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E-MailS. Burcu Avci is an Adjunct Lecturer at Vanderbilt University, H. Nejat Seyhun is the Jerome B. and Eilene M. York Professor of Business Administration and Professor of Finance at the University of Michigan Ross School of Business, and Andrew Verstein is a Professor of Law at the UCLA School of Law. This post is based on their recent paper.
Corporate executives and directors are legally allowed to sell their shares directly back to their corporation, rather than selling them in the open market. What is most interesting and most unusual about this situation is that insiders are decision-makers on both sides of the trade. They decide to sell out of their personal account and buy into a corporate account. If they are directors, they even approve their own sales. This pits executives against their own shareholders. To the best of our ability, no one has studied what happens in these situations.
At the very least, there are potential conflicts of interest in corporate governance at the highest levels. You might expect executives to benefit themselves at the expense of their shareholders whenever there is a direct conflict. If stock prices subsequently drop, shareholders lose and insiders win. Insiders have to choose between shareholders’ interests and their personal interests, and risk violating their fiduciary duty if they sell based on adverse, material, non-public information.
Insiders’ direct sales to the corporation are stealth trades, since no sell order ever hits the market. There is no price impact or price pressure. There is no disclosure before the trade. Even the brokers are in the dark. The market only finds out, upon 16a reporting (which could be late), that a D-sale took place. Insiders report these transactions (on Form 4) to the SEC using a ‘D’ code. The corporations lump insider buybacks in with other buybacks when they report them publicly. There is usually no separate 8-K disclosure requirement. There is currently no limit on the amount insiders can sell. This means the counterparty traders will not even know they are harmed. Furthermore, they may not be able to prove they are harmed in court, since the trade does not trigger an immediate price impact.
These D-sales are much larger in volume than normal S-sales. There are multitudes of trades over $10 million or $100 million. What is to stop the insiders from taking advantage of their dual roles since they are on both sides of these large trades?
Not the law, for the most part. The SEC provides a regulatory exemption for D-trades from the 16b short-swing profits rule (buy-and-sell within 6 months), since these trades are assumed to be benign and liquidity-based. Insiders can potentially buy large amounts of shares and turn around and dump the shares back to the corporation the next day (or dump first and buy back later). This can affect executives’ incentives to manipulate the flow of information.
Initially, the SEC assumed that those trades related to compensatory plans like stock options, restricted stock, or stock purchase plans, and that such trades were fundamentally different from the speculative trading activities Section 16(b) was designed to deter. (Later, the SEC eliminated the compensation-connection requirement, see Dreiling v. Am. Exp. Co., 458 F.3d 942, 948 (9th Cir. 2006)). The SEC’s original viewpoint was that these compensatory transactions generally don’t present the same opportunities for insiders to exploit short-term, undisclosed information for personal gain at the expense of the market or other investors. The regulatory question then becomes, are these D-sales liquidity-based or information-based? Should this regulatory exemption continue even for non-compensation-related trades?
In 2002, Sarbanes-Oxley required these D-trades to be reported on Form 4 within 2 days, rather than on Form 5 with up to a 45-day delay after the end of the fiscal year. Does prompt reporting affect the information content of these trades? Were the regulations effective in changing executives’ behavior? These are some of the questions we investigate.
Our evidence shows that insiders’ D-trades are highly informative. Stock prices drop about 10% abnormally (after adjusting for market movements) following insiders’ D-trades. They fall even more (14%) if the D-trades are reported 21 or more days late, suggesting that these are information-based trades. Insiders in large-cap firms benefit more from D-sales since prices drop about 14%, instead of 7% in small-cap firms. Most of the information is in large volume trades, when insiders sell more than $10M of shares back to their corporations. With small sales, less than $100k, there is no information. The fact that insider trade greater amounts when they have more valuable information suggests that insiders are fully aware of their informational advantages. There is also a hierarchy to insiders’ D-trades. Top executives benefit the most, followed by large shareholders, and lastly by officers. Yes, large shareholders also sell shares back to their corporations by entering into an employment relationship with the firm (such as appointing a representative to the board).
None of the so-called reforms of the past decades, such as Sarbanes-Oxley (2002) or Dodd-Frank (2010), has put an end to this practice. Insiders have been trading profitably against their corporation even after 2010. This practice continues to this day. Finally, our evidence indicates that potential backdating cannot explain the entirety of the evidence.
From a corporate governance perspective, our evidence indicates that the Board of Directors may be complicit in these opportunistic transactions. The board may want to reward the CEO who nominated it to the board, or they may approve extractive trading by one director in the hopes of enjoying the same treatment someday. Indeed, directors can lawfully repurchase their own shares and approve their own proposed sales.
Here are some policy implications from our study: The most obvious implication is that government investigators, plaintiffs, and journalists should be more distrustful of insider transactions against the corporation—even when the transaction has been approved by the board—particularly if the transaction is reported late. When a D-coded transaction is filed, onlookers should not assume the best. With a few additional specifications, such a transaction is more likely to be opportunistic than an open market sale.
The SEC should consider revisiting reforms that might make it harder for insiders to hide or misreport their transactions with the corporation. Opaque, delayed disclosure makes it safer for insiders to sell overvalued stock to the corporation. They can misreport their trades or delay disclosure until investigators are no longer focused on the firm. This is a serious risk, given that we found substantial apparent misreporting and much higher insider profits for delayed filings. The strategies of misreporting or delaying would be less feasible if corporations provided timely, granular disclosures of their trades.
Our proposed reforms, along with existing rules, could be further strengthened by private rights of action. Investors could probably sue auditors if they are held responsible for due diligence regarding insiders’ D-sales. We have also argued in other work that investors have a private right of action to sue for intentional miscoding in a Form 4. The SEC could formalize rules authorizing shareholder suits to avoid doubt.
