Timing Stock Trades for Personal Gain: Private Information and Sales of Shares by CEOs

Robert Parrino is Professor of Finance at the University of Texas at Austin. This post is based on an article by Professor Parrino; Eliezer Fich, Associate Professor of Finance at Drexel University; and Anh Tran, Senior Lecturer in Finance at City University London. Related research from the Program on Corporate Governance includes Insider Trading via the Corporation by Jesse Fried (discussed on the Forum here), Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.

In October 2000, the SEC enacted Rule 10b5-1 which enables managers to reduce their exposure to allegations of trading on material non-public information by announcing pre-planned stock sales up to two years in advance. In our paper, Timing Stock Trades for Personal Gain: Private Information and Sales of Shares by CEOs, which was recently made publicly available on SSRN, we examine the impact of Rule 10b5-1 on the gains that CEOs earn when they sell large blocks of stock.

Since sales under Rule 10b5-1 are planned well in advance, managers presumably schedule them before material time-sensitive inside information becomes available. This should reduce the ability of managers to earn abnormal returns on sales of their personal shares.

However, even under Rule 105b-1, stock sales could be susceptible to opportunistic behavior by managers. For example, a CEO can cancel a planned sale without legal exposure through the use of limit orders if the firm’s stock price is likely to increase after the planned sale date due to the contemporaneous release of material non-public information. A CEO also has the ability to, at least temporarily, affect the market price of the firm’s shares before the sale. These decisions might involve investment, operating, financing, or reporting choices, or the timing of the release of price-sensitive information. In addition, a CEO who sells shares within a 10b5-1 plan can always profit if he or she has sufficient foresight regarding the resolution of uncertainty about the value of a firm’s shares.

Using a sample of 610 large stock sales by CEOs of public U.S. firms from 2003 through 2009, we investigate whether the CEOs systematically profit from sales involving at least one percent of their firm’s market capitalization. This size threshold is selected because a large trade is unlikely to be casual and more likely to be strategically timed to result in considerable gains for the selling CEO if such timing is possible. This experimental design enables us to evaluate the effectiveness of Rule 105b-1 in limiting opportunistic sales.

We find that sales that are not executed as part of 10b5-1 plans are preceded by an average 40 day cumulative abnormal return (CAR) of approximately 4 percent and followed by an average 40 day CAR of -8 percent. In contrast, large stock sales executed as part of 10b5-1 plans are preceded by an average 40-day CAR of 10 percent, but, on average, the CAR over the following 40 days is approximately 0 percent. Furthermore, the average monthly alpha of a firm following a sale under a 10b5-1 plan is 2.09 percent over the three years following the sale. This compares with a zero percent monthly alpha for sales outside of such a plan.

The return patterns we uncover indicate that 10b5-1 plans appear to make it more difficult for CEOs to sell their stock before bad news is revealed to the market. However, some CEOs in our sample are still able to sell stock at an advantageous time even when they sell as part of a 105b-1 plan. Specifically, sales executed under 10b5-1 plans often follow positive abnormal stock returns. We find that average proceeds from stock sales under 10b5-1 plans are about $1.2 million higher than they would have been if the sales had occurred 40 trading days earlier.

A factor that complicates the interpretation of our findings is that most stock sales under 10b5-1 plans are limit orders in which the sale is executed only if the share price exceeds a specified value. Consequently, it is not surprising that personal stock sales by CEOs under 10b5-1 plans are preceded by a sharp appreciation of their firms’ share prices. Such price appreciation might occur mechanically.

In an order to better understand the determinants of the excess returns that CEOs earn when they sell under 10b5-1 plans, we examine financial performance, financial reporting, and other information disclosures around the sales.

Financial characteristics at more than 50 percent of the firms in our sample with 10b5-1 stock sales, exhibit substantial declines around the sales. These declines are observed in key metrics such as sales, capital expenditures, and return on assets. We also find evidence of earnings management in the fiscal year preceding the large CEO stock sales. On average, accounting accruals decline significantly from the fiscal year before the sale takes place to the year of the sale. This is consistent with CEOs dressing up the books in advance of a 10b5-1 stock sale.

Evidence on the nature of news about the firms at which the selling CEOs are employed suggests that some selling CEOs are timing the release of discretionary information (information releases for which the timing is discretionary) in a way that benefits them. Specifically, examination of the news immediately following CEO stock sales reveals that discretionary news are significantly more likely to be released after a sale that takes place under a 10b5-1 plan than after a sale that is not planned.

For the entire sample, CARs following large CEO stock sales are more negative at firms with a greater number of independent directors who hold at least three directorships in publicly traded firms (busy directors). However, these CARs are positively related to the number of outside directorships held by the CEO and the level of the CEO’s total compensation. These relations suggest that corporate governance in general, along with specific factors such as the monitoring effectiveness of the board and the reputational concerns of the CEO, play an important role in determining the ability and inclination of the CEO to strategically time large stock sales for personal gain.

The contributions of our study are as follows. First, it adds to an extensive body of academic work showing that insiders use private information about the firm to personally benefit from trading their firm’s stock. Second, the evidence we present on the potential weaknesses associated with 10b1-5 plans advances the literature on the effectiveness of the mechanisms aimed at deterring the ability of managers to profit from trading on private information. Third, our study provides new evidence showing that managers have the ability to temporarily affect the valuation of their firms. Fourth, our results on the governance characteristics associated with large stock sales by CEOs contribute to the debate on whether a firm’s governance mechanisms tend to be too weak for efficient monitoring of the CEO. Finally, our paper has important public policy implications. Our results on the ability of some CEOs to earn abnormal profits regardless of whether their stock sales are covered under 10b1-5 plans should be of interest to regulators, corporate governance activists, and other interested parties because they imply weaknesses in the surveillance of insider trading in general and suggest non-trivial loopholes on 10b1-5 plans in particular.

The full paper is available for download here.

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