Suspicious Insider Trading around Company Debt Renegotiation

Insiders have reaped substantial profits from increased trading of a faltering company’s stock when the firm is renegotiating its debt, according to a recent study by Professor Paul Griffin and colleagues David Lont and Kate McClune of the University of Otago, New Zealand.

The aggregate return to insider traders—the sum of their losses avoided from selling and their gains from buying stock—approached nearly $2 billion over an eight-year period. The study tracked insider stock transactions during or near 1,718 first-time disclosures of debt covenant violations by U.S. public companies from 2000–2007.

We find strong circumstantial evidence of what some may view as illegal insider trading that cannot be attributed to other factors. –Professor Paul Griffin

The waiver of a debt covenant is an important step taken by a lender to resolve a company’s debt problems and help bring the company back to financial health. Companies must disclose violations of debt covenants and the negotiated outcomes with lenders to the Securities and Exchange Commission. The disclosures are public. Griffin and his co-authors documented increased insider selling as stock prices dropped just before disclosures of debt covenant violations, partly because of uncertainty that the company could go bankrupt.

These stock sell-offs were followed by increased insider buying following the disclosures, as stock prices recovered in response to the company’s turnaround. The researchers’ statistical analysis showed that insiders sell one to two months ahead of the market decline that precedes the disclosure, and buy one to two months ahead of the market recovery. “We find strong circumstantial evidence of what some may view as illegal insider trading that cannot be attributed to other factors,” Griffin said. “But the trouble with this type of insider trading is that the risk of liability or prosecution for the insider is low because the trading typically takes place weeks or months before the public disclosure. This makes it extremely difficult to establish a ‘smoking gun’ or nexus between the trade and the unfair profits from the trade.”

Griffin’s latest research examines investors’ response to a company’s disclosure of the receipt of a Wells notice, which the SEC issues when it plans to recommend to the full commission that formal charges be filed against a company or its officers for a violation of securities law. Companies must make a decision to disclose or not disclose receipt of a notice to shareholders.

Some firms keep a Wells notice under wraps and tend to disclose it only when prompted by a more serious inquiry, which can occur months after the initial notice. Griffin and co-author Yuan Sun of UC Berkeley’s Haas School of Business found that stock prices fall significantly in the three days around a first-time Wells disclosure and, for disclosures that involve subsequent timely litigation, stock prices drop more sharply, by more than three percent. Providing further evidence that a Wells notice is a material event, they also found a significant shift from insider buying to selling up to four weeks before disclosure, although this tracks best with stock return in the same period.

Following an international search, the Executive Committee of the American Accounting Association (AAA) in April named Griffin as co-editor of Accounting Horizons, one of the association’s two flagship academic journals. Founded in 1916, the AAA promotes worldwide excellence in accounting education, research and practice.

Accounting Horizons publishes high-quality scholarly articles that bridge a healthy dialog among academics, professionals, regulators and students of accounting. “One of my major tasks will be to uphold the rich legacy built by past editors and then move forward by delivering academic research to a readership versed in accessing information digitally,” Griffin said. He will share the editorship with Professor Arnold Wright of Northeastern University. They will assume the posts in late spring 2012, and serve a three-year term.


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