Opportunism as a Managerial Trait

In trading their firms’ stocks, insiders must balance the profits of informed trading before news, the scrutiny by regulators that such trading can engender, formal policy restrictions by firms of insider trading activities, and diversification and liquidity motivations for selling shares after vesting of equity-based compensation. This mixture of motivations and constraints makes it is hard to decipher the information content of insider trades, especially because different trades may be intended to exploit news arriving at short or long horizons. This noise makes it feasible, up to a point, to conceal deliberate opportunism from regulators such as the SEC.

Empirically, there are some indications that insiders do exploit private information. Past research finds that insider purchases positively predict subsequent abnormal returns. On the other hand, effects are much harder to identify for insider sales, presumably because such sales are often performed for non-informational reasons, such as to reduce risk or to consume.

In our paper, Opportunism as a Managerial Trait: Predicting Insider Trading Profits and Misconduct, we develop a new method of identifying opportunistic insider trading, and test whether opportunistic insiders earn higher profits on their future insider trades. We also test whether opportunism is a firm or managerial trait that extends to other domains, such as misleading financial reporting or pressuring the firm for excessive compensation. In other words, are some managers just “bad apples”? Similarly, at the firm level: are some firms prone to opportunistic behaviors of various sorts?

To identify opportunistic insiders, we examine the profitability of insider trades made during the weeks leading up to Quarterly Earnings Announcements (henceforth, QEAs), which are the most important and frequent dates of material information disclosure by firms. Profitability is measured by the returns experienced after these trades during the 5-day window centered at the QEA date. We hypothesize that insiders who make high profits on their pre-QEA trades are opportunistic.

Our approach may seem surprising since many firms have policies that limit the extent of insider trading during “blackout periods” prior to QEAs, and since enforcement authorities have reason to scrutinize such trading as well. However, many firms do not have such blackout periods, and even firms that do often allow pre-QEA trading on a by-request basis. Furthermore, managers sometimes violate these blackout periods. Overall, in our 1986-2014 sample, trading prior to QEAs is quite common—on the order of about 16% of total insider trades and total market value of trades.

To implement our approach, at the beginning of each year, we rank insiders into quintiles based on the profitability of their past pre-QEA trades. We call insiders in the highest profitability quintile opportunistic insiders. We then examine the performance of stocks subsequently traded by insiders in different past profitability categories.

In our 1986-2014 sample, we find that opportunistic buying and selling generates very substantial and significant incremental returns, beyond that which insiders normally achieve. A long-short trading strategy constructed using trades of insiders with a history of high pre-QEA profits (top quintile) generates a value-weighted abnormal return of 1.12% per month (highly significant)—the same portfolio constructed using trades of all insiders generates an abnormal return of only 0.5% per month. In contrast with most previous research, the effect is substantial and significant even on the short-side. Stocks sold by opportunistic insiders have abnormal returns of −0.34% per month (equal-weighted) or −0.53% per month (value-weighted), both highly significant. Similar results hold using regression tests with extensive controls. Almost all of the performance effects that we document come from subsequent non-pre-QEA trades. Our measure therefore identifies a general tendency of the insider to trade profitably.

To see whether these effects are driven by managerial traits or by firm characteristics such as a lax organizational culture, we also compare the trading performance of opportunistic insiders versus general insiders at the same firm and during the same year. Similar conclusions apply, suggesting that these effects capture opportunism as a managerial trait—some managers are “bad apples.”

We next test whether opportunism extends across decision domains using firm-level measures of opportunism: levels of restatements, SEC enforcement actions, shareholder lawsuits, earnings management, option grant backdating, and excess executive compensation. We find that profitable pre-QEA trading is positively associated with the financial reporting misconduct variables (the first four items above) controlling for various other possible determinants of misconduct. For example, having an opportunistic CEO or CFO is associated with an increase of 15.5% in the probability of restating earnings relative to the unconditional probability of restatement.

Furthermore, we show that firms with a high fraction of opportunistic insiders, or which have an opportunistic CEO/CFO, are substantially more likely to be involved in option backdating during the pre-SOX period in which there was a substantial potential benefit to backdating. Having an opportunistic CEO/CFO increases the likelihood of backdating by 18.7% (relative to the unconditional mean). In another very different decision domain, we find that our opportunism measures are associated with high excess compensation of CEOs and top-5 executives even after controlling for well-known determinants of executive compensation.

Overall, these findings suggest that opportunism is domain-general—opportunistic insider trading is informative about other forms of misconduct. Some of these effects could derive from opportunism being a firm-level rather than a managerial trait (despite our controls for firm characteristics). In either case, our tests identify a trait of managers and/or firms that carries across different forms of opportunism. These findings therefore suggest that past trading profitability can be useful for boards of directors, shareholder groups, and regulators as a screen for monitoring and deterring opportunism.

The full paper is available for download here.