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Investors Relations Business, November 12, 2001

Insider Trading is Linked to Earnings Breaks

Copyright (c) 2001 Thomson Financial, Inc.

Despite the threat of punitive action and shareholder lawsuits, some corporate insiders still trade on their knowledge of future earnings announcements, a recent academic study claimed.

The paper, jointly penned by Pennsylvania State University professors Steven Huddart and Bin Ke, and Michigan State University professor Kathy Petroni, said it provides evidence that insiders know about significant accounting disclosures as much as two years before they are released. The researchers analyzed the trading patterns of insiders at nearly 4,000 companies in the run-up to a break in a series of consecutive earnings increases. The results showed that there was no unusual amount of insider training in the two quarters immediately preceding the earnings break-so as not to arouse suspicion, the paper suggested-but the frequency of insider trades three to nine quarters before the earnings break was higher than usual.

While the report doesn't claim that all trades by company insiders are driven by knowledge of a future earnings hit, it is a significant factor, it said.

Furthermore, insider sales influence stock price, but not necessarily in a bad way, Huddart said.

"Research shows that these trades improve the market, although the Securities and Exchange Commission may disagree. The findings are provocative in relation with other research-there is certainly evidence that the exercise of stock options is a predictor of a future downturn," he said.

The study looked at the timing of negative news and when it's traded upon measured against stock price. It found that insider sales tend to occur six to nine quarters before a break in earnings.

"Corporate counsel is pretty stringent on trading immediately before an earnings break, but this just means the timing has been pushed back," Huddart said.

These findings are consistent with an earlier study that found insider trading was predictive of future stock returns. There is a very strong component driven by insider knowledge, he said.

The issue for the SEC is what type of disclosure to mandate. This is a tough question and there is no obvious answer. These variables explain 5% of insider trading, which means the relationship is significant. The analysis has yet to be done on the magnitude of profits resulting from insider trades, Huddart said.

"How does anybody get away with beating the market? If everyone stuck to Regulation FD, it would be impossible for fund managers to beat market performance," he said.

There is potential for the market to learn something: high volume, plus news of insider selling and the date the announcement is made could all move stock price. Investors should pay attention to this, Huddart said.

"The argument is that it helps get information to prices faster, and that's a potential benefit. The cost is that people who trade against insiders lose money," Huddart said. "In terms of bankruptcies, while there is no insider selling immediately before, there is excessive insider selling two years before."

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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