Are corporate insiders, including finance chiefs, dumping shares after their company has received a troublesome comment letter from the Securities and Exchange Commission’s division of corporate finance?In some cases, yes, according to a study from Patricia M. Dechow and two other professors at the University of California at Berkeley’s Hass School of Business.
The study, “SEC Comment Letters and Insider Sales,” found that when comment letters raised the particularly nettlesome accounting issue of revenue recognition, top executives took advantage of the pre-disclosure period to sell company shares.
The study of 6,728 comment letters from 2006 through 2012 found insider sales were 70% above normal in the five business days prior to public disclosure of SEC comment letters that involved revenue recognition.
In the five days, insiders unloaded shares with a value of $360 million above normal, with CEOs, CFOs, board members and other higher-ups all involved in selling. The heavy insider selling continued after the public disclosure of the comment letter, “proceeding at 30% above normal from disclosure day through day five then rising to 108% above normal from day six through day 10,” says the American Accounting Association.
As the AAA notes, executives appear to be taking advantage of their knowledge of the content of comment letters, and “the time delay in comment letter disclosure provides
opportunities to strategically profit from insider trading.”
When the SEC has concerns about what’s in a 10-K, it sends a comment letter to the filer, and the filer has 10 days to respond. Once the comments are resolved, the letters aren’t made public for 20 days. But even once disclosed, the market’s reaction to a comment letter is slow, says the study — there is little immediate media coverage and few investors download the comment letters from the SEC’s web site.
The study’s authors — Dechow, Alastair Lawrence, and James Ryans of the University of California, Berkeley — say the slow market reaction enables insiders “to wait until after the comment-letter release date to trade, and [thereby] fulfill their fiduciary and ethical duties. However, the lack of an immediate negative stock-price response to the release of the comment letter correspondence would make it difficult for class-action lawyers to sue the insider.”
As the AAA notes, “since receiving a comment letter is a relatively rare event for many firms, corporations are unlikely to have specific policies prohibiting insiders from trading before comment letters are released.”
The delay in public disclosure serves corporate insiders, the authors charge, and they have a couple of remedies: the SEC (1) should encourage boards of directors to set “insider blackout periods” during a comment letter review process and (2) shorten the time lag of public disclosure from its current 20 days. Investor access to comment letters also needs to be improved, Dechow tells the AAA. “The current set-up is quite opaque unless you check daily,” she says.
Not all of the 1,299 companies that received a revenue recognition comment letter during the study period saw abnormal levels of insider sales, of course. Executives and board members seemed particularly motivated at two subgroups of companies — those whose stock had a large amount of short interest and those with high levels of non-cash accounting items (accruals).
Among the 293 companies in the top-fifth for short interest, insider sales in the five days before comment letter disclosure was 200% above normal, found the study. Among the 255 companies in the top fifth for accrual levels, insider sales were 77% above normal.
The insiders had good reason to sell: at these two kinds of firms, 20 days after the public disclosure of the SEC comment letter stock returns started to go “south,” according to the study. The stock of companies with high short interest produced returns 5% below the overall market at the 50-day mark, and high accrual level firms produced returns 2% below the overall market in the same period.
Do the insider sales actually correlate to a depression in a company’s stock price? Maybe. For the entire subset of firms that received revenue recognition letters, when insider selling was not above normal for the 50 days after public disclosure, shares performed at roughly market levels. But at firms where executives took an opportunity to sell stock based on their insider knowledge, a company’s shares performed 1% below the overall market.
With the issuance in late May of a new Financial Accounting Board standard on revenue recognition, and the resulting big overhauls in accounting models and systems for some industries, the SEC may be issuing a lot more comment letters on revenue recognition in the next few years.
“SEC Comment Letters and Insider Sales” was presented at an August meeting of the American Accounting Association.