure requirements as defined in Section 16 of the Exchange Act of 1934 until

August 2002, and Section 403 of the Sarbanes-Oxley Act subsequently. I select all open

market purchases and sales (including those of shares resulting from option exercises)

executed by CEOs, CFOs, COOs, Chairmen of the Board and Presidents between 1989

and 2004. Trades between 1989 and 1994 are included to build histories of insider trading

for firms with data available in that period (a total 7,509 trades). The actual sample

period spans the 1995-2004 decade, which consists of 83,787 insider transactions14

(including 58,934 sales) for which shares outstanding data is available. Since in the pre-

SOX period, many trades (usually by the same insider in the same calendar month) are

reported on a single Form 4, I aggregate trades at the insider/filing date level in most of

the tests, in which case the sample contains 16,752 purchases and 35,413 sales. Using

reported transaction prices, the mean (median) dollar value of insider sales in my sample

is $955,754 ($166,577). As a percentage of shares outstanding (respectively shares held

by the insider), the average sale is 0.077% (11.59%) while the median is 0.025%

(3.42%)15. In terms of profitability, the mean (median) Profit for sales is $119,836

($12,225), and 67% of sales in the sample are profitable16. The mean and median

14This is after a cleansing process that eliminates transactions with reported prices outside of the lowest bid-highest ask available or CRSP, with a number of shares exceeding total common shares outstanding. 15 The reader should keep in mind that my holdings measure understates the true amount of managers’ stock holdings and exert caution in interpreting or comparing these results. 16 This is substantially higher than the proportion reported in Ke and Huddart (2004), which is potentially driven by the fact that my restrictive choice of insiders (“top managers”) biases towards more profitable

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Ln_Profit are 2.47 and 1.60. The base case for abnormal trading detection17 results in

17,576 transactions (for 3,579 firm-years) being flagged. Other descriptive statistics can

be found in Table 1.

2) Short- and long-term returns following insider sales

The first hypothesis tests the timing and profitability of insider sales. Tables 2 and

3 report univariate results. Table 2 presents results for firms that have both normal and

abnormal sales in the sample period. As found in Panel A, the average across firms of the

difference between the mean aggregate yearly profit for abnormal and normal sales is

significantly positive for 3, 6 and 9 month horizons (0.01 level of significance for log

profits, 0.10 for raw profits). These results indicate that for the average firm and using a

six-month horizon, yearly average profits to abnormal insider sales are greater than

average normal profits by $1,110,668. Panel B reports similar results, at the individual

trade level. On average, in a given firm, abnormal sales are followed by six-month

abnormal returns that are 3.7% lower than normal sales, and represent profits greater by

$168,834 (all results are significantly different from zero at the 0.01 level).

Results reported in Table 3 are based on Net_Shrout quartiles (pooled cross-

sectional time-series) and indicate that within a given quartile, abnormal sales are – on

average – more profitable than normal sales, as the mean and median (log)profit is

significantly greater for abnormal vs. normal trades within all quartiles except for mean

profits in the fourth quartile, which is supportive of the contention that abnormal sales are

more likely to be information-motivated. The fact that for three out of four quarters, there

is no significant within-quartile difference between normal and abnormal mean

sales, plus differences in sample periods and abnormal return computation. Since the purpose of my study is to look at the differences between normal and abnormal sales, this remains of little concern. 17 i.e. including firm-years with zero trading as normal trading observations, classifying as abnormal total sales that exceed the past 2 to 5 years’ firm average by more than 3 standard deviations (or are more than 150% times the previous year’s level) both with respect to shares outstanding and shares held as deflators (provided the data is reliable for the latter, i.e. no trade is more than 100% of holdings and beginning-of-the-year holdings are consistent with previous year’s holdings). Note that in terms of holdings, firm-year aggregation is a weighted average across all insiders in the firm, whether they trade or not in a given year. Modifying the parameters has little impact on the classification of abnormal trades. For example, using 5 instead of 3 standard deviations and 200% instead of 150% results in 16,128 trades being flagged as abnormal.

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Net_Shrout shows that using Net_Shrout as a linear measure of insider selling intensity

masks cross-sectional differences that can be identified with firm-level time series

comparisons. In order to introduce control variables, I analyze the association between

normal vs. abnormal sales and both short- (for timing) and long- (for profitability)

window returns around those sales, using a logit test. Table 4 summarizes the results with

respect to both timing and profitability. The negative and significant coefficient on FFRet

in column (1) indicates that the more bad news follow a trade over six months, the more

likely the trade is abnormal. By contrast, the significantly positive coefficient on PostRet

shows that abnormal sales are timed ahead of greater returns (more positive or less

negative) than normal sales. Since PreRet is insignificant, abnormal sales are not driven

by passive trading with respect to recent news. Column (2) summarizes the results where

the regression includes good/bad news dummy and interaction variables. The results are

consistent with the first hypothesis: abnormal trades are more likely to be profitable (i.e.

preempt 6-month negative abnormal returns), as captured by the significantly positive

coefficient on PosProfit, but not to be timed shortly before bad news (since the

coefficient on PostBad is insignificantly different from zero), so the loss avoided by

abnormal sales materializes further away from the trade. The coefficient on PostRet

indicates that the larger the positive returns following an insider sale, the more likely it is

abnormal. Also, abnormal trades do not appear to be timed after good news more than

normal sales, although they are more likely to be timed at an all-time high stock price

(coefficient on Allhi significantly positive). Other longer-run past performance measures

are insignificant (Rett-1 and ∆ROAt-1), which indicates overall that abnormal sales exhibit

more active than passive trading. As expected, firm size and book-to-market ratio are

negatively associated with Abn. Hence, so far, the results indicate that abnormal trades, as

detected using firm-level trading patterns, are more likely to be motivated by private

information. Next, I examine specific news events following insider trades to shed light

on the nature of the information that insiders trade upon.

3) Returns around earnings announcements after normal and abnormal sales

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Table 5 presents the results with respect to the abnormal returns around quarterly

earnings announcements following insider sales. In Panel A, the univariate analysis

reveals that on average, the returns around the three earnings announcements following

abnormal sales are significantly more negative than those following normal sales, except

for the median return two quarters ahead. For example, the mean abnormal return around

next quarter’s earnings announcement is -0.71% for abnormal sales vs. -0.03% for

normal sales, the difference being significant at the 0.01 level. In Panel B, you can find

logit regression results. The coefficients on PosEAt, PosEAt+1 and PosEAt+2 indicate that

abnormal sales are significantly more likely to precede bad news two quarters ahead but

neither around the closest forthcoming earnings announcement nor two quarters later.

The insignificant coefficient on PosEAt is interpreted as the effect of litigation avoidance

while the one on PosEAt+2 may be due to this event being too far away from the trade

(more than six months). In terms of magnitude, most variables are insignificant. The

significantly negative coefficient on PosEAt*CarEAt shows that abnormal sales are less

likely to precede good news of large magnitude around the closest earnings

announcement. The results in Table 5 extend the findings of Roulstone (2004) who

documents that the occurrence of insider sales is negatively associated with abnormal

returns around up to three quarterly earnings announcements ahead. Hence, so far, the

results show that abnormal sales are more likely to avoid losses over a six-month horizon

than normal sales, and the negative returns partially materialize around subsequent

earnings announcements, albeit not the closest. The distance between abnormally large

sales and salient events such as earnings announcements conveying bad news is

consistent with the litigation avoidance argument mentioned in H1 as well as prior

research. However, these events do not capture all the bad news following large insider

sales, and the combination of abnormal insider selling with subsequent bad news is the

typical scenario that puts the firm and its officers at risk for a securities lawsuit. The next

results pertain to the interaction between firm-level litigation risk and insider sales.

4) Litigation and normal vs. abnormal sales

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Table 6 presents the results of the tests related to H2a. In Panel A, univariate tests

indicate that overall, insider selling volume tends to be decreasing in litigation risk (4-6%

for highest sales quartile vs. 10-14% for the smallest), whether ex-ante or ex-post. Within

quartiles, except for the sales of smallest magnitude, the average ex-ante litigation risk is

significantly higher for normal selling activity. The litigation risk contemporaneous to

insider selling increases for both normal and abnormal sales, but more so for abnormal

sales, and the difference becomes insignificant. Finally, the ex-post average litigation cost

is significantly greater following firm-years with abnormal sales compared to normal

sales. The results in Panel A are thus indicative of insiders engaging in abnormal selling

activity when their litigation risk is relatively low, but once they do so, the firm bears a

higher litigation cost. Panel B reports the results of the logit analysis. The coefficients of

interest are of the expected sign, i.e. negative for 1tLawfit − (lower ex-ante litigation risk

for abnormal sales) and significantly positive for ex-post litigation risk . 1tLawfit +

5) Patterns of discretionary accruals and pre-managed earnings around normal vs.

abnormal insider sales

Table 7 reports the results with respect to the occurrence of earnings manipulation

around insider sales. The estimates on the left-(right-)hand side of the table report logit

regression results testing model 7 (8). As indicated by the signs on the Pump coefficients,

in any of the five quarters around an insider sale, normal sales are more likely than

abnormal sales to be timed when reported earnings appear to be “pumped”, i.e. with

discretionary accruals that offset an earnings decrease. The pattern of coefficients on

(negative, significant), 1tDump − 1tDump + (negative, significant) and (positive,

significant) is consistent with managers avoiding to time their abnormally large trades

after and shortly ahead of a quarter reporting an earnings decrease driven by large

discretionary accruals and delaying such bad news until the following quarter, where

income decreasing accruals exceed an otherwise positive change in pre-discretionary

accruals. The insignificant coefficient on may be due to the fact that managers

2tDump +

tDump

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avoid selling their stock before reporting disappointing earnings, whether the amount of

sales is abnormal or not. In the test where levels of accruals are used instead of changes,

the significantly positive coefficients on 1tBoost − , tBoost and 1tBoost + indicate that

managers are more likely to engage in abnormal equity sales right before and after

reporting positive discretionary accruals that exceed in magnitude negative unmanaged

earnings. The results with respect to tBoost are consistent with H3a and both the

earnings-inflation and litigation avoidance explanations for the joint occurrence of high

discretionary accruals and abnormal insider selling activity. The positive coefficient on

1tBoost − indicates that managers also tend to engage in abnormal sales after inflating

earnings, which does not fit in the litigation avoidance story. This result does not

necessarily conflict with those in Beneish et al. (2005) but emphasizes the usefulness of

looking at the timing of insider sales on a quarterly basis. Finally, the significantly

negative coefficient on indicates that managers avoid reporting deflated earnings

right after their abnormal sales, which is also consistent with H3a. However, we observe

no sign reversal in the pattern of coefficients on Drag variables, so abnormal sales do not

seem to predict large negative discretionary accruals that would turn a profit into a loss

within a year. Taken together, the results in Table 7 indicate that managers use accruals

to avoid reporting losses around their abnormal sales and refrain from engaging into large

sales during quarters where a loss or an earnings decrease driven by discretionary

accruals is reported, which is more likely to occur two quarters away from their trades.

Despite the occurrence of income increasing accruals around abnormal insider sales, six-

months abnormal returns following those sales are more likely to be negative than for

normal sales. The next test presents results with respect to the effect of discretionary

accruals (and litigation) on the timing of stock returns after insider sales.

tDrag

6) Earnings inflation and timing of bad news following insider sales

Table 8 reports the joint test of H2b and H3b. The amount of good news

(measured in terms of opportunity cost Lostxprof or positive abnormal stock return

Cumax) following insider sales is positively associated with , which is 1tLawfit −

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consistent with H2b, i.e. insiders time their sales further away from bad news as they face

a higher ex-ante litigation cost, so as to conceal their suspicious trades. The significantly

positive coefficient on Abn indicates that on average, profitable abnormal sales precede

larger positive stock returns (0.8%) than normal sales, which complements the results

related to H1. There is – however - no incremental slope effect for abnormal trades on the

association between ex-ante litigation cost and positive returns subsequent to insider

sales. The results in terms of discretionary accruals are such that the null of H3b is

rejected, but loss and earnings decrease avoidance have different implications for stock

returns following insider sales. For normal trades, both Pumpt and Boostt are significantly

negative, which indicates that in quarters where they are inflating earnings, managers are

more likely to trade at a peak in stock returns, which is consistent with their maximizing

their proceeds, possibly at an inflated price. This association is accentuated for abnormal

trades contemporaneous to loss avoiding accruals, since Boostt*Abn exhibits a

significantly negative coefficient: the proceeds-maximizing explanation for the joint

occurrence of earnings inflation and abnormal insider sales as developed by Bartov and

Mohanram (2004) is descriptive in the case of loss avoiding accruals. By contrast,

Pumpt*Abn being significantly positive (as well as the sum of Pumpt and Pumpt*Abn,

according to an F-test not reported in Table 8), managers appear to time their abnormal

sales away from the reflection of bad news in stock price when an earnings decrease is

offset by an increase in discretionary accruals. Such result is consistent with managers

delaying bad economic news using positive accruals in order to decrease their exposure

to litigation, as Beneish et al. (2005) argue. However, since the previous table indicates

that managers are less likely to engage in abnormal selling when offsetting earnings

decreases with accruals, another possible interpretation from the results in both sets of

tests is that “pumping” earnings is associated with higher litigation risk, which is why

managers refrain from selling suspicious amounts of stock contemporaneously, and even

when they do so, they time their trades away from the revelation of bad news with respect

to future cash flows.

7) Market reaction to insider sales SEC filings

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Table 9 presents the results of market reactions to insider sales SEC filings tests.

Panel A reports univariate results for three-day returns ( 0,2Abret ). They indicate that the

differences in mean and median return between the highest and lowest quintiles of Abnfit

are significantly negative for post-SOX trades but not pre-SOX, which is consistent with

the market reacting more negatively to insider sales disclosure when sales are more

“suspicious”, but only after SOX. In addition, in all quartiles, the median return for post-

SOX trades is significantly negative, as opposed to the bottom three quartiles in the pre-

SOX sub-sample, which suggests that the market reaction to insider sales is generally

more pronounced post-SOX. The regression results in Panel B are tabulated for five-day

abnormal returns starting on the filing date ( 0,4Abret ). The coefficient on Abnfit is

insignificant, while the one on *Abnfit PS is significantly negative (-1.14%). This

suggests that market participants impose a greater discount to stock price when they learn

about a trade and assess that it is more likely to be private information motivated, but

only so after Section 403 came to effect (an untabulated F-test shows that the sum of the

two coefficients is significantly negative). Finally, the coefficient on PostRet is strongly

significant and positive, which shows that the return following the disclosure of insider

sales is positively associated with the return between the trade and its disclosure. This is

consistent with the market expecting more bad news when learning from a trade

immediately followed by bad news, but other explanations are plausible. From Panel A

and Panel B, we can conclude that market participants revise their beliefs about the

intrinsic value of the stock downward after the disclosure of insider sales when those

appear as suspicious, but only for trades subject to disclosure requirements of Section 403

of SOX.

6. Conclusion

This paper investigates the timing of abnormally large insider sales with respect to

forthcoming news, in terms of stock returns and accounting numbers, and the information

content of insider trade disclosure based on whether they are abnormal or not.

The findings indicate that abnormal insider sales are more likely to be followed

by negative stock returns on the medium/long term (several months) but not the short-

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term (within a month). Those returns materialize partly around earnings announcements,

albeit not the closest one following abnormal sales. In addition, I explicitly document that

managers are less likely to engage into abnormal stock selling activity when their firm-

level ex-ante litigation cost is high. Hence, when managers decide to increase their stock

sales to a level that raises suspicion, they do so under conditions that limit the risks of

triggering a securities lawsuit.

As suggested by the patterns of discretionary and non-discretionary portions of

earnings around insider sales, managers are more likely to use discretionary accruals to

avoid reporting losses in the quarters around their abnormal sales. The evidence also

suggests that insiders delay the recognition of earnings decreases driven by discretionary

accruals two quarters away from their large sales. The positive stock returns following

insider sales contemporaneous to income increasing discretionary accruals indicate that

when avoiding losses, managers time their trades close to a peak in returns, whereas they

delay the recognition of bad news after their trades when avoiding to report an earnings

decrease. That said, because insiders tend not to use positive accruals to offset earnings

decreases around their abnormal sales, the proceeds-maximizing interpretation of the

joint occurrence of high insider selling activity and income-increasing accruals appears to

be more descriptive than the litigation avoidance one.

