The factors affecting illegal insider trading in firms with violations of GAAP

Author: Maya Thevenot, Ph.D.

Release Date: Sep 27, 2016

 MEDIA CONTACT: Jim Hellegaard
561-319-2233, jhellegaard@fau.edu

The high incidence of financial statement restatements and high-profile accounting scandals in the last decade has spurred a great deal of attention from the media, investors, legislators and researchers. A major concern is that managers not only “cook the books” to meet market expectations but they also profit from the violations through informed insider trading. This potential profit is not without risk, however, as trading on the knowledge of existing accounting misstatements exposes the firms and its executives to high litigation and SEC enforcement risk.

Examining this tradeoff between high potential insider trading profit and high litigation risk, the paper finds that illegal insider sales decrease in the costs of potential private litigation and SEC enforcement. If the estimate of the litigation likelihood increases by 10 percentage points, the dollar value of net sales decreases by over $24 million. A 10-percentage point increase in the SEC enforcement probability is associated with a decrease in insider net selling of over $19 million. The enactment of the Sarbanes-Oxley Act in 2002 with provisions requiring increased personal responsibility and criminal penalties for misconduct, did not strengthen the private litigation effect but increased the deterrent effect of public enforcement by the SEC.

Gaining insight into the actual monetary losses from this behavior, the study considers 384 cases of severe accounting misstatements, of which 33 percent had a class action case only, 8 percent had an SEC enforcement action but not private litigation case and 28 percent had both.  The data shows that firms and executives with both an enforcement action from the SEC and a private class action litigation case are associated with the largest settlement amounts and disgorgement of profits. It is especially interesting that executives from these firms suffer much higher personal losses in terms of settlements amounts, penalty fees and disgorgements of profits than executives from firms with SEC enforcement action but without a class action litigation case. Moreover, there are 31 cases where a legitimate legal claim exists but private enforcement has not occurred and it is plausible that this is due to the lack of evidence of informed insider trading, which often indicates intent or knowledge of wrongdoing.

This paper is availble for download / purchase here: http://www.sciencedirect.com/science/article/pii/S0165410111000589