JEOPARDY, NON-PUBLIC INFORMATION, AND INSIDERTRADING AROUND SEC 10-K AND 10-Q FILINGS†

Steven Huddart, Pennsylvania State University

Bin Ke, Pennsylvania State University

andCharles Shi, University of California, Irvine

Forthcoming, Journal of Accounting & Economics

Evidence contrasting U.S. insider trades in high- and low-jeopardy periodsand across firms at high and low risk for 10b-5 litigation indicates that insiderscondition their trades on foreknowledge of price-relevant public disclosures, but avoidprofitable trades when the jeopardy associated with such trades is high, such asimmediately before earnings announcements. Insiders avoid profitable trades beforequarterly earnings are announced and sell (buy) after good (bad) news earningsannouncements. Insiders trade most heavily after earnings announcements and profitfrom foreknowledge of price-relevant information in the forthcoming Form 10-K or10-Q filing.

JEL Classification: J33 K22 M12

Keywords: accounting standards, government regulation, insider trading, liti-gation risk, stock-based compensation

this draft: June 18, 2006

† Seminar participants at the 2005 Canadian Academic Accounting Association meetings, the2005 Hong Kong University of Science and Technology summer symposium, Monash University, thePennsylvania State University, Rice University, the University of California–Berkeley, the University ofHong Kong, the University of Queensland, and Yale University provided many useful comments. Wethank Francois Brochet, Sandra Chamberlain, Thomas Lys (the editor), Gans Narayanamoorthy, KarenNelson, Adam Pritchard, Alan Ramsay, Louis-Philippe Sirois, Jake Thomas, Mark Vargus, Serena ShuoWu, and an anonymous referee for many useful comments. Karen Hennes and Santhosh Ramalingegowdaprovided able research assistance. We especially thank Karen Nelson for sharing data on litigation riskwith us. Part of this research was completed while Steven Huddart was a visiting fellow at the Universityof Queensland.

Send correspondence to:

Steven HuddartSmeal College of BusinessPennsylvania State UniversityBox 1912University Park, PA 16802-1912

telephone: 814 865–3271facsimile: 814 863–8393

e-mail: huddart@psu.eduweb: www.smeal.psu.edu/faculty/huddart

1. Introduction

We examine and contrast how the frequency and value of insider trades in the

United States are associated with two significant information releases that occur in every

fiscal quarter: the earnings announcement, which is a summary measure of firm perfor-

mance that is highly price-relevant, and the subsequent Form 10-K or 10-Q filing, which

contains more detailed financial results and also represents price-relevant information.

We replicate earlier findings of a weak association between insider trades shortly before

the earnings announcement and the subsequent earnings announcement.1 We provide

new evidence that insider trades before earnings announcements are relatively infrequent

and occur when the magnitude of the earnings announcement abnormal return is small.

In sharp contrast, insiders trade relatively heavily after the earnings announcement and

these trades are significantly associated with the stock’s returns over narrow windows

around both the forthcoming 10-K or 10-Q filing and the preceding earnings announce-

ment.2 Returns over these windows are proxies for the price-relevant information re-

leased to the market by the disclosure that occurs within the window. The pattern of

associations is consistent with the interpretation that variation in jeopardy over a fis-

cal quarter (i.e., the combined risks of unfavorable publicity, civil liability, and criminal

prosecution) restrains insiders seeking to profit from foreknowledge of corporate disclo-

sures more before earnings announcements than before 10-K and 10-Q filings. Buttress-

ing this interpretation, we present evidence that variation in insider trading across firms

is associated with firm-specific variation in the ex ante risk of 10b-5 litigation. Collec-

tively, these findings are consistent with insiders conditioning their trades on foreknowl-

edge of price-relevant public disclosures but limiting their trades to periods when the

jeopardy they face due to trade is low.

1 The results of studies that have examined the relationship between insider trades and corporatenews released within the next three months are mixed. Givoly and Palmon (1985) find little associationbetween insider trades and subsequent Wall Street Journal reports, a sample composed mainly of earningsannouncements. Sivakumar and Waymire (1994) find trading by insiders in one quarter is not correlatedwith errors in analysts’ forecasts of next quarter’s earnings. Noe (1999) finds that increases in insidertrades in the twenty days prior to disclosure of management forecasts are not correlated with managementearnings forecast errors. Other studies, however, find evidence of an association between insider trades andthe next earnings announcement. Lustgarten and Mande (1995) present evidence that insiders purchaseundervalued stocks (but no evidence that insiders sell overvalued stocks) in the 30 days before earningsannouncements. Roulstone (2004) documents a statistically significant but economically small associationbetween insider trades in the two months before an earnings announcement and the abnormal return atthe earnings announcement.

2 Insiders’ trades after the 10-K or 10-Q filing are significantly associated with the stock’s returns overnarrow windows around both the preceding announcement and filing.

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Since it does not seem possible to elicit from insiders directly and unbiasedly the

motives behind their trades, evidence on the litigation avoidance hypothesis necessarily

is circumstantial. This paper offers evidence drawn from two related settings that plau-

sibly differ in the seriousness of the jeopardy. Trade that shortly precedes and is condi-

tioned upon a forthcoming earnings announcement has resulted in prosecutions and so is

risky.3 Legal advice that insiders should avoid trading in the period immediately before

an earnings announcement is widespread. Many corporations stipulate blackout peri-

ods that cover the preannouncement period and during which insiders may not trade.

In contrast, we know of no complaint filed against an insider for trading improperly on

foreknowledge of the contents of a 10-K or 10-Q.4 Relatedly, Bettis, Coles, and Lemmon

(2000) document that blackout periods typically end on the second trading day after the

earnings announcement, so corporate policy typically permits trades in this period. This

suggests that the risk stemming from trade after the earnings announcement are lower

than that risks from trade before the announcement.

According to Kelson and Allen (2004, p. 13): “A well-designed insider trading pol-

icy that is properly followed creates an effective prophylactic against inadvertent insider

trading, and provides a defense for a company’s insiders against any allegation that such

trading has occurred. Adoption and enforcement of a written insider trading policy also

provide a method for the corporation to demonstrate that ‘appropriate steps’ have been

taken to prevent insider trading violations, and to assert a defense against ‘controlling

person’ liability for trades made by its insiders under Sections 20A, 20(a), and 21A of

the Securities Exchange Act of 1934 (Exchange Act).” They further point out that only

a minority of companies keep trading windows closed (or blackout periods in place) un-

til after the filing of their 10-Qs and 10-Ks. Neither legislation nor SEC rules require

3 A relevant case in this area is SEC v. Lipson, No. 97-CV-2661, 129 F. Supp. 2d 1148.4 No centralized database of securities law complaints exists—these documents are filed in courthouses

around the country—so it is not feasible to conduct an exhaustive search. However, a variety of keywordsearches uncovered no document alleging improper trade related to any of over 1,000 securities for whichdocuments are available at the Securities Class Action Clearinghouse (http://securities.stanford.edu).Furthermore, a keyword search of the Lexis/Nexis file “SEC Litigation releases, Administrative Releases,and AAERs” using the search string “insider trading” w/50 “10-K” or “10-Q” yields 21 documents, noneof which relate to an allegation of improper trade shortly before the filing of a 10-K or 10-K. This suggeststhe SEC has never pursued an insider for trading on foreknowledge of information contained in a 10-K or10-Q.

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firms to restrict insider trades to particular periods or circumstances. Thus, firm poli-

cies that prohibit or discourage trade at specific times are an endogenous and volun-

tary response by firms (and their managers and shareholders) to the more fundamental

risks that insiders and the corporation face. We term these risks “jeopardy”. Jeopardy

arises from the formal surveillance and policing activities of the exchanges and the SEC;

the resulting enforcement actions and precedents; and the less formal disciplinary roles

of the business press, who publicize certain insider trades, and the plaintiffs’ bar, who

launch 10b-5 class action lawsuits. Given that the jeopardy an insider faces from trade

varies over the fiscal quarter, and, in particular, jeopardy is higher before the earnings

announcement than in the period between the announcement and the 10-K or 10-Q fil-

ing, it is interesting to ask whether insider trade clusters in low-jeopardy periods and

whether such trades are profitable to insiders.

Prior research has examined the connection between insider trading and a variety

of information releases.5 We believe our study is the first to examine insider trading

around the filing of 10-Ks and 10-Qs. As such, it provides evidence on the specific

nature of the private information related to proximate financial disclosures that insiders

possess and use in making their trading decisions. The filing of a 10-K or 10-Q is an

important and interesting informational event because (i) it occurs frequently and

regularly, (ii) the magnitude of the stock price response is sometimes large—for 5% of

the observations, the abnormal return at the filing is less than −9.78%, and for 5% of

the observations, it is more than 9.77% (as we explain in more detail below)—and (iii)

compared to informed trade before an earnings announcement, there are reasons to

believe the jeopardy due to trade before the filing is lower.

Johnson, Nelson, and Pritchard (2004) examine whether insider trading is a deter-

minant of subsequent securities litigation. They find that plaintiffs’ lawyers’ filings and

5 Among these studies are examinations of insider trades around earnings forecasts (Penman, 1982and Noe, 1999), news announcements in the Wall Street Journal (Givoly and Palmon, 1985), declarationsof bankruptcy (Seyhun and Bradley, 1997), dividend initiations (John and Lang, 1991), seasoned equityofferings (Karpoff and Lee, 1991), stock repurchases (Lee, Mikkelson and Partch, 1992), and takeoverbids (Seyhun, 1990). Hillier and Marshall (2002) document the abnormal returns associated with insidertrading before and after the two-month long trading ban preceding earnings announcements that appliesto companies listed in the United Kingdom.

3

allegations point to the level of insider stock sales as evidence of management’s fraudu-

lent intent. Our research question is different. Rather than asking if insider trading con-

tributes to litigation, we ask how the combined threats of SEC scrutiny, litigation, and

adverse publicity (i.e., jeopardy) may discipline or limit insider trading. We do this by

contrasting insider trading decisions in firm- and time-specific situations where jeopardy

is either high or low.

Jagolinzer and Roulstone (2004) examine the evolution of the distribution of insider

trades around earnings announcements in the years 1984–2000. Over this 17-year period,

they find that insider trades in the month after the earnings announcement, as a fraction

of all insider trades, has increased. Their evidence also suggests a shift of insider trades

to the period after the earnings announcement. The shift is more pronounced at firms

that have certain characteristics: small market capitalizations, low analyst following,

low institutional ownership, more volatile earnings surprises, and more volatile returns.

Given a trend over time towards greater jeopardy for improper trade and assuming

greater jeopardy at firms with those certain characteristics, their time-series analysis

complements this study in identifying how jeopardy influences insiders’ trades.

Corporate insiders profit from foreknowledge of price-relevant information disclo-

sures by selling before the disclosure of bad news or after the disclosure of good news.

Some argue that instead of altering the time of trade to profit from information releases,

insiders may alter the time of the disclosure or the content of the disclosure.6 Along

these lines, Beneish, Press, and Vargus (2001) examine whether earnings management

precedes or follows insiders’ trades. In our setting, the time of disclosure of the 10-K or

10-Q is fixed within narrow limits by regulation. Further, many firms voluntarily dis-

close the date on which they plan to announce earnings. The evidence in Bagnoli, Kross,

and Watts (2002) is that, by and large, firms do announce earnings on the planned-and-

disclosed date.7 This suggests that earnings announcement dates are known in advance

6 Aboody and Kasznik (2000) present evidence that CEOs adjust the timing of voluntary disclosuresaround fixed stock option award dates, so as to expedite disclosure of bad news and delay disclosure goodnews, thereby increasing the value of options granted at the money. Bartov and Mohanram (2004) presentevidence that is consistent with executives reporting inflated earnings prior to option exercises, followed bya pattern of lower-than-expected earnings after exercise, which represents a reversal of the earlier inflation.

7 Delaying the announcement is associated with a significant price drop, which is personally costly toinsiders holding long positions in the stock.

4

and sticky. Also, the scope to modify the content of the disclosure likely is limited by

the facts that earnings have been reported after either a review by public accountants

in the case of 10-Qs, or audited in the case of 10-Ks. As a consequence, the components

of earnings have been fixed. Further, consistency over time of the principles used in the

preparation of financial reports is required by reporting standards, filing is mandatory,

and deadlines are prescribed, so the setting we examine is one in which insiders have dis-

cretion to choose the time and quantity of trade, but are limited in their ability to alter

the content or timing of their disclosures.

For investors, our findings indicate that the informativeness of insider trades de-

pends, in part, on when during the fiscal quarter the trade takes place and character-

istics of the firm including the risk of litigation that the firm faces. The link between

jeopardy and the timing of insider trades may interest jurists studying how individuals’

actions change in response to statute, case law, and regulation. These findings also have

implications for regulatory choices. For regulators seeking to limit the information rents

gathered by informed insider traders, an important question is how to balance the trad-

ing needs of top executives who receive substantial stock-based compensation against the

profitable trading opportunities created when insiders have private information and sub-

stantial trading discretion. We provide a measure of insider trading profits attributable

to foreknowledge of the contents of 10-K and 10-Q filings.

The paper is organized as follows. Section 2 describes key features of the setting

and the data. Section 3 describes our empirical methods and presents our analysis of the

distribution of insider trades over the fiscal quarter. Section 4 documents how insider

trades vary across firms in response to the risk of litigation the firm faces. Section 5

concludes.

2. Data and institutional background

In this section, we describe the data, the strategies insiders may use to profit from

private information about corporate disclosures, and the timeline relating the disclosures

to the trading periods we examine in each firm-quarter. Next, we define active and

passive trading, describe the construction of the variables used in the analysis, and

present descriptive statistics on these variables.

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2.1 Data

The data used in this study come from three sources. The 10-K and 10-Q filing

dates are from the SEC’s Edgar online database. Stock returns and financial informa-

tion come from the CRSP and Compustat files. Insider trading data are from First

Call/Thomson Financial Insider Research Services Historical Files. These data are the

transactions of persons subject to the disclosure requirements of Section 16(a) of the Se-

curities and Exchange Act of 1934 reported on Forms 4 and 5. Because our objective is

to examine trading by insiders motivated by foreknowledge of company disclosures, the

transactions included in the study are limited to open market purchases and sales by of-

ficers and directors. Non-open market transactions, including, e.g., option grants and

exercises, transactions related to dividend reinvestment plans, stock transfers between

spouses, and certain pension and other benefit program transactions are excluded. Also,

transactions that are reportable solely because the transacting entity is a large share-

holder are excluded.

Since the requirement to file 10-Ks or 10-Qs through Edgar online became effective

on January 1, 1996, our sample includes only calendar years 1996–2002. The SEC

requires that 10-Qs be filed within 45 days after the fiscal quarter’s end and 10-Ks be

filed within 90 days after the fiscal year end.8 In our sample, 95% of the 10-Q (10-K)

filings are made within 47 days (92 days) of the fiscal quarter’s end (fiscal year’s end).

Our research questions are best addressed by studying situations where the timing

of disclosures is fixed in advance and the content of disclosures is privately known to

insiders. Accordingly, we exclude instances where announcements and filings are greatly

delayed. Specifically, we require (i) the quarterly earnings reporting date to be no later

than 45 days after the fiscal quarter’s end, (ii) the 10-Q filing date to be no later than

47 days after the fiscal quarter’s end, (iii) the annual earnings reporting date to be no

later than 90 days after the fiscal quarter’s end, (iv) the 10-K filing date to be no later

than 92 days after the fiscal quarter’s end. We impose these data restrictions because

a delayed filing or announcement likely indicates that the disclosure is not finalized

8 For most companies, the deadlines for filing 10-Qs and 10-Ks are being shortened gradually to 35 and60 days, respectively, by SEC Release No. 33-8128 (issued September 5, 2002 and effective November 15,2002). The SEC subsequently proposed to delay by one year the implementation of this rule change. SeeSEC Release No. 33-8507 (issued November 17, 2004 and effective December 23, 2004).

6

timely. Also, delays generally signal bad news, which Bagnoli et al. (2002) show leaks

out in advance of the announcement. Finally, delays may indicate that the disclosure

is contentious or lacks representational faithfulness. Situations where either insiders do

not know the content of the disclosure, insiders late-adjust the content of the disclosure,

the content of the disclosure is leaked, or the disclosure is misleading are inconsistent

with the experimental setting we seek to explore.9 The final sample contains 110, 305

firm-quarter observations, representing 7,791 unique firms. We count as an observation

each of the three periods of the firm-quarters meeting the data requirements, including

quarters in which there are no insider trades. The sample sizes for some regression

specifications are smaller due to missing values for certain independent variables.

2.2 Opportunity to profit from foreknowledge of disclosures

Consider how an insider may profit from short-lived private information about the

contents of a forthcoming public disclosure. When the disclosure contains good (bad)

news the insider ought to buy (sell) before the disclosure. Further, when the insider

must sell stock for such reasons as personal liquidity needs, but he nevertheless has some

discretion over when to trade, the insider benefits from postponing the sale until after

good news is released. Likewise, when the insider must purchase stock for such reasons

as achieving a stock ownership target established by his compensation contract, the in-

sider benefits by postponing the purchase until after bad news is released. The insider’s

opportunity to profit from the price impact of a public disclosure ends when the disclo-

sure is made, since at that point the insider has either traded or postponed his intended

trade. However, if the insider strategically delays purchases (sales) until after bad (good)

news is released, then trades will be correlated with past stock returns. Our tests for

an association between insider trades before and after the earnings announcement and

10-Q and 10-Q filings with the short-window stock returns around those events are tests

of whether and how insiders exploit specific pieces of short-lived private information,

namely foreknowledge of the contents of the announcements and filings.

9 Note, however, that qualitatively similar results obtain if we relax the data requirements so that the10-Q is filed no later than 60 days after the quarter’s end and the 10-K is filed no more than 180 daysafter year’s end.

7

Assuming that insiders know in advance the contents of the disclosure and can

predict the price reaction that will occur when the disclosure is made, larger absolute

returns imply a larger potential profit to insiders from conditioning their trades on

the disclosure.10 To assess whether the profit opportunity before the announcement

is comparable to the profit opportunity before the filing, Table 1 presents summary

statistics on the distributions of the raw, market-adjusted, and the absolute value of

market-adjusted stock returns around the earnings announcement and the subsequent

SEC filing.

[Table 1]

We choose the 10-Q and 10-K event windows to be brief periods of concentrated

price reaction associated with these disclosures. In a study of 10-K and 10-Q reports

filed electronically with the SEC using the EDGAR system, Griffin (2003, p. 435) ob-

serves that the “EDGAR document will normally reside in the public domain at zero

or low cost within one or two business days following the filing date”. Using the abso-

lute excess stock return as a measure of investor response to the filing, he finds that the

response is concentrated on the day of and the two days after the filing date. Accord-

ingly, we define RET FD to be the return over days 0 to +2 relative to the filing and

call these days the Filing Window. We choose an earnings announcement window that

is the same length as the filing window, namely 3 trading days. Since Morse (1981) finds

that the price response to earnings announcements (measured as the median absolute

return residual) is largest on days −1 to +1 relative to the announcement, accordingly

we define RET EA to be the return over days −1 to +1 relative to the announcement

and call these days the Announcement Window. ARET EA and ARET FD are the cor-

responding abnormal returns computed as the difference between the buy-and-hold raw

returns and buy-and-hold value-weighted market index. Not surprisingly, the mean and

median values of these returns are near zero.

10 This seems a reasonable assumption since there is a long line of research documenting stockprice reactions to the unexpected component of these announcements—beginning with Ball and Brown(1968), who study price movements around earnings announcements; and including Balsam, Bartov, andMarquardt (2002), who study price movements around 10-Q filings.

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The active component of an insider’s trading gain from a stock purchase is the

product of the value of the shares he buys and the subsequent abnormal return. Like-

wise, the trading loss an insider avoids from a stock sale equals the value of shares he

sells times the subsequent abnormal return. To assess the frequency with which insid-

ers are faced with the opportunity to receive a gain by buying or avoid a loss by selling,

and to make potential gains comparable to potential losses, in Table 1 we also report the

absolute value of returns. Comparing the magnitude of the trading opportunity insiders

face before the announcement with the opportunity they face before the filing, observe

that the absolute value of the market-adjusted return over the earnings announcement,

abs(ARET EA), has a mean of 6.40% and a median of 3.96%, while the absolute value

of the return over days 0 to +2 relative to the 10-K or 10-Q filing, abs(ARET FD), has

a mean of 4.38% and a median of 2.80%. Comparing the ratio of either the means or

medians, it is apparent that the average or typical profit opportunity at the filing is

about 70% of the profit opportunity at the announcement. The smaller magnitude of

the return at the filing implies that, all else equal, insiders’ incentive to trade on fore-

knowledge of the filing is smaller than the incentive to trade on foreknowledge of the an-

nouncement. This makes it less likely that our test will detect an association between

insider trades and the return at the filing than at the announcement. Nevertheless, large

returns at the filing are frequent: For 5% of the observations, the abnormal return at the

filing is less than −9.78%, and for 5% of the observations, it is more than 9.77%. The

magnitude of these returns implies that insiders’ potential gains from well-timed trade

are significant.

It is useful to compare the profit opportunity at these events with the opportunities

at other events. Jensen and Ruback (1983) point out that the abnormal returns of tar-

get firms subject to a merger or acquisition is more than 20% over the month leading up

to the announcement. Case law establishes a clear obligation for insiders to avoid trade

in this period. Seyhun and Bradley (1997) point out that the abnormal return experi-

enced by a firm in the year leading up to a bankruptcy filing is about −50% and that

insider selling during this period is abnormally high. Ke, Huddart, and Petroni (2003)

document increased insider selling before breaks in a string of consecutive earnings in-

creases; the average abnormal return over the 32 days before and including this event is

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−4.29%, which is comparable to the means of abs(ARET EA) and abs(ARET FD) mea-

sured over only three trading days. Thus, the announcements around which we study

insider trades are associated with price movements that in many cases are as large as

those associated with major corporate events like mergers, bankruptcy filings, and ex-

treme earnings surprises. Therefore, these events should be large enough to prompt in-

siders to trade. Moreover, the events we study occur four times each year for every pub-

lic company.

Given a difference in jeopardy and economically significant profit opportunities from

private information, a test of the litigation avoidance hypothesis is therefore possible

by comparing the strength of the associations between (i) insider trades preceding

the announcement with the announcement return and (ii) insider trades between the

announcement and the filing with the filing return.

2.3 Timeline

In our experimental design, we focus on insider trading in three non-overlapping

periods within every fiscal quarter. The first period is the twenty calendar days ending

two days before a quarterly earnings announcement. The second period, begins on

the second trading day after the announcement date and ends on the earlier of (i)

the 20th calendar day after this day and (ii) the calendar day before corresponding

10-K or 10-Q is filed. The third period is the twenty calendar days beginning on the

third day after the 10-K or 10-Q filing date. Because the stock market reaction to

earnings announcements typically occurs on the three days centered on the earnings

announcement date while the market reaction to SEC filings occurs on the three days

beginning on the filing date, we construct Periods 1, 2, and 3 so that they surround the

Announcement and Filing Windows, but not overlap them. To facilitate the comparison

of coefficient estimates across regressions based on observations from different periods,

we construct the periods so that they are as close in length as possible. In the variable

definitions introduced below, the index p ∈ {1, 2, 3} denotes the period. Figure 1 plots

each of the periods on a timeline representing a typical firm-quarter.

[Figure 1]

10

Because of variation in the time between the announcement date and filing date,

Period 2 is less than 20 calendar days for some firm-quarters.11 In other firm-quarters,

the Filing Window begins more than 20 calendar days after the Announcement Window

ends, so the last days before the filing are excluded from Period 2. As a robustness

check, we repeated the analysis reported below after redefining Period 2 to include all

the days between the end of Announcement Window and the beginning of the Filing

Window. Results are qualitatively unchanged.

2.4 Active and passive trading

If a trade is driven by the insider’s desire to profit from a particular disclosure,

the direction and magnitude of insider trades both before and after the event may be

correlated with the price reaction to the disclosure because the insider may engage in

both active and passive trading strategies. The definitions of active and passive trading

below parallel those in Seyhun (1998, p. 50).

Take first the case of stock sales. To profit from foreknowledge of a public an-

nouncement of bad news, an insider may trade actively: anticipating the stock price fall

after the bad news is disclosed, the insider may sell before the announcement, receiving

an active return from his action. Empirically, active returns are indicated by more-than-

expected sales transactions and more-than-expected sales value before bad news. To

profit from foreknowledge of a public announcement of good news, an insider may also

capture a passive profit: anticipating that the stock price will rise after the good news is

disclosed, the insider may delay selling until after the announcement, receiving a passive

return from postponing action. Empirically, passive returns are indicated by more-than-

expected sales transactions and more-than-expected sales value after good news.

Correspondingly in the case of stock purchases, active returns are indicated by

more-than-expected purchase transactions and higher-than-expected purchase value

before good news, while passive returns are indicated by more-than-expected purchase

transactions and more-than-expected purchase value after bad news.

11 Firm-quarters in which the filing date is 0, 1, or 2 trading days after the announcement date areexcluded from the analysis. Period 2 does not exist in such cases because there is no interval betweenthe Announcement Window and the Filing Window, which represent 12% of firm-quarters. This situationarises, e.g., if a firm does not formally announce its earnings in press release that precedes the filing of a10-K or 10-Q.

11

Combining these observations, a positive association between net purchase transac-

tions or net purchase value and future abnormal returns indicates active trading, while

a negative association with past abnormal returns is consistent with passive trading.

This interpretation is offered, e.g., by Seyhun (1986). It is possible, however, that the

association between net purchase transactions and past returns is not driven by pri-

vate information that prompts insiders to delay trading. Instead, it may be that insiders

make contrarian trades in response to recent stock returns. Lakonishok and Lee (2001)

and Cheng and Lo (2005) present evidence that insiders buy (sell) when the abnormal

stock return is negative (positive) over the previous 3 to 6 months. In examining the re-

lation between insider trade and abnormal returns in narrow windows surrounding the

announcement and filing, we include as a regressor the stock’s return over a six-month

window preceding these disclosures. Despite this, our tests do not allow us to rule out

either contrarian tendencies or private information as drivers of the association between

insider trades and abnormal returns at prior disclosures.

2.5 Definition of test variables

The principal dependent variables in our analyses are the signed frequency and the

signed value of net insider trading in the three specified periods of each firm-quarter.

So that the measures of trade reflect the net direction, frequency, and value of trade

in a given period when some insiders may be selling while others are buying, trade

frequency and trade value in a firm-quarter-period are defined as follows: FREQpfq is

the number of purchase transactions minus the number of sale transactions in period

p at firm f in quarter q. VALUEpfq is the value, in millions of dollars, of purchase

transactions minus the value of sale transactions in Period p at firm f in quarter q.12 In

over half the periods we examine, there are no insider trades. In these cases FREQp and

VALUEp, are set to zero. In a smaller number of cases FREQp (respectively, VALUEp)

is zero when the number (respectively, value) of purchase transactions in a firm-quarter-

period equals the number (respectively, value) of sales transactions. Overall, FREQp

and VALUEp are zero for 91% of Period 1 observations, 71% of Period 2 observations,

and 77% of Period 3 observations.

12 Results are similar if FREQpfq and VALUEpfq are scaled by the number of insiders at that firm

who trade in that period.

12

[Table 2]

Panel A of Table 2 presents descriptive statistics on the dependent variables. Be-

cause sales transactions exceed purchase transactions in number and value and because

sales transactions are coded as negative values, the mean values of FREQp and VALUEp

are negative. The large standard deviations of these variables are driven by the small

number of quarters where insiders trade heavily. For instance, the smallest and largest

values of FREQ2 are −986 and 218, meaning that in one firm-quarter there are 986

stock sale transactions (net of stock purchase transactions) in that firm-quarter dur-

ing Period 2 while in another there are 218 stock purchase transactions (net of stock

sale transactions) in that firm-quarter during Period 2. The 1st and 99th percentiles of

these FREQ2 are only −16 and 7. Similarly, the smallest and largest values of VALUE2

are far from zero, although the 1st and 99th percentiles of these variables, −11.500

and 0.400, respectively, are much closer to zero. The distributions of both FREQp and

VALUEp are highly leptokurtic. Because of the potential for extreme values of the de-

pendent variable to be highly influential in the regression analysis, in the reported re-

gression results we eliminate outliers using Cook’s (1977) distance statistic. As well, in

untabulated supplemental analyses, we perform rank regressions. The results of the rank

regressions are qualitatively similar to the reported results.

It is also useful to consider how much trade takes place in the three 20-calendar-day

periods we consider and what fraction of all trades takes place in these periods rather

than at other times in the quarter. Our analysis is based on 406,357 trades that take

place over 110,305 firm-quarters, which implies that the average number of trades, both

purchases and sales, is 3.68 trades per firm-quarter. The percentages of these trades

that occur in Periods 1, 2, and 3, respectively, are 7.8%, 37.1%, and 24.6%, for a total

of 69.5%. Thus, about two-thirds of trades occur in the three periods we examine, which

represent 60 of the 91 calendar days in a typical quarter. It is notable that insider trades

are unevenly distributed across periods. The number of trades in Period 2 is more than

four times the number of trades in Period 1.

13

2.6 Definition of other independent variables

Other independent variables used in the basic regression are: PRIOR RETpfq, the

buy-and-hold return for the six calendar months before the beginning of the period;

MVfq, the market value of equity, in billions of dollars; and BMfq, the ratio of the book

value to the market value of equity. MV and BM are computed as of the end of the

fiscal quarter to which the announcement and filing relate.

Prior returns are included because insiders tend to be contrarian (i.e., insider buy-

ing is greater after low stock returns and lower after high stock returns), as documented

by Rozeff and Zaman (1998) and Lakonishok and Lee (2001). Based on this research,

the coefficient estimate on PRIOR RETp is predicted to be negative in all periods.

The firm’s market value is included as a control because Seyhun (1986) reports

that insider trading varies cross-sectionally with firm size.13 Additionally, portfolio

rebalancing for reasons unrelated to private information is often cited by executives

as a reason for trading stock. For this reason, larger stock trades, both purchases and

sales, are likely to be associated with larger insider stock and stock option positions.

Hence, a positive relation between holdings and trade size would be expected. Insider

stock and option holdings are available in machine-readable form on Execucomp for

only a small number of firms. Since executive compensation and the value of executive

stock and option holdings are strongly positively correlated with firm size, firm size

could be used in place of insider stockholdings as a measure of non-information based

motives for trade. To preserve sample size, we adopt this approach. Findings in prior

research also suggest that the coefficient estimate on MV should be negative in all

periods because insiders purchase less stock at large firms. For this reason, we expect

that MV is negatively related to FREQp and VALUEp in each period.

The book-to-market ratio controls for the effect documented by Rozeff and Zaman

(1998) that insider buying climbs as stocks change from growth to value categories.

Accordingly, the coefficient estimate on BM is predicted to be positive.

Panel B of Table 2 presents descriptive statistics on the explanatory variables.

The distributions of PRIOR RET1, PRIOR RET2, and PRIOR RET3 are very similar

13 Specifically, Seyhun (1986, Table 3) documents that the absolute value of stock trades by insiders(scaled by the value of all stock trades) is negatively related to firm size.

14

because they are computed over similar periods. Our data are drawn from the years

1996–2002. From the beginning of this period until the third quarter of 2000, prices

generally rose. In the following period, prices generally fell. Despite the retreat that

began in 2000, from June 1995 to December 2002, the period over which prior returns

are computed, the S&P 500 Index and the NAS/NMS Composite Index both rose

by more than 40%, implying that the median 6-month returns of between 2% and

3% reported in Table 2 are consistent with overall market movements. The median

observation has a market value of common equity at the beginning of the fiscal year

of $254.2 million and the mean MV is nearly 10 times greater. Because MV is highly

skewed, we report regression results for ln(MV), which is the natural logarithm of MV.

The book-to-market ratio, BM, over sample firm-quarters has mean and median values

of 0.6165 and 0.4959, respectively.

3. Analysis of trade over time

Finding that the net number of insider purchases, FREQp, is positively correlated

with the abnormal return associated with a forthcoming announcement means that

insiders are more likely to buy stock before good news is released and more likely to

sell stock before bad news is released. For a given price reaction (i.e., abnormal return)

to an announcement by a firm, insiders’ profits are proportional to the value of stock

traded, VALUEp. Finding that the value of stock traded increases in the magnitude of

the abnormal return at the announcement means the value of insider trades and, hence,

insider trading profits increase when their information advantage (as proxied by the

abnormal return) is greater.14

To test for these associations, we regress FREQp and VALUEp on the information

content of the announcements and the filings, as proxied by the abnormal returns at

these events, and the other independent variables:

FREQpfq = β0 + β1ARET FDfq + β2ARET EAfq

+ β3PRIOR RETpfq + β4ln(MVfq) + β5BMfq + ǫfq and (1)

VALUEpfq = β0 + β1ARET FDfq + β2ARET EAfq

+ β3PRIOR RETpfq + β4ln(MVfq) + β5BMfq + ǫfq. (2)

14 Relative to the value measure, the signed frequency measure equally weights the insider’s tradingdecisions. If high-value insider trades are more likely to be motivated by liquidity needs or a desire todiversify or are subject to greater scrutiny by regulators (as is suggested by Seyhun, 1998, p. 75), then anequal-weighting of trades may better capture the informed component of insider trade.

15

Separate regressions are run for each of the periods, p ∈ {1, 2, 3}. These regressions pool

data across firms and quarters. The chief interests in these regressions are the coefficient

estimates on ARET FD and ARET EA, i.e., β1 and β2. Regressions control for firm,

calendar year quarter, and fiscal quarter fixed effects.

Periods 1 and 3 are 20 days long in every case. Because some firms file 10-Ks or

10-Qs shortly after announcing earnings, Period 2 is less than 20 days in some cases.15

To control for the possibility that either FREQ2 or VALUE2 is correlated with the

number of days in period 2 (e.g., when period 2 is less than 20 days there might be

fewer insider trades simply because there are fewer days on which to trade), the set of

explanatory variables for period 2 is augmented with indicator variables (coefficients not

reported).16

We analyze interim and fourth quarter observations separately because it is possi-

ble that the relation between insider trade and the abnormal returns at the announce-

ment and the filing may differ across quarters for at least four reasons. First, the time

between an interim earnings announcements and the filing of the 10-Q is shorter than

the time between the fourth quarter earnings announcement and the filing of the 10-K:

on average the elapsed days between the Announcement Window and the Filing Window

for these events are 16 and 41 calendar days, respectively.17 Second, Salomon and Stober

(1994) find that the stock price response to earnings surprises is greater at interim earn-

ings announcements that at fourth quarter announcements. Third, Griffin (2003) finds

that the price response to 10-K filings is greater, on average, than the price response to

10-Q filings. Finally, for both announcements and filings, two-sample Wilcoxon rank-

sum tests indicate significant differences (at better than the 0.001 level) in the distri-

butions of absolute abnormal returns for the fourth quarter compared to interim quar-

ters. These differences in price reactions and time between information events could lead

15 Over the first three fiscal quarters of the firm-year, the median, mean and minimum number ofcalendar days between the Announcement Window and the Filing Window are 17, 16 and 1 days,respectively. For 25% of the observations, there are 11 or fewer days between the Announcement Windowand the Filing Window. For the last fiscal quarter, the gap between the earnings announcement date andthe 10-K filing date is longer: the median, mean and minimum number of days between the AnnouncementWindow and the Filing Window are 43, 41 and 1 days, respectively.

16 Specifically, 19 indicator variables, Dn for n = 1, . . . , 19, are created. Let n be the length of period 2in calendar days. For an observation for firm f in quarter q where n < 20, the indicator variable Dnfq is

equal to 1; otherwise, it is zero.17 Recall that for the years we study, the SEC requires 10-Qs to be filed no later than 45 days after the

end of the quarter, while 10-Ks must be filed no later than 90 days after the end of the quarter. In thesample, 10-Qs, on average, are filed 43 days after the quarter’s end, while 10-Ks are filed, on average, 84days after the fiscal year-end.

16

insiders to adopt different trading strategies across interim and fourth quarter disclo-

sures; however, the signs, magnitudes, and significance levels of coefficient estimates (re-

ported below in Table 3) are quite consistent between the annual 10-K and three quar-

terly 10-Qs.

3.1 Predicted associations of trade with announcement and filing returns

If trades are prompted by an insider’s desire to actively exploit foreknowledge of the

content of either the earnings announcement or the regulatory filing, then there should

be a positive association between either the number or value of purchase transactions

(net of the number or value of sales transactions) and the forthcoming information re-

leases. If trades are prompted by an insider’s desire to passively exploit foreknowledge

of the content of either the earnings announcement or the regulatory filing, then there

should be a negative association between either the number or value of purchase transac-

tions (net of the number or value of sales transactions) and a prior information release.

Thus, if insiders trade actively to profit from private information in a period, then the

coefficient estimate on the abnormal returns at a disclosure (i.e., either the announce-

ment of earnings, or the filing of a 10-K or 10-Q) that follows the period should be posi-

tive. If insiders trade passively to profit from private information in a period, then the

coefficient estimate on the abnormal returns at a disclosure that precedes the period

should be negative. Prior research reports mixed evidence on the association between

insider trades before the earnings announcement and the announcement return. Accord-

ingly we predict no association between the trade measures (i.e., FREQ and VALUE)

and ARET EA in Period 1. Because jeopardy is high before the announcement, we

further predict no association between the trade measures and ARET FD in Period 1.

Given the lower jeopardy insiders face for active trade after the earnings announcement,

we predict (i) positive associations between the trade measures and ARET FD in Pe-

riod 2, (ii) negative associations between the trade measures and ARET EA in Period 2,

and (iii) negative associations between the trade measures and both ARET EA and

ARET FD in Period 3.

17

3.2 Active and passive trading within Periods 1, 2, and 3

3.2.1 Main tests

The first three columns of Table 3 lay out the predicted signs on the event return

coefficient estimates that follow from the discussion above for each of the three peri-

ods. In Table 3, specifications (1a)–(1c) correspond to Period 1, (2a)–(2c) to Period 2,

and (3a)–(3c) to Period 3. Thus, the dependent variable is FREQ1 in Panel A and

VALUE1 in Panel B in specifications (1a)–(1c); it is FREQ2 in Panel A and VALUE2

in Panel B in specifications (2a)–(2c); and the dependent variable is FREQ3 in Panel A

and VALUE3 in Panel B in specifications (3a)–(3c). In the (a) specifications, results are

presented for all quarters pooled. In the (b) and (c) specifications, results are reported

for the interim quarters and the fourth quarters separately.

[Table 3]

Regarding Period 1 (i.e., the period before the earnings announcement), Table 3 in-

dicates that associations between insider trades and the forthcoming announcement and

filing are insignificant, with the exception of a positive coefficient estimate on ARET EA

in specifications (1a) and (1b) of Panel A, where the coefficient estimate is significantly

positive at the 5% level using a two-tailed test. Thus, there is some evidence that insid-

ers buy (sell) more often before good (bad) news earnings announcements in quarters

1–3, but no evidence of this in quarter 4 and no evidence that the value of shares traded

varies with the abnormal return at the announcement. The lack of any significant asso-

ciation with ARET FD in Period 1 suggests that the value of insiders’ trades in Period 1

is not increased by the desire to profit from foreknowledge information in the filing not

conveyed by the earnings announcement.18

The results for Period 2 are sharply different. The pattern of insider trades in this

period suggests that insiders use their private information to derive both active and

passive profits. Consistent with the realization of active profits, insider trades, measured

in Panel A by the signed frequency of trade, is positively associated at better than the

18 Coefficient estimates and standard errors are very similar when market-adjusted returns are replacedwith raw returns in this and subsequent regressions.

18

5% level with the abnormal return of the forthcoming filing. Note from Panel A that the

coefficient estimates for Period 2 on ARET FD in specifications (2a), (2b), and (2c) are

more than 10 times the coefficient on ARET EA in specifications (1a), (1b), and (1c),

which implies that for a given abnormal return at the disclosure, the effect on insider

trades is more than 10 times greater in Period 2 compared to Period 1. The significantly

positive coefficient estimate on ARET FD in Period 2 implies that insiders buy before

filings interpreted by the market as good news and sell before filings interpreted as bad

news.19

We turn next to Panel B, where the dependent variable is the signed value of

shares traded. When all quarters are pooled, the coefficient estimate on ARET FD is

significantly positive at the 5% level using a two-tailed test. Thus, there is evidence that

the value of shares purchased by insiders is higher before a good news filing (and lower

before a bad news filing). When the observations for quarters 1–3 and quarter 4 are

analyzed separately, the sign and magnitude of the coefficient estimates on ARET FD

is similar, but the relationship is insignificant.

Consistent with the realization of passive profits, insider trades, measured either by

the signed frequency or signed value of trade, is negatively associated at the 1% level

with the abnormal return at the preceding announcement. The significantly negative

coefficient estimate on ARET EA in Period 2 is consistent with the notion that insid-

ers sell after announcements interpreted by the market as good news and buy after an-

nouncements interpreted as bad news.20

For Period 3, the coefficient estimates on the abnormal returns at the preceding fil-

ing and announcement both are significantly negative (with the exception of ARET EA

for quarter 4 analyzed separately), which is consistent with trade in Period 3 being

driven in part by insiders’ passive use of private information. Such an association with

past news also could arise from a contrarian trading strategy under which insiders condi-

tion their trades on past stock price movements so that they buy after bad news events

19 The positive coefficient on ARET FD in Period 2 is not a result of insiders’ trading on the postearnings announcement drift because the coefficient on ARET FD is unaffected by the inclusion of theearnings surprise in the immediately preceding earnings announcement, defined as the seasonal differencein earnings per share scaled by stock price at the end of fiscal quarter −4 relative to the observation quarter(results not reported).

20 To alleviate the concern of cross-sectional dependence of insider trades, we also run a Fama-MacBethregression of specification (2a) of Table 3 by calendar year and draw similar inferences.

19

and sell after good news events. We control partially for the possibility of contrarian

trading by including in the regressions PRIOR RETp, the return over the six months be-

fore the beginning of Period p. Despite this, contrarian trading with respect to the past

filing or earnings announcement cannot be ruled out.

The coefficient estimates on ARET EA and ARET FD in specification (2a) of Ta-

ble 3 have an economic interpretation. For instance, the coefficient estimate of 0.579

on ARET FD in Panel A specification (2a) implies that an abnormal return of 10% at

the filing increases the net number of insider purchases in Period 2 by an average of

0.0579. This coefficient implies that, if 17 (i.e., 1/0.0579) firms experience abnormal

returns at the filing of 10%, at one of those firms there would be one more insider pur-

chase (or one less sale) transaction than would be expected if those firms had experi-

enced returns of 0% at the filing. This effect should be interpreted in light of the rarity

of insider trades—in our data, insider trade occurs in only 53% of firm-quarters. Fur-

thermore, trades are spread over the 90 days of the quarter, while Period 2 is 20 days at

most.

Turning to the coefficient estimate of 0.290 in Panel B specification (2a), an abnor-

mal return of 10% at the filing implies that the value of stock purchased by insiders in

that firm-quarter increases by $29,000, on average. From Table 2, the mean value of the

net stock trades by firm insiders in Period 2 over all firm quarters is $863,800 sold. This

implies that a 10% return at the filing is associated with an increase of 3.4% in the value

of stock purchased by insiders. Thus, the associations documented in Table 3, while

highly significant in a statistical sense, are less significant from an economic standpoint.

A potential concern with these findings is that insiders might not learn earnings

precisely until shortly before the earnings announcement, so that insiders are not in-

formed about earnings until the latter part of Period 1. In contrast, at the start of Pe-

riod 2, insiders likely know how the earnings figure was achieved although this infor-

mation may not be publicly revealed until the filing date. Hence, insiders may know

at the beginning of Period 2 whether there is likely some further reaction by investors

around the filing date. To address this concern, we reperform the analysis in specifica-

tions (1a), (1b), (1c), (2a), (2b), and (2c) of Table 3 after shortening the periods over

which we examine trades from 20 days to 10 days. The results reported in Table 3 are

20

qualitatively unchanged when we focus on just the 10 days before and the 10 days after

the Announcement Window.

Also in Table 3, the coefficient estimates on the PRIOR RETp and ln(MV) are

consistent with prior findings in all periods. Consistent with Rozeff and Zaman (1998),

the coefficient estimate on BM is positive in Panel A where the dependent variable

is FREQp. In contrast, in Panel B, wherever the coefficient estimate is significantly

different from zero, it is negative so the value of insider net purchases decreases in the

book-to-market ratio. We note that Rozeff and Zaman’s (1998) evidence is based on the

proportion of trades that are purchases, not on the value of trades.

3.2.2 Additional tests

The generally insignificant relationships in Period 1 between insider trades and

the earnings announcement documented in Table 3 may be due in part to the paucity

of insider trades in Period 1. As noted earlier, 7.8% of all trades occur in Period 1 as

compared to 37.1% and 24.6% of trades in Periods 2 and 3, respectively.21 Across firm-

quarters, the mean values of total insider trades (i.e., the sum of insider stock purchases

and sales) in Periods 1, 2, and 3 are $95,000, $741,000, and $388,000, respectively. One

cause of the lower frequency and value of trades in Period 1 may be the higher jeopardy

that attaches to trades in this period. However, another explanation for fewer insider

trades in Period 1 than in other periods may be that all traders avoid trade in Period 1.

To rule out alternative explanations for the relatively low amount of insider trades

in Period 1, we consider reasons why particular groups of traders may avoid trade in Pe-

riod 1 and trace out the implications. Applying the logic in Foster and Viswanathan’s

(1990) model of variation in interday trading volume, Chae (2005) suggests that un-

informed traders avoid the period before the earnings announcement because informed

traders, who have advance knowledge of the announcement, seek to profit from their pri-

vate information at the expense of uninformed traders. Anticipating a decrease in un-

informed trade, market makers widen the bid-ask spread and the sensitivity of price to

21 Park, Jang, and Loeb (1995), who study insider trades drawn from 1986 and 1987, document asignificant decrease in insider trading in the 10 days prior to an annual earnings announcements relativeto the preceding 140 days.

21

order flow increases so trading costs are higher. Despite the heightened price sensitiv-

ity, which is caused by the anticipation of informed trades, informed traders nevertheless

can profit from their private information about earnings by trading before earnings are

announced at the expense of uninformed traders who do not have discretion over the

timing of their trades. Thus, if insiders were informed (and ignoring, temporarily, the ef-

fect of jeopardy on the pattern of insider trades), we might expect insiders to trade more

intensely before the earnings are released than afterwards. This is because some of the

insiders’ information is dissipated by the earnings announcement. On the other hand,

if insiders were uninformed and traded only for liquidity reasons they might choose to

trade after the earnings announcement when trading costs are lower for the same reasons

and in the same proportion as traders in general. In this case, we might expect to see

fewer insider trades in Period 1 and more insider trades in Period 2, but in proportion to

total trading volume in Periods 1 and 2, respectively.

To summarize, we see no reason (other than jeopardy) for insider trading to be

disproportionately greater in Period 2 than in Period 1. For Periods 1, 2, and 3, the

mean values of insider trades in the firm-quarter-period as a fraction of all trade in

that firm-quarter-period are 0.44%, 1.67% and 1.19%, respectively. Thus, the fraction

of trade that is due to insiders in Period 3 is more than twice the fraction in Period 1.

The fraction of trade that is due to insiders in Period 2 is almost four times the fraction

in Period 1. These results are more consistent with the jeopardy hypothesis than the

alternative explanations described above.

We use ARET FD as a proxy for the private information contained in the SEC fil-

ing that insiders use for their stock trades in Period 2. However, formal models, includ-

ing Huddart, Hughes, and Levine (2001), predict that disclosures of insider trades that

precede news releases preempt part of the information content of forthcoming news re-

leases. Empirical evidence (including Damodaran and Liu, 1993; Udpa, 1996; and Roul-

stone, 2004) is consistent with this prediction. Preemption, by reducing the magnitude

of abnormal return at the release, weakens the associations we seek to document. De-

spite this, we document a highly significant correlation between trade in Period 2 and

the abnormal return at the filing.

22

To check the potential impact of preemption on the association between insider

trades and ARET FD in Period 2, we rerun the regression specification (2a) of Table 3

on (i) the subset of observations that excludes firm-quarters for which the trade dis-

closure date is after the filing date for more than half of the trades in the quarter and

(ii) the complementary subset of observations that excludes firm-quarters for which

the trade disclosure date is before the filing date for more than half of the trades in the

quarter. In the period we study, insider trades must be disclosed by the 10th day of the

calendar month following the month of the trade. Although some preemption may be

due to insider trades not disclosed before the news is released, preemption is likely to be

stronger when insider trades are disclosed before the news is released. Thus, the above

sample partitioning allows us to assess the impact of preemption on our inferences. Re-

sults reported in Table 4 reveal that coefficient estimates and significance levels com-

puted for the subsets are very similar to each other and to the corresponding results re-

ported in Table 3. We conclude that the location of the trade disclosure date in relation

to the filing date does not appear to affect the relation between insider trades and the

information in the filing.

[Table 4]

We argue that the positive coefficient on ARET FD in specification (2a) of Table 3

reflects insiders’ trading response to the information in the SEC filing. However, because

insider trades in Period 2 precede the measurement of ARET FD in calendar time, it

is possible that the positive coefficient on ARET FD represents the market’s reaction

to the insider trades in Period 2. To rule out this reverse causality, we estimate the

regression specification (2a) using a two-stage least-squares regression approach.

Bagnoli et al. (2002) find that the market reacts negatively if a firm does not report

earnings on the expected earnings announcement date. Moreover, the market reaction

at the actual earnings announcement date is more negative the later firms report their

earnings, which they summarize as “a day late, a penny short”. We conjecture the

results in Bagnoli et al. should apply also to SEC filings. Accordingly, we use as an

instrumental variable for ARET FD a proxy for the lateness of the filing date relative

to the expected filing date. A firm’s actual filing date is defined relative to the fiscal

23

quarter end. Each firm’s expected filing date is the median filing date of the firm in our

sample. Because firms are allowed to have a longer time to file their annual filings than

quarterly filings, the expected filing date is allowed to differ for the annual and quarterly

filings. The instrumental variable is the difference between the actual filing date and

the expected filing date. Consistent with Bagnoli et al., the instrument variable is a

significantly different from zero and negatively associated with ARET FD in the first

stage regression. In addition, we argue that the instrument should not be correlated

with the error term in the regression specification (2a) because insiders should always

trade on the filing information in Period 2 regardless of whether the SEC filing will be

on time or late. Therefore, the instrument satisfies the two necessary conditions for

being a valid instrument.

Using the two-stage least-squares regression approach, we find the coefficients on

ARET FD for specification (2a) are larger than those in Table 3 and significant at the

1% two-tailed level (results not tabulated). The larger coefficients on ARET FD are

reasonable because we expect a portion of insiders’ private information to leak into stock

prices before the SEC filing date, thus creating a downward bias in the OLS regression

coefficients. The coefficients on the other variables have the same signs and similar

significance levels to those reported in Table 3.

3.3 Differential implications of trade on price reactions across periods

If jeopardy is high in Period 1, then what type of trades take place in Period 1?

One might naively suppose that firm policies that establish approved trading windows

also prohibit trade by insiders in Period 1, yet the data indicate that in 9% of firm-

quarters insiders trade in Period 1. Some firms do not have trading policies. Some firms

that do have policies permit, but discourage trade outside approved trading windows—

see Jagolinzer and Roulstone (2004, p. 4) for an example.

Trade in Period 1 may be desirable when the insider has a motive for trade (e.g., a

desire for liquidity or diversification) other than the desire to profit from foreknowledge

of the forthcoming earnings announcement. However, if he intends to buy (sell) and also

believes the return at the earnings announcement will be positive (negative), jeopardy

may prevent him from trading in Period 1. If the insider intends to buy (sell) but

24

instead believes the return at the earnings announcement will be negative (positive), he

benefits by delaying his trade until Period 2. Finally, assuming jeopardy is lower when

subsequent stock price movement does not result in a profit to the insider, an insider

may trade in Period 1 when he anticipates a price reaction to the forthcoming earnings

announcement that is close to zero.

Hence, trade frequency and value should be greater in Period 1 when the abnormal

return at the earnings announcement, ARET EA, is near zero. Since an insider also may

be at risk from trading in Period 1 when the return at the filing is extreme, it follows

that trade frequency and value are greater in Period 1 when the abnormal return at

the filing date, ARET FD, is near zero; however, because the time between the trade

and the price reaction is greater, the effect should be weaker because establishing that

trade was improper is harder to prove when the trading event and the price movement

are separated by a greater interval of time.

In Period 2, the opposite implication applies: given jeopardy is low, it follows that

informed trade frequency and value are greater in Period 2 when the abnormal return at

the forthcoming filing is extreme. Likewise, given jeopardy is lower in Period 2, trades

motivated by liquidity or diversification needs are less likely to be impeded by the poten-

tial for an extreme return at the filing than in Period 1. Also, a consequence of avoiding

trade in Period 1 when the magnitude of abnormal returns at the announcement is large

may be to shift trades to Period 2. Hence, trade value and frequency should be greater

in Period 2 when the abnormal return at the preceding announcement is extreme. Fi-

nally, to the extent insiders delay trades into Period 3, trade value and frequency in Pe-

riod 3 should be greater when the returns at the filing and announcement are extreme.

The following tobit regressions offer evidence on the hypothesized link between

trade frequency and value and the magnitude of the price reaction at the announcement

and filing:

SUM FREQpfq = β0 + β1abs(ARET FDfq) + β2abs(ARET EAfq)

+ β3abs(PRIOR RETpfq) + β4ln(MVfq) + β5BMfq + ǫfq and(3)

SUM VALUEpfq = β0 + β1abs(ARET FDfq) + β2abs(ARET EAfq)

+ β3abs(PRIOR RETpfq) + β4ln(MVfq) + β5BMfq + ǫfq. (4)

25

In these regressions, SUM FREQp is the number of insider stock transactions (both

purchases and sales) in the period-firm-quarter; SUM VALUEp, defined as the total

value of insider stock transactions (both purchases and sales) in the period-firm-quarter;

and abs(ARET EA) and abs(ARET FD) are the absolute values of ARET EA and

ARET FD, respectively. Regressions control for calendar year quarter and fiscal quarter

fixed effects.

The foregoing discussion suggests that higher jeopardy in Period 1 implies negative

association in Period 1 between the frequency and value of insider trades (respectively,

SUM FREQ1 and SUM VALUE1) and the magnitudes of the abnormal returns at

the announcement and the filing, after controlling for variation in firms’ prior returns,

market capitalizations, and book-to-market ratios. Conversely, lower jeopardy implies a

positive association in Periods 2 and 3 between the frequency and value of insider trades

and the magnitudes of the abnormal returns at the announcement and the filing.

[Table 5]

Results in Table 5 are consistent with our predictions except that in Panel B, the

sign on abs(ARET FD) in Period 2 and on abs(ARET EA) in Period 3 are insignifi-

cantly different. Overall, the results support the notion that insider trading frequency

and value are lower in periods of high jeopardy when the forthcoming news is extreme.

This suggests that insiders eschew some, but not all, trades in periods of high jeopardy.

Specifically, insiders proceed with trades when they foresee zero or small price responses

to forthcoming announcements and avoid trades when they foresee large price move-

ments. Thus, insider trades shortly before an earnings announcement are, on average,

an indication that the price reaction at the announcement and filing will be small.

3.4 Effects of news type and past trading on insider trades

In this section, we examine two questions regarding determinants of insider trades

in Period 2: whether good and bad news have differential effects on trade and whether

past insider trading affects current insider trading. To conduct these analyses, the basic

regression for Period 2 from Table 3 pooling across all quarters (i.e., specification (2a))

is revised to more precisely identify the relationship between insider trades and the

forthcoming filing. Results are reported in Table 6.

[Table 6]

26

3.4.1 News type

In specification (1) of Table 6, the abnormal return variable is decomposed into

three parts so that the effects of forthcoming good news and bad news at the filing on

insider trades in anticipation of that news can be examined separately. ARET FD is

replaced by: IND ARET FD, which is an indicator variable equal to 1 if the abnormal

return at the filing is positive and zero otherwise; POS ARET FD, which is defined to

be max(0,ARET FD); and NEG ARET FD, which is defined to be min(0,ARET FD).

In Panel A, the coefficient on IND ARET FD, reflecting an intercept shift in

FREQ2 across positive and negative returns, is positive and significant, implying that

insiders buy more (or sell less) shares before good news disclosures than bad news dis-

closures. The coefficient estimate on POS ARET FD is significantly different from zero,

indicating that more positive news at the filing implies more insider purchases. While

the coefficient estimate on NEG ARET FD is not significantly different from zero, nei-

ther is it significantly different from the coefficient estimate on POS ARET FD. This

indicates that the marginal effect of a more positive return at the filing is indistinguish-

able from the marginal effect of a more negative return. In other words, the associations

between insider trading and the subsequent filing return magnitude are comparable for

good and bad news. In Panel B, the coefficient estimate on NEG ARET FD is signifi-

cantly different from 0 at the 10% level (two-tailed test), but indistinguishable from the

coefficient estimate on POS ARET FD. We conclude that there is no evidence that fore-

knowledge of good news has a larger or smaller marginal effect on insider trading than

foreknowledge of bad news.

3.4.2 Past trading

The next question we address is whether past insider trades affect current insider

trades. Autocorrelation in insider trading may be induced by the short swing profit

recovery rules of Section 16(b) of the Securities Exchange Act of 1934, which requires

an insider to disgorge any profits received from any purchase and sale transactions that

occur within the same six-month period. If an insider has purchased stock within the

past six months and the price has increased, then he may purchase more stock without

violating the rule, but a sale would trigger disgorgement. Another possibility is that

27

insiders may trade repeatedly on the same long-lived private information as outlined

by Huddart, Hughes, and Levine (2001). To examine this potential serial dependence,

we include in the regression LAG FREQ. This variable is computed like FREQp, except

that the period over which LAG FREQ is computed begins on the day after the earnings

announcement date in the previous quarter and ends on the day before the earnings

announcement date for the current quarter. LAG VALUE is defined analogously. To

examine how the short swing rule affects the intensity of passive and active insider

trades, we examine the coefficient estimates on the interactions of ARET EA and

ARET FD with LAG FREQ or LAG VALUE. The short swing rule leads us to predict a

positive coefficient on the interaction terms.

As predicted, the coefficient estimates on LAG FREQ, ARET FD*LAG FREQ,

ARET EA*LAG FREQ, LAG VALUE, ARET FD*LAG VALUE, and

ARET EA*LAG VALUE are significantly positive in specification (2) of Table 6. Thus,

insider purchases (sales) in the past quarter imply further purchases (sales) in the cur-

rent quarter. Moreover, insider purchases (sales) in the current quarter for a given ab-

normal return at the filing or earnings announcement are increasing (decreasing) in the

net number of purchases made in the prior quarter. Also notable is that the R2 of the

regressions are more than double the values reported in specification (2a) of Table 3,

suggesting that past insider trades are important predictors of current insider trades.

Nearly identical results obtain if the period over which LAG FREQ and LAG VALUE

are computed by aggregating transactions in the previous two quarters (i.e., the aggrega-

tion period begins on the day after the earnings announcement date in the second previ-

ous quarter and end on the day before the earnings announcement date for the current

quarter).

3.5 Distribution of insider trades between the announcement and the filing

We earlier noted that insider trades are distributed unevenly across Periods 1, 2,

and 3. We now examine whether insider trades are distributed evenly over the interval

between the announcement and the filing and how the intensity with which insiders

make use of their private information varies over this period. Define Period 2′ to be the

days between the Announcement Window and the Filing Window.

28

In general, two countervailing factors may affect insiders’ trades in relation to a

forthcoming disclosure. First, as the disclosure approaches, the precision of insiders’

information about the content of the disclosure increases. An insider therefore may be

expected to trade most intensely on his private information right before its release. If, as

seems plausible, jeopardy increases as the time between the trade and the event becomes

shorter, then the insider may refrain from trade immediately before the disclosure.22

Which of these two effects dominates is an empirical question, but we note that after

the earnings announcement the insider is likely to have precise information about the

content of the filing, so that the precision of the insiders’ information with respect to the

filing may not increase much over the period. Jeopardy, on the other hand, would seem

to increase as the filing date approaches. This leads us to conjecture that insider trades

are concentrated early in Period 2′ and that the intensity with which insiders trade on

private information about the disclosure is highest early in Period 2′.

Turning to the data, we note first that insider trades within Period 2′ are concen-

trated early in the period, consistent with our conjecture. Recall that the median num-

ber of days between the end of the Announcement Window and the beginning of the Fil-

ing Window, in the case of an interim quarterly announcement, is 17 days. Over 75%

of the trading activity in Period 2′ occurs in the first 10 days of this period. There is a

similar concentration of insider trades in the first part of the period following an annual

earnings announcement: the median number of days between the end of the Announce-

ment Window and the beginning of the Filing Window is 43 days. Over 70% of all trad-

ing activity in Period 2′ occurs in the first 20 days of this period.