The results of this study are also consistent with market participants reacting to

disclosure about insider sales, especially under the new disclosure regime as defined by

Section 403 of SOX, whereby insiders are required to file a Form 4 with the SEC within

two business days. Post-SOX returns around Form 4 filing dates of insider sales are

negatively associated with the probability that the trade is private-information motivated.

The empirical tests in this paper are subject to several caveats. First of all, the

parameters chosen for the normal/abnormal trade distinction are very arbitrary, and for

lack of reliable data availability on insider holdings in many cases, missing an important

determinant of insider liquidity needs. That being said, the purpose of this study is not to

determine equilibrium levels of insider trading and obtain complete separation of

opportunistic sales from liquidity sales, but rather show that techniques accepted in courts

to establish that managers acted with scienter are useful in detecting private-information

based trades. Other proxies such as discretionary accruals and the fitted probability of

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litigation cost also measure with error the true variables used by managers in their

trading/reporting decision model, to an extent that remains unknown. As for the returns

around Form 4 filing dates, they are consistent with a market reaction to the trade(s)

being filed, but I cannot rule out the possibility that they are driven by other news.

Finally, potential issues of endogeneity are rampant in the insider trading literature.

However, the private information that jointly determines insiders’ trading and disclosure

decisions is unobservable, so finding valid instruments remains challenging.

This study warrants additional tests to increase the validity of the results and gain

more insight into questions such as how litigation affects managerial decisions to resort

to earnings manipulation around their suspicious sales. Further investigation on the

information content of insider sales and market’s responsiveness to their disclosure is

also on my agenda.

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Appendix: Estimation of Lawfit and Abnfit Litigation cost (Lawfit): this model is directly adapted from Rogers and Stocken (2005), the only difference being that I use logit instead of probit and run the model on an annual basis.

0 1 2 3 4 5

6 7

Pr( 1) ( _ _ )j

j

Litigation f Size Turnover Beta Return Std RetSkewness Min Ret HighRiskIndustries

α γ γ γ γ γ

γ γ γ

= = + + + + +

+ + +∑ ε+ (10)

Litigation: dummy equal to 1 if a securities class action lawsuit was recorded by the Securities Class Action Clearinghouse during a calendar year, zero otherwise. Explanatory variables include log firm size, average daily share turnover, stock beta measured against CRSP value-weighted index, cumulative annual raw return, standard deviation of daily returns, lowest daily return and dummies for high litigation risk industries (biotech, computer hardware, electronics, retailing and software). For more details, refer to Appendix A in Rogers and Stocken (2005). Lawfit distribution (pooled cross-sectional time-series sample, observations are firm-years):

N Mean (%)

Std Dev. (%)

1st quartile (%)

Median (%)

3rd quartile (%)

43,519 3.76 6.10 0.94 1.88 3.98 Probability that a trade is abnormal (Abnfit):

0 1 2 3 4 1 5

6 7 1 8 1 9 10 11

12

Pr( 1) ( * + _ _ _ )

t

t t

k kk

Abn f PreGood PreRet PreGood PreRet Lawfit BMSize ROA Ret Allhi Net Shrout Lag ShroutR D Position

β β β β β ββ β β β β β

β β ε

− −

= = + + + ++ + ∆ + + + +

+ + +∑ (11)

All variables in this model are listed in the variable definition list, except Lawfit which is described above. The model uses data available prior to insider sales. The coefficients are estimated separately for each calendar year from 1996 to 2004 using data from the previous year. Abnfit distribution: N Mean

(%) Median

(%) Std Dev. (%) #>50%

1996 604 42.4 40.5 25.1 227 1997 732 37.3 35.7 25.1 229 1998 830 39.4 39.5 23.1 275 1999 865 42.1 41.4 23.6 317 2000 1,426 50.0 51.5 22.9 743 2001 2,014 40.3 40.5 24.1 704 2002 2,354 36.2 40.9 23.6 771 2003 4,790 31.2 32.2 22.5 1,062 2004 3,437 27.9 27.9 22.1 660

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Variable definitions

A few terms: Insider: CEO, CFO, COO, Chairman of the Board, President. Purchase (sale): open market purchase (sale) of common shares. Sales following option exercises are included in the sample, but not the actual option exercise. Insider Trading Variables: Net_shr Number of shares sold by an insider on a transaction date. Held Maximum number of common shares held by an insider over a

calendar (fiscal) year. Includes shares holdings and exercised options. Net_hold Net_shr divided by Held on a given transaction date. Shrout Number of common shares outstanding. Net_shrout Net_shr divided by Shrout on a given transaction date. Lag_hld Net_shr divided by Held over the previous calendar (fiscal) year. Lag_shrout Total insider-year level Net_shr divided by Shrout over the previous

calendar (fiscal) year. Position Set of dummy variables taking the value of 1 if the insider’s title is

CEO, CFO, COO, Chairman of the Board or President, zero otherwise.

Profit FF_Ret (see definition below) times Net_shr times the transaction price as reported by the insider on a given transaction date.

Ln_ Profit Natural logarithm of unsigned Net_shr times the reported transaction price, times FF_Ret.

Abn Dummy variable set equal to 1 if total Net_shrout and Net_hold at the firm-year level is more than 3 standard deviations above its past mean based on up to five years. If only one year of prior trading is available, Abn equals 1 when Net_shrout and Net_hold are 50% higher than the previous year. Abn equals zero otherwise.

Abnfit Fitted probability of a trade being abnormal, using a logit regression of Abn on variables listed in Appendix B.

