Why insider traders are hard to catch

UC DAVIS (US) —Insiders have little to fear when they reap big profits from increased trading of a faltering company’s stock, because trading often takes place months before public disclosure.

A new study, posted by the Social Science Research Network, finds that the aggregate return to insiders—the sum of losses avoided by selling and gains from buying stock—neared $2 billion over an eight-year period.

Researchers tracked insider stock transactions that occurred during or near 1,718 first-time disclosures of debt covenant violations by U.S. public companies between 2000 and 2007.

The waiver of a debt covenant is an important step taken by a lender to resolve a company’s debt problems and help bring the company back to financial health. Companies are required to disclose violations of debt covenants and the negotiated outcomes with lenders to the Securities and Exchange Commission. The disclosures are public.

A waiver of a covenant not only gives the company a better chance to succeed but may also be preferred by the lender not wanting to initiate costly bankruptcy proceedings.

Insider selling increased as stock prices dropped just before disclosures of debt covenant violations, partly because of uncertainty that the company could go bankrupt. The stock sell-offs were followed by increased insider buying following the disclosures, as stock prices recovered in response to the company’s turnaround.

The researchers also examined whether insiders simply mimic the swings in stock price or actually place their trades ahead of the market using their perceived “insight” based on nonpublic information.

Statistical analysis shows that insiders sell one to two months ahead of the market decline that precedes the disclosure, and buy one to two months ahead of the market recovery.

The authors considered other reasons for spikes in insider trading such as earnings reports and other filings, but found no other simple explanation for buying and selling that could account for roughly $1.97 billion in profits over the eight-year study period. The study ended before the stock market crash in 2008.

“We find strong circumstantial evidence of what some may view as illegal insider trading that cannot be attributed to other factors,” says Paul Griffin, professor of management at the University of California, Davis.

“But the trouble with this type of insider trading is that the risk of liability or prosecution for the insider is low because the trading typically takes place weeks or months before the public disclosure.”

“This makes it extremely difficult to establish a ‘smoking gun’ or nexus between the trade and the unfair profits from the trade, to use legal language.”

A requirement introduced in 2003, under which insiders must report their trades to the SEC within two days of the transaction date, seems to have lowered insiders’ propensity to trade ahead of the market, the study shows. That is good news for regulators and the average investor.

Insider trading reports filed with the SEC are of high interest to analysts and investors as a potential source of new information about a company. Some insiders’ trades might reveal new details about the company’s prospects—and uncover patterns of excess returns by insiders.

“We are not the only ones to showcase this unusual activity,” Griffin says. “The SEC in the last few years has brought several actions of insider trading in stock and debt by members of creditors’ committees who allegedly have breached confidentiality agreements, and similar trading behavior has been shown in academic research on institutional investors.”

It’s hoped that pointing out suspicious and highly profitable insider trading near the time of a debt covenant waiver event, will attract the attention of regulators and prosecutors who can bring criminal charges against accused traders.

“We may have a long wait, however,” says study co-author David Lont of the University of Otago in New Zealand.

“U.S. regulators and prosecutors currently have a raft of complex cases on their hands involving nonpublic information acquired by giant hedge funds through expert networks.”

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