Across firm-quarters, the mean values of total insider trades (i.e., the sum of insider

stock purchases and sales) in the first and second halves of Period 2′ are $629,000 and

$292,000, respectively. While lower jeopardy may drive the higher mean value of insider

trades in the first half of Period 2′, it could also be that all traders avoid trade in second

22 The regulatory history of Rule 16b-3(e) supports the notion that the SEC supposes the informationaladvantage of insiders is low in the 10 days following an earnings announcement: Rule 16b-3(e) (sincerevised), stipulated that to avoid liability under §16(b) when exercising SARs, insiders should exercisethem “during the period beginning on the third business day following the date of release of the financialdata specified in paragraph (e)(1)(ii) of this section [i.e., quarterly and annual summary statements ofsales and earnings] and ending on the twelfth business day following such date” (17 CFR 240.16b-3 1996).We thank Mark Vargus for this observation.

29

half of Period 2′. To address this possibility, we express insider trades in each half of

Period 2′ in each firm-quarter as a fraction of all stock trades in that half of Period 2′

for the firm-quarter. The mean values of insider trades as a fraction of all trade in the

first and second halves of Period 2′ are 1.06% and 0.80%, respectively. Thus, relative

to shares traded by all market participants, trade by insiders is disproportionately

concentrated in the first half of Period 2′, which is consistent with the explanation that

lower jeopardy in the first half of Period 2′ serves to concentrate insider trading there.

[Table 7]

Panel A of Table 7 reports the results of regressions identical to those reported

in specification (2a) of Table 3 except that the dependent variable (either FREQ or

VALUE) is redefined. In specification (1), the dependent variable is measured over

the first half of Period 2′. In specification (2), the dependent variable is measured

over the second half of Period 2′. That is, for each firm-quarter, Period 2′ is divided

into two sub-periods of equal duration. The dependent variables for each sub-period

are recomputed over each sub-period, and regression (2a) of Table 3 is rerun for each

sub-period. The signs and significance levels of the coefficient estimates in Table 7 are

consistent with the corresponding regressions in Table 3 except that the coefficient

estimate on ARET FD in Panel B for the latter part of Period 2′ is indistinguishable

from zero. Notably, the coefficient estimates on ARET FD are greater for the first half

regression than for the second half regression, for both FREQ and VALUE. Again, this

is consistent with the conjecture that insider trading intensity is greater when jeopardy

is lower.

In Panels A and B, the coefficient estimates on ARET EA for the first half of

Period 2′ are more than twice the corresponding estimate for the second half, consistent

with the interpretation that some insiders postponed a sale (purchase) until just after

the earnings announcement knowing that the earnings announcement contained good

(bad) news. Alternatively, if insiders are contrarian, then the evidence indicates that the

sensitivity of insider trading to the Earnings Window returns attenuates the longer the

time since the earnings announcement.

30

4. Litigation risk

In this section, we address two questions: First, how does litigation risk affect the

timing of insider trades over a fiscal quarter? Second, how does litigation risk affect

the intensity (as measured by either FREQ or VALUE) with which insiders trade on

foreknowledge of 10-K or 10-Q filings? To answer these questions, we require a measure

of the cross-firm variation in litigation risk, which we develop next.

4.1 Measuring litigation risk

To assess whether and how insider trades vary in response to firm-specific litigation

risk, we relate insider trades to an ex ante probability estimate of likelihood a firm will

be the subject of 10b-5 litigation in the coming year. This probability is the predicted

probability derived from a first-stage logit regression in which the dependent variable

is an indicator variable that is 1 if the firm is reported to have been sued by Securities

Class Action Clearinghouse (http://securities.stanford.edu) in a given year on character-

istics of the firm.23 The construction of these estimates closely follows the methodology

described in Johnson, Kasznik, and Nelson (2000).

There are 1,062 firm-years in which securities class action lawsuits are filed over the

60,044 available firm-years in the period 1995–2001. The fitted predicted probability

from the prior year is an ex ante estimate of the probability that firm will be the subject

of 10b-5 litigation in the current year. This estimate ranges from less than 0.01% to over

99%. Across the years for which the estimate is available, its mean and median values

are 2.2% and 0.6%, respectively, while the 75th percentile is 2.0%. To examine whether

insider trades are associated with litigation risk, we partition sample observations into

two groups, depending on whether the estimated risk is at or above the 75th percentile.

We define the indicator variable HIGH LITiq to be 1 if the ex ante risk of litigation is

more than 2.0% for firm i in the year in which the quarter q earnings announcement

falls. HIGH LITiq is 0 otherwise.

23 Specifically, the explanatory variables are the market value of common equity measured at the end ofthe year, firm beta relative to an equal-weighted market index, the stock return over the year, the minimumstock return over any consecutive 20-day trading period in the year, the skewness of raw daily returns forthe year, stock turnover (measured as 1 − [1 − TURN]n), where n is the number of trading days in theyear and TURN is average daily trading volume divided by shares outstanding), and industry indicatorvariables for biotech, computer hardware, electronics , retailers, and computer software (SIC codes in theranges of 2833–2836, 3570–3577, 3600–3674, 5200–5961, and 7371–7379, respectively). We are grateful toKaren Nelson for providing us with these data.

31

4.2 Timing of trade

In this section, we examine how litigation risk, which is a component of jeopardy,

affects the timing of insider trades within a quarter. We first construct measures of

the insider trades that takes place in each firm-quarter-period as a fraction of all the

insider trades that take place in that firm-quarter. We define F FREQp to be the sum

of insider purchases and sales frequencies over period p divided by the sum of all insider

purchases and sales frequencies between the two earnings announcement dates in which

period p falls. F VALUEp is defined similarly using dollar values. Firm quarters with

zero insider trades between the two earnings announcement dates or missing HIGH LIT

are excluded.

Next, we examine whether the fraction of insider trades in each period is greater or

lower when litigation risk is high, by regressing F FREQp and F VALUEp, respectively,

on HIGH LIT for p ∈ {1, 2, 3}. Table 8 presents the results of these regressions.24 Note

that, for both dependent variables, the coefficient estimates on HIGH LIT are signifi-

cantly negative in Period 1. This is evidence that insiders at high litigation risk firms

undertake a smaller fraction their trades in the period before the earnings announcement

than insiders at low litigation risk firms. Conversely, in Period 2, the coefficient estimate

on HIGH LIT is strongly positive, which indicates that insiders at high litigation risk

firms undertake a higher fraction of their total trades in Period 2. The coefficient esti-

mate on HIGH LIT is insignificant in Period 3. The coefficient estimate on HIGH LIT is

larger in Period 2 than in Period 3, which is consistent with the interpretation that, at

high litigation risk firms, insiders concentrate their trades more in Period 2 where jeop-

ardy is plausibly least.25

[Table 8]

24 To ensure the results in Table 8 are not merely a size effect, we include ln(MV) as a control andobtain similar inferences.

25 We also regress the sum of insider purchases and sales frequencies over the first half of Period 2′

divided by the sum of all insider purchases and sales frequencies over Period 2′ on HIGH LIT and find asignificantly positive coefficient on HIGH LIT. Thus, insiders at high litigation risk firms execute a greaterportion of all their trades in Period 2′ immediately after the earnings announcement than insiders at lowrisk firms. This result is consistent with the argument above that litigation risk is lower early in Period 2′

than later in the period.

32

4.3 Intensity of trade

The last question we address is how litigation risk affects the intensity with which

insiders trade on foreknowledge of 10-K or 10-Q filings in Period 2. To study the role of

firm-specific litigation risk on insider trades, we include three additional regressors in the

basic regression developed earlier and reported in specifications (2a), (2b) and (2c) of

Table 3: HIGH LIT, and the interactions of HIGH LIT with ARET FD, ARET EA.

Including HIGH LIT and its interactions should not alter the basic relationship

between insider trades and either past or forthcoming disclosures, so the sign of the

coefficient estimate on ARET FD should be positive, while the sign of the coefficient

estimate on ARET EA should be negative. To the extent that insider trades at high

litigation risk firms are shifted from periods of high jeopardy to periods of low jeopardy,

we expect a stronger negative correlation between insider trades in Period 2 and the

information that is made public before the Period 2. This is an implication of the

hypothesis that at high litigation risk firms, insiders are less likely to engage in active

trading before earnings announcements—instead, they engage in passive trading after

earnings announcements. For this reason, we predict a negative sign on the coefficient

estimates of ARET EA*HIGH LIT.

As we explain next, there are counteracting forces at work on the other variables.

Since the relative importance of these forces is unknown we make no predictions on

the signs of the coefficients on either HIGH LIT or ARET FD*HIGH LIT. Insiders

at firms at high risk for class-action lawsuits have at least many reasons as insiders at

other firms to avoid trading on private information when there is an established legal

jeopardy. This implies that insiders at firms where litigation risk is high should be ex-

pected to avoid certain trades (like trades that actively exploit foreknowledge of earn-

ings announcements or takeovers) because such trades clearly are proscribed. Whether

insiders at high litigation-risk firms are less likely to trade on the foreknowledge of the

forthcoming 10-K or 10-Q disclosure is less clear since there may be no jeopardy associ-

ated with such trades. Therefore, we make