Return and Litigation Variables PreRet Average daily size-adjusted return over the 10 trading days prior to

the first transaction date as reported on a Form 4 SEC filing. PreGood Dummy variable equal to 1 if PreRet is strictly positive. PostRet Average daily size-adjusted return from the first transaction date as

reported on a Form 4 SEC filing until the filing date. PostBad Dummy variable equal to 1 if PostRet is strictly positive. Abret Size-adjusted return starting on Form 4 SEC filing date of an insider

sale. Window ends 1 to 4 trading days after the filing date. CarEAt Three-day size-adjusted return around quarter t earnings

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announcement date. PosEAt Dummy variable equal to 1 if CarEAt is positive, zero otherwise. FF_Ret 6-month five-factor adjusted return. Factor loadings are estimated

using a regression of daily returns on the four factors as in Carhart [1997] and an earnings quality factor as in Aboody et al. (2005) over the two-year period prior to the calendar month where each insider transaction occurs. Daily abnormal returns are computed as the difference between the actual raw return and the predicted return using the daily factors and the loadings from the first-stage regression. Daily abnormal returns are then summed over six months after the trade.

Lawfit Estimated probability that a Rule 10b-5 securities lawsuit will be filed against a firm in a given year, using a model akin to that in Rogers and Stocken (2005).

Accrual variables Dat Quarter t discretionary accruals, calculated using the cross-sectional

version of the Jones (1991) model, as in Dechow et al. (1995) PreDAt Net income before extraordinary items and DatPumpt Dummy variable equal to 1 if ∆Dat is positive, ∆PreDAt negative and

∆DAt exceeds ∆PreDAt in terms of magnitude, zero otherwise. Dumpt Dummy variable equal to 1 if ∆DAt is negative, ∆PreDAt positive and

∆DAt exceeds ∆PreDAt in terms of magnitude, zero otherwise. Boostt Dummy variable equal to 1 if DAt is positive, PreDAt negative and

DAt exceeds PreDAt in terms of magnitude, zero otherwise. Dragt Dummy variable equal to 1 if DAt is negative, PreDAt positive and

DAt exceeds PreDAt in terms of magnitude, zero otherwise. Control Variables Size Natural logarithm of the market capitalization of the firm, as of the

end of the most recent fiscal quarter. BM Book value of common stockholder equity divided by market value

of equity, as of the end of the most recent fiscal quarter. ∆ROAt-1 Change in ROA from fiscal year t-2 to t-1, where ROA is defined as

operating income before depreciation over total assets. Rett-1 Buy-and-hold raw return over the most recent past fiscal quarter. R_D Indicator variable equal to 1 if the firm reported a non-zero R&D

expense in the most recent fiscal quarter, 0 otherwise. All_hi Indicator variable set equal to 1 if the price on the insider transaction

date is an all time high (compared to past split-adjusted prices), 0 otherwise.

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Table 1: Descriptive statistics

Variable Mean Std Dev 25th Median 75th

Insider trading Net_hold (%) 11.59 19.06 7.06 3.43 13.03 Net_shrout (‰) 0.80 2.76 0.09 0.26 0.72 Returns and profits Pre_dxret (%) 0.22 1.00 -0.33 0.14 0.71 Post_dxret (%) 0.00 1.11 -0.57 -0.02 0.52 Profit ($) 119,836 364,056 -2,611 12,225 88,638 Ln_Profit 2.52 4.88 -0.45 1.57 4.88 Form 4 filing returns and volumes

Aret0,1 (%) -0.09 4.03 -1.97 -0.15 1.64 Aret0,4 (%) -0.43 6.68 -3.53 -0.30 2.79 News CarEAt (%) 0.39 7.57 -3.32 0.19 3.95 CarTent (%) -0.04 5.16 -2.57 -0.17 2.30 Accruals DAt (%) 2.12 12.47 -4.22 2.04 8.42 PreDAt (%) -0.92 27.11 -7.35 0.74 8.92 Controls Ln_Market 6.01 1.89 4.65 5.94 7.17 BM 0.53 0.51 0.23 0.43 0.71 ∆ROAt-1 (%) 0.09 5.89 -0.92 0.00 0.89 Rett-1 (%) 6.93 36.65 -11.38 2.49 17.65 All_hi 0.04 - - - - R_D 0.42 - - - -

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Table 2: profitability of insider sales – firm by firm analysis Panel A: firm-year aggregate profits (mean and median of firm-level means) Profits (proceeds from sale times 3/6/9-month abnormal return following trade times (-1)) accruing to insider sales are aggregated at the firm-year level. The mean firm-level aggregate profit is then calculated separately for years with normal trades (Abn=0) and abnormal (Abn=1). The table reports the mean and median across firms of the difference between the firm-level mean profits for Abn=1 and Abn=0, using 3,6 and 9 months to compute abnormal returns. Same for log(profits) where proceeds are transformed using natural logarithm.

Abn=1 – Abn=0 3 months 6 months 9 months Mean difference in profits 469,131***

(2.60) 757,198***

(3.45) 1,076,350***

(3.09)

Median difference in profits 9,380*** (71.5)

21,306*** (96.5)

32,091*** (105.5)

Mean difference in log profits 2.71*** (2.67)

5.19*** (2.81)

7.93*** (2.81)

Median difference in log profits 0.22* (37.5)

0.81*** (65.5)

1.28*** (85.5)

N 1,982 1,982 1,982 Panel B: trade-specific returns and profits (mean and median of firm-level means) Abnormal profits/returns are averaged at the firm-level separately for Abn=1 and Abn=0 individual insider sales. The table reports the mean and median of the difference across firms between the firm-level mean profits/returns for Abn=1 and Abn=0, using 3,6 and 9 months to compute abnormal returns. Same for log(profits) where proceeds are transformed using natural logarithm.

Abn=1 – Abn=0 3 months 6 months 9 months Mean difference in profits ($) 109,172***

(5.06) 196,266***

(4.91) 310,000***

(5.49)

Median difference in profits ($) 1,959*** (66.5)

3,433*** (79.5)

5,926*** (103.5)

Mean difference in log profits 0.19** (2.37)

0.44*** (3.43)

0.70*** (3.96)

Median difference in log profits 0.03 (30.5)

0.17*** (91.5)

0.23*** (109.5)

Mean difference in returns -0.010 (-1.57)

-0.026** (-2.51)

-0.042*** (-2.98)

Median difference in returns 0.000 (1.5)

-0.007*** (-77)

-0.009*** (-89.5)

N 2,268 2,268 2,268 ***,**,* indicate that the means and medians are significantly different from zero at the 0.01, 0.05 and 0.10 levels, based on t-stats for means and sign tests for medians (reported in parenthesis).

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Table 3: profitability of insider sales – cross-sectional quartile analysis

This table presents results from a univariate analysis of profits (proceeds from sale times 6-month abnormal return following the sale times (-1)) accruing to insider sales. The mean and median profits and log-profits (same as profits but proceeds are natural log transformed) are reported separately for normal (Abn=0) and abnormal (Abn=1) sales, within each quartile of the distribution of Net_shrout (number of shares traded scaled by number of shares outstanding), based on all insider sales in the sample period 1995-2004. The rows labeled “Difference” report t-statistics for differences in means, z-statistics for differences in medians and corresponding p-values.

Variable Q1 Q2 Q3 Q4 Mean Median

Mean Median Mean Median Mean Median

Abn=0

0.0084% 0.0076% 0.036% 0.036% 0.100% 0.095% 0.494% 0.325%Abn=1 0.0086% 0.0081% 0.037% 0.036% 0.102% 0.097% 0.626% 0.338%Net_shrout Difference -1.11

(0.27) -0.75 (0.45)

-1.42 (0.15)

1.53 (0.12)

-1.69 (0.09)

-1.55 (0.12)

-3.31 (<0.01)

-2.21 (0.03)

Abn=0

117,633 8,503 225,726 24,616 477,527 56,693 1,140,070 126,585Abn=1 200,899 10,096 434,886 38,641 829,778 84,239 1,581,296 182,579Profit Difference -2.62

(<0.01) -2.50 (0.01)

-2.83 (<0.01)

-4.37 (<0.01)

-2.58 (<0.01)

-5.43 (<0.01)

-1.26 (0.21)

-3.08 (<0.01)

Abn=0

3.87 1.43 4.98 2.21 6.88 3.14 9.99 4.80Abn=1 4.68 1.68 7.57 3.07 10.21 4.39 11.93 5.35Ln_Profit Difference -1.11

(0.27) -2.27 (0.02)

-3.04 (<0.01)

-4.30 (<0.01)

-3.81 (<0.01)

-4.81 (<0.01)

-1.66 (0.09)

-2.27 (0.02)

Abn=0

2,385 2,366 2,315 2,070N Abn=1 1,204 1,224 1,275 1,519

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Table 4: Timing and profitability of insider sales - Logit

This table provides logit regression results for the association between the classification of insider sales as normal (Abn=0) or abnormal (Abn=1) and the following independent variables: short-window daily abnormal returns around trades (PreRet before, PostRet after) and profitability (six-month return after trade FFRet). Since each firm-insider-reporting date observation may include several transactions, returns are an average of returns following each transaction weighted by the proceeds. Model (1) includes only magnitudes of those variables, while Model (2) includes dummy variables PreGood, PostBad and PosProfit equal to 1 respectively if the insider sale is timed right after a 10-day positive abnormal return, right before a negative abnormal return measured until the SEC filing date of the trade and if the six-month abnormal return following the sale is negative. Model (2) includes interaction terms. The sample is restricted to pre-SOX trades (i.e. transactions before August 29, 2002). Calendar year dummies are included but not tabulated. Variable Expected

sign Coefficient (Chi-Square) Coefficient (Chi-Square)

(1) (2) Intercept ? -0.636*** (29.39) -0.834*** (35.60)

PreGood -0.036 (0.40)

PreRet 0.2186 (0.03) -4.514 (0.98)

PreGood*PreRet 6.447 (1.69)

PostBad 0.037 (0.43)

PostRet 6.5956*** (11.81) 10.573*** (7.58)

PostBad*PostRet -6.796 (1.32)

FFRet - -0.3293*** (49.27) -0.129 (0.72)

PosProfit + 0.195*** (8.94)

PosProfit*FFRet - -0.104 (0.39)

Size -0.0527*** (17.95) -0.046*** (13.02)

BM - -0.2491*** (12.28) -0.236*** (10.98)

∆ROAt-1 -0.1459 (0.17) -0.146 (0.17)

Rett-1 0.0137 (0.11) 0.013 (0.10)

All_Hi + 0.3211*** (11.08) 0.334*** (11.85)

R_D -0.1647*** (13.70) -0.180*** (15.86)

Percent concordant 59.2 59.5 Likelihood Ratio 264.53*** 280.35***

N (Abn=1 / Abn=0) 10,172 (3,460 / 6,712) ***,**,* indicate significance at the 0.01, 0.05 and 0.10 levels

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Table 5: Normal vs. abnormal insider sales and subsequent earnings announcement returns

Panel A: mean and median 3-day abnormal returns around the 3 earnings announcements following an insider sale, computed separately for normal (Abn=0) and abnormal (Abn=1) sales. T-statistics and Z-statistics are reported for mean and median differences.

CarEAt CarEAt+1 CarEAt+2Returns in % Mean Median Mean Median Mean Median Abn=0 -0.25 -0.07 -0.03 0.29 -0.13 -0.15

Abn=1 -0.75 -0.22 -0.71 -0.25 -0.43 -0.05

T-stat or Z-stat for difference -3.80*** -3.13*** -5.07*** -5.86*** -2.29** 1.57

Panel B: logit regression results for the timing of abnormal (Abn=1) vs. normal insider sales (Abn=0) with respect to earnings announcements at the end of the quarter contemporaneous to the insider sale as well as the next two. The model includes dummy variables equal to 1 when the returns around those events are positive (PosEA), magnitudes of the returns (CarEA) and interaction terms. The independent variables also include controls (tabulated) and calendar year dummies (untabulated).

Variable Exp. Coefficient Chi-Square sign (1) Intercept -0.211** (3.74)

PosEAt - -0.018 (0.15)

PosEAt+1 - -0.146*** (10.37)

PosEAt+2 - -0.047 (1.12)

CarEAt 0.335 (1.15)

CarEAt+1 -0.258 (0.67)

CarEAt+2 -0.170 (0.29)

PosEAt* CarEAt -0.882* (3.00)

PosEAt+1* CarEAt+1 0.613 (1.57)

PosEAt+2* CarEAt+2 0.092 (0.04)

BM - -0.120** (4.74)

Size - -0.118*** (123.46)

∆ROAt-1 0.077 (0.06)

Rett-1 0.147*** (12.39)

All_Hi + 0.459*** (28.07)

R_D -0.182*** (26.38)

% concordant 62.7 Likelihood ratio 781.71

N (Abn=1/Abn=0) 17,166 (5,859/11,307) ***,**,* indicate significance at the 0.01, 0.05 and 0.10 levels

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Table 6: litigation and abnormal sales

Panel A: this table reports mean litigation costs separately for normal and abnormal insider selling firm-years within quartiles based on the distribution of Net_Shrout aggregated at the firm-year level across all sample observations from 1995 to 2004. Estimated probabilities of a Rule 10b-5 lawsuit being filed in the years before (Lawfitt-1), contemporaneous (Lawfitt) and after (Lawfitt+1) each firm-year observation are computed. Within-quartile differences are reported, as well as t-statistics in parenthesis. Quartile 1 Quartile 2 Quartile 3 Quartile 4

Abn=0 10.2% 7.3% 6.5% 5.0% Abn=1 10.4% 6.2% 5.6% 4.1%

Lawfitt-1

Diff. -0.2% (-0.66)

1.1%*** (5.60)

0.9%*** (4.70)

0.9%*** (6.38)

Abn=0 11.7% 8.1% 7.2% 6.0% Abn=1 14.1% 7.8% 7.4% 6.1%

Lawfitt

Diff. -2.4%*** (-6.56)

0.3% (1.34)

-0.2% (-0.93)

-0.1% (-0.54)

Abn=0 10.6% 7.3% 6.7% 5.6% Abn=1 10.6% 8.8% 7.4% 6.0%

Lawfitt+1

Diff. -0.0% (-0.14)

-1.5%*** (-7.16)

-0.7%*** (-3.89)

-0.4%** (-2.22)

***,**,* indicate significance at the 0.01, 0.05 and 0.10 levels Panel B: Logit analysis of normal (Abn=0) vs. abnormal (Abn=1) insider selling firm-years on ex-ante, contemporaneous and ex-post litigation cost (Lawfit), plus controls, and non-tabulated calendar year dummies.

Variable Expected sign

Coefficient (Chi Square)

Intercept 0.316** (4.48)

Lawfitt-1 - -3.293*** (27.43)

Lawfitt 0.500 (1.08)

Lawfitt+1 + 1.761*** (15.43)

Size -0.086*** (16.09)

BM -0.307*** (12.75)

∆ROAt-1 -0.477 (0.85)

Rett-1 0.047 (0.54)

R_D -0.261*** (16.30) Percent concordant 59.0 Likelihood Ratio 103.55

N (Abn=1/Abn=0) 4,967 (1,851 / 3,116) ***,**,* indicate significance at the 0.01, 0.05 and 0.10 levels

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Table 7: normal vs. abnormal insider sales and discretionary accruals This table reports logit regression results for differences in patterns of discretionary accruals and unmanaged earnings around normal (Abn=0) and abnormal (Abn=1) insider sales. Model (1) includes dummy variables Pump (Dump) equal to 1 if the firm reports a positive (negative) change in quarterly discretionary accruals that exceeds in magnitude a negative (positive) change in pre-discretionary accruals earnings, zero otherwise. Model (2) includes similar variables (Boost and Drag), except that they are defined in terms of levels of discretionary and non-discretionary portions of income instead of changes. For both models, the subscript indicates the quarter over which those earnings components are calculated, t being the quarter during which the insider sale occurs. Calendar year dummies are included but not tabulated. Variable Coefficient Chi-square Variable Coefficient Chi-square (1) (2) Intercept -1.096*** 23.76 Intercept -0.988*** 23.89

Pumpt-1 + -0.041 0.48 Boostt-1 + 0.142** 7.47

Pumpt + -0.101* 2.99 Boostt + 0.276*** 27.50

Pumpt+1 -0.108* 3.40 Boostt+1 0.105** 4.24

Pumpt+2 -0.048 0.62 Boostt+2 -0.210*** 15.81

Pumpt+3 -0.238*** 13.91 Boostt+3 -0.138*** 6.89

Dumpt-1 - -0.340*** 24.87 Dragt-1 - 0.048 0.19

Dumpt - 0.098 2.12 Dragt - -0.430*** 11.32

Dumpt+1 -0.191*** 7.95 Dragt+1 -0.138 1.55

Dumpt+2 0.303*** 22.98 Dragt+2 0.010 0.01

Dumpt+3 -0.069 1.17 Dragt+3 -0.159 2.34

BM -0.039*** 10.18 BM -0.153** 4.75

Size -0.074*** 22.52 Size -0.100*** 49.32

∆ROAt-1 -0.550 0.94 ∆ROAt-1 -0.326 0.56

Rett-1 0.208 0.27 Rett-1 0.138*** 7.99

All_Hi 0.429*** 11.23 All_Hi 0.473*** 16.59

R_D -0.055 1.25 R_D 0.029 0.40 % concordant 64.2 64.0

Likelihood ratio 477.74 565.88 N (Abn=1/0) 8,994 (2,806 / 6,188) 10,467 (3,506 / 6,961)

***,**,* indicate significance at the 0.01, 0.05 and 0.10 levels

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Table 8: distance to bad news, litigation and discretionary accruals This table reports OLS regression results. In model (1), the dependent variable is the profit forgone by insider sales measured between the transaction date and the date where abnormal returns reach their highest point within six months. In model (2), the dependent variable is simply the abnormal return aforementioned. Only trades that are followed by a negative six-month abnormal return are included in the sample. The main variables of interest are Lawfitt-1 (ex-ante litigation cost), Pump/Dump (dummy variable equal to 1 if current quarter discretionary accruals are positive/negative and exceed negative/positive pre-managed earnings, either in terms of changes, zero otherwise) and Boost/Drag (dummy variable equal to 1 if current quarter discretionary accruals are positive/negative and exceed negative/positive pre-managed earnings, either in terms of levels, zero otherwise). T-statistics are reported in italic.

Ln_Lostprof Cumax (1) (2)

Expected sign Coefficient t-stat Coefficient t-stat

Intercept 1.654*** 21.93 0.163*** 26.09

Abn + 0.155*** 3.38 0.008** 2.15

Lawfitt-1 + 1.395*** 6.09 0.112*** 5.90

Lawfitt-1*Abn + -0.083 -0.21 -0.010 -0.32

Pumpt -0.061 -1.56 -0.006* -1.75

Pumpt *Abn 0.182*** 2.66 0.020*** 3.49

Boostt -0.097*** -2.51 -0.009*** -2.78

Boostt *Abn -0.123* -1.91 -0.010* -1.80

Dumpt -0.076 -1.63 -0.006 -1.47

Dumpt *Abn 0.006 0.07 0.001 0.16

Dragt 0.031 0.40 0.003 0.42

Dragt *Abn -0.099 -0.69 -0.000 -0.04

BM -0.190*** -4.09 -0.014*** -3.51

Size -0.109*** -11.31 -0.013*** -16.62

R_D 0.176*** 6.12 0.017*** 7.02

R2 4.41% 2.81% N 9,471 9,471 *,**,*** indicate significance at the 0.10, 0.05 and 0.01 level.

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Table 9: returns around SEC filings of insider trades and probability that the trades are abnormal

Panel A: mean and median three-day returns (Aret0,2) starting on filing dates of insider sales, per quartile of Abnfit (constructed for each calendar year), separately for pre- and post- August 29, 2002 trades. The last two columns report the difference in means or medians between the two extreme quartiles and t-stats (Wilcoxon Z-stats) for differences in means (medians). Abnfit Q1 Q2 Q3 Q4 Q4-Q1 t- or Z-stat

Mean -0.07 -0.13 -0.32† -0.01 0.06 0.29

Pre-SOX Median -0.22 -0.03 -0.33† -0.15 0.07 0.26

N 1,611 1,673 1,636 1,551

Mean 0.03 0.01 -0.10 -0.28† -0.31*** -2.75

Post-SOX Median -0.09 -0.24† -0.14† -0.25† -0.16*** -2.66

N 2,093 2,039 2,708 2,145 † indicates that the mean or median is significantly different from zero at the 0.10 level or better. Panel B: results from OLS regression where the dependent variable is the five-day abnormal return Aret0,4 starting on the filing date of an insider sale. The independent variables are a dummy PS equal to 1 if the trade was executed after August 29, 2002 (subject to filing requirements of Section 403 of SOX), the fitted probability Abnfit that the trade is private information-motivated, and the average daily return PostRet from the transaction date until the day before the filing date, plus interaction terms and additional controls (incl. untabulated dummy variables for reporting insiders’ position in the firm, i.e. CEO, CFO, COO, Board Chairman).

Variables Exp. sign

Aret0,4 t-stats

Intercept -0.653** -2.00

PS 0.430** 2.37

Abnfit - 0.043 0.14

Abnfit*PS - -1.141*** -2.60

BM 0.228 1.41

Size 0.042 1.27

R_D - -0.184* -1.68

PostRet + 16.642*** 10.41

PostRet*PS 4.359* 1.90

Adj. R2 1.91% F value 25.06*** Obs. 14,825

In both panels, ***,**,* indicate two-tailed significance at the 0.01, 0.05 and 0.10 levels. In panel B, t-stats are based upon standard errors robust to heteroskedascity, using the Newey-West correction procedure.

50