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and Future

How Regulations
Impact Insider
Buying and Selling

Research by
Darren T. Roulstone

Darren T. Roulstone is associate professor of accounting at the University of Chicago Graduate School of Business

Even though insider trading laws have become stricter over time, insiders are still trading their company's stock and making money from trades. New research examines how insiders limit trading their company's stock for fear of legal repercussions when future earnings reports are likely to become extremely positive or negative.

In the study “Evidence on the Nonlinear Relation between Insider Trading Decisions and Future Earnings Information,” University of Chicago Graduate School of Business professor Darren T. Roulstone and Joseph D. Piotroski of Stanford University provide new evidence that regulation of insider trading does impact insider behavior.

In an earlier study, Roulstone and Piotroski established that corporate insiders (i.e., top officers and directors) are more likely to sell their company’s stock if future earnings reports will contain bad news and more likely to buy their company’s stock if those reports will contain good news: the relation between earnings news and trading was “linear.”

Given that insiders can be prosecuted for trading on information not known to other market participants, Roulstone and Piotroski questioned whether this linear relationship had a limit. In particular, if future earnings news is highly unusual and more likely to be visible to the market and market regulators, would insiders be reluctant to trade on the information?

Roulstone and Piotroski document their results in their new study.

“The reluctance to trade on extreme news is even more pronounced when insiders are selling their shares or exercising stock options,” says Roulstone. “That is consistent with the fact that when you have really good news to report, no one is unhappy or cares what you do. But when you have bad news to report, people focus more on the trading and may file lawsuits. It’s more difficult to sell before bad news than it is to buy before good news.”

Good News and Bad News
Prior research on insider trading has focused on whether insiders are making money trading their own company’s stock. Roulstone and Piotroski took a closer look at the issue by examining what types of information insiders have, and how insiders might use such information. One possible piece of inside information concerns future earnings.

“Insiders likely know more about how earnings are developing,” says Roulstone. “Insiders may know many facts about the firm such as what sales they’re making today that will turn into income in the future, what products they’re developing, what projects they’re investing in, and what new markets they’re trying to open up. All of this information comes together to give the insider an advantage over outside market participants in predicting how prices will move in the future.”

Laws against insider trading prohibit insiders from using material knowledge that investors would consider relevant to trading stock, and which the insider has a duty to disclose to market participants, notes Roulstone. The more extreme earnings news is, the more apparent an insider’s knowledge of that news will have been, and the more likely the news will be considered relevant to market participants.

The authors found insiders were particularly reluctant to keep selling shares and exercising options if future earnings contain especially negative information.

“If there is eventually a business disaster, it will look bad for me to sell all my shares right before the stock collapses,” says Roulstone. “That becomes an Enron-type of situation. In lawsuits, shareholders often argue that the fact that the manager was selling shares indicates the manager knew there was a problem and should have disclosed the news.”

An alternative explanation for the study’s findings is that extreme news is simply more difficult for insiders to forecast and trade upon.

“The diminishing effect of extreme news occurs when something comes in that’s not natural, such as a major change in the market or the discovery of a new product,” says Roulstone. “Therefore, you expect to see less of a relationship between insider behavior today and what the actual news is next year. The insider simply didn’t see the news coming.”

To investigate this issue, Roulstone and Piotroski measured the predictability or persistence of changes in company performance. Persistence was measured by observing whether a change in annual earnings was followed by a change in annual earnings in the same direction. A persistent earnings increase is one that is followed the next year by another increase. One would expect that the more persistent the increase or decrease, the easier it would be for insiders to predict. Thus, if extreme news is less persistent, insiders may not be trading on the news simply because they cannot predict it� not because of legal fears. Roulstone and Piotroski separated earnings changes into persistent and nonpersistent changes to see if the nonlinear relation (the decline in trading before extremely good or bad earnings reports) would disappear among persistent changes.

What the authors found is that even when changes are persistent, insiders ignore them if they are too large. Thus, the hypothesis that insiders avoid trading on extreme earnings changes due to legal risks still holds true: a nonlinear relation between trading and earnings changes exists even when a story based on persistence cannot explain it.

The authors found no relation at all between trading and future earnings news when the future news is nonpersistent (when increases or decreases in future earnings are reversed in the subsequent year).

“Our results suggest that insiders are quite successful at predicting not only changes in financial performance, but how permanent those changes will be,” says Roulstone. “That makes sense, because if you are investing based on future news, you want it to be on news that will have a strong effect on firm value.”

The information that a company is going to experience a one-time change in earnings and then return to normal the following year is not as valuable as a permanent change in earnings-producing capability.

“If you have temporary bad news, why sell the stock?” asks Roulstone. “But if there is a persistent decline in firm performance, you may want to start taking your investments out of your firm. Insiders seem to do a pretty good job at figuring out which of these shocks are long-lasting.”

Data Use
Roulstone and Piotroski used insider trading data, including data on option grants and option exercises, from 1996 to 2004 from Thomson Financial, which tracks insiders’ filings with the SEC. They combined that data with company earnings records from Compustat and calculated yearly changes in income.

“We took the change in annual earnings divided by current total assets and related that measure to whether or not there were buying, selling, or option exercises at the firm,” says Roulstone. “We measured buying at a firm as cases where buying of shares exceeded selling of shares among company insiders. In any given year, people sell stock to cash out their shares or diversify, even if they don’t know anything about the future. Similarly, insider selling was measured as cases where selling exceeded buying among the firm’s insiders.”

Roulstone and Piotroski also accounted for option grants, since executives tend to sell off some of their prior options or shares after receiving such grants.

The Value of Earnings
The authors chose to study earnings because they have such great impact on stock prices, even though they are just one indicator of a company’s financial state.

“We worry about earnings a lot,” Roulstone said. “When earnings-per-share numbers come out, we compare them to analyst forecasts. Stock prices vary wildly based on exceeding or falling short of forecasts. It’s only one piece of information that goes into market prices, but it’s probably the piece the insiders know the best or derive the greatest advantage from� even more so than analysts. This is a clear advantage the insider has on one relevant piece of information.”

The authors document that the relation between earnings and insider trading is not explained by other determinants of insider trading, such as past stock returns or the firm’s market- to-book ratio. However, the study’s findings regarding earnings should not be overstated, says Roulstone.

“Over the course of a year, earnings are a very broad measure,” says Roulstone. “A lot of other financial information about a company comes out, and often much quicker than earnings. Earnings are a lagging indicator of how a firm is doing, while stock prices usually anticipate the public disclosure of an earnings change. But regardless of past, present, or future returns on their company’s stock, insiders buy or sell their shares in anticipation of future earnings reports. They have an advantage regarding earnings news and they exploit it.” 


"Evidence on the Nonlinear Relation between Insider Trading Decisions and Future Earnings Information." Joseph D. Piotroski and Darren T. Roulstone. Forthcoming in the Journal of Law, Economics, and Policy.