Is executive insider trading a problem?

November 28, 2012

The WSJ is making a very big deal of its latest investigation into when and how executives trade stock in their own companies. But I’m not particularly impressed: it seems like much more of a fishing expedition than a wide-ranging scandal.

Certainly the WSJ contrives to be shocked at stuff which really isn’t shocking at all:

Douglas Bergeron, CEO of VeriFone Systems Inc., set up a trading plan in January 2011 and then in late March sold nearly $14 million of VeriFone stock. In trades from March 28 to March 30, 2011, he received between $55 and $57 a share.

On April 5, VeriFone’s stock began a long slide—exacerbated by a May 12 Justice Department lawsuit to block a VeriFone acquisition—that left the shares just above $30 in August.

There’s no way that the Bergeron would have known about the Justice Department lawsuit in March, when the suit didn’t appear until mid-May; what’s more, VeriFone is on the record as saying that he didn’t know about it. So it’s hard to see what the WSJ thinks it’s doing, here.

More generally, the WSJ’s methodology seems designed to produce exactly the results that it came up with:

The Journal examined regulatory records on thousands of instances since 2004 when corporate executives made trades in their own company’s stock during the five trading days before the company released material, potentially market-moving news.

Among 20,237 executives who traded their own company’s stock during the week before their companies made news, 1,418 executives recorded average stock gains of 10% (or avoided 10% losses) within a week after their trades. This was close to double the 786 who saw the stock they traded move against them that much.

It’s not obvious what the WSJ considers to be “material, potentially market-moving news”, but I think that two assumptions are probably fair here. Firstly, stocks tend to take the stairs up and the elevator down: if there’s a sharp move in a stock, it’s much more likely to be a fall than a rise. Secondly, executives trading in their own stock are much more likely to be sellers than buyers. They get awarded stock as part of their compensation package: that’s not trading. And once they’re awarded it, they have every right to sell it — and selling it makes perfect sense, in terms of portfolio diversification if nothing else.

Put those two assumptions together, however, and you get exactly the result that the WSJ is so shocked by. Let’s assume that nothing untoward is going on at all, and executives are trading their stock all year long. Assume too that most of those trades are sales. Then assume that the WSJ looks only at the trades which happen before sharp moves in a stock. Since most of those trades are going to be sales, and most of the sharp moves are going to be downwards rather than upwards, it stands to reason that the executives are going to look like they were avoiding losses, rather than seeing the stock move against them.

On top of that, the WSJ seems to deliberately elide key information at points. For instance:

Mr. Zinn bought about $800,000 of Micrel stock in the four days before Micrel put out an earnings news release saying the company hadn’t been significantly affected by the slowing economy—and announcing that it would begin paying a dividend. Within a month, the shares Mr. Zinn purchased just ahead of this news were up 27%.

Mr. Zinn’s timing was good again in early 2010. He bought about $295,000 of Micrel stock during the two trading days before Micrel executives made news at an investor conference by saying the company’s business was improving. Within a month, the stock rose 36%.

The WSJ doesn’t provide dates or stock charts here, and it’s far from clear what “made news” means in the context of executives saying upbeat things about their own company. But what is clear is that the WSJ tells us only what happened to the stock “within a month”, rather than between the trades and the news. If the stock moved after the news was public, that should be neither here nor there.

Not all of the WSJ’s examples are this dubious. But by its own admission, the paper examined thousands of trades, all of which took place in the run-up to potentially market-making news. Even if they were all perfectly innocent, statistically speaking some of them would end up looking suspicious. If you suspect bad-faith dealing, and then you look for it in a certain place and then you find it there, that’s a bright-red flag. But if you had no reason to be suspicious in the first place, then you need a lot more evidence. It’s a bit like discovering that two of your friends share a birthday: it’s a coincidence, but it’s not particularly noteworthy, because statistically speaking it’s pretty much certain that two of your friends share a birthday.

In order for the WSJ’s findings to be newsworthy, then, we’d need a pretty solid analysis of how many cases like this you’d expect just from random chance — and that analysis seems to be missing. The closest we get is this:

“We’ve found a lot of evidence that these insiders do statistically much better than we’d expect,” said Lauren Cohen, an associate professor of business administration at Harvard University who co-wrote a study published this year about the performance of insiders who time their trades. “The perch that they have—they not only have proximity to this private information, but they can actually affect the outcomes.”

There’s no link to the study, but I assume the paper in question is this one. It’s an interesting paper, but it doesn’t use the WSJ dataset, and it doesn’t look for “potentially market-moving news”: it just takes the results of executives with a regular and predictable share-trading pattern, and compares them to the rest.

Altogether, then, I think there’s less here than meets the eye. There might be future shoes to drop, and some of the trades they have found could turn out to be illegal. But I would have preferred less tarring of possibly-innocent executives, and more substantive discussion of what could actually be done to improve the system. The WSJ makes the case that the current system of 10b5-1 plans, where executives pre-plan stock sales, is flawed. But how could it be fixed? You could ask executives to commit to a fixed schedule of purchases or sales long in advance, but all such schedules have to be editable somehow, and in any executive’s life things happen which can drastically change that person’s need for liquidity.

And then more conceptually there’s the whole problem with the idea that executives can’t trade when they have material nonpublic information about a stock — which is just silly at its heart, because executives always have nonpublic information about a stock, and that information would nearly always be considered material for, say, a third-party hedge fund.

The SEC’s rules, as a result, are always going to be a bit unsatisfying, because they need to reconcile two irreconcilable facts: that executives have material nonpublic information, and yet at the same time they have to be able to sell their stock somehow. Lauren Cohen’s paper demonstrates that nothing untoward takes place if the stock sales are scheduled long in advance, taking place on a regular and predictable schedule. But life doesn’t always happen according to regular and predictable schedules, and it’s very far from clear that the problem here is big enough to justify a sweeping new regulation, just to try and prevent an unknown but possibly very small amount of insider trading.


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