Corporate Insider Trading
All animals are equal, but some are more equal than others.
Jeff Skilling was the CEO of the Enron Corporation during the infamous Enron scandal. The company was considered one of the fastest-growing and most innovative companies1 in the U.S. However, in reality, they had artificially inflated revenues and hidden losses using massive accounting and corporate fraud.
The infuriating part of the scandal was that the upper management knew what was going on. They were dumping shares even as they were telling investors to buy. In 2000, right before the crash, Skilling sold 1.1 million shares, pocketing $62 million, and then chairman Kenneth Lay sold 2.3 million shares for $123 million. Finally, just a few months before bankruptcy, Skilling abruptly resigned from the company and sold another half a million shares as he had inside information that the company was in serious trouble.
You can’t do anything if you have material inside information, but that’s true for any human being on the planet and that’s a decision I have to make. — Skilling to his stockbroker
Skilling was eventually convicted by the jury of conspiracy, insider trading, and securities fraud and was sentenced to 24 years in prison. While only the high-profile cases make it to the news, illegal insider trading by company executives is not as rare as you think — it accounted for 4% of the SEC’s total actions in 2021.
Some of the other recent controversies worth highlighting were when the Silicon Valley Bank CEO sold $3.6 million worth of shares2 a few days before the bank collapsed and when Pfizer CEO Albert Bourla sold 62% of his stock the same day the company announced its experimental COVID-19 vaccine succeeded in clinical trials3.
The Random Walk theory states that stock prices are random, implying efficient markets. One exception to this can be company insiders — due to the nature of their work, they possess information unavailable to the public. Does this unfair advantage translate to market returns? [emphasis by author]
In general, studies suggest that corporate insiders were willing to exploit their preferential and superior access to non-public information in order to get unfair informational advantage over the market.
Besides, the profits generated by insiders (i.e., the returns of these trades) were found statistically significant.
How to detect illegal corporate insider trading? Fevzi Esen et al., Intelligent Systems in Accounting, Finance, and Management
Let’s dig in:
Insider trading data
Whenever there is a material change in the holdings of company insiders, they are expected to report it to the SEC via Form-44. SEC has made these filings public since mid-2003, and we have nearly 3M+ insider transactions that we can analyze over the past two decades. While it’s challenging to get the data directly from the SEC as the filings are usually scanned copies/PDFs, much progress has been made in structuring this data.
A professor at the University of Melbourne has created an open-access repository in Nature, which is updated daily.
The SEC provides a quarterly updated structured dataset
Do corporate insiders benefit from non-public information?
While it’s illegal for company insiders to trade on non-public and proprietary information, identifying and prosecuting insider trading is challenging due to the subtle distinctions between what is and isn’t legal.
Researchers at the University of Minnesota devised a novel approach5 to identify if insiders were potentially trading on non-public information. They used the time stamps from audit letters of 2,000+ public companies to identify if the CEOs and directors sold their stock from the time the audit report was submitted to the time the audit report went public. The results were so striking that the team presented their findings to the SEC and the Public Company Accounting Oversight Board (PCAOB). This is what they found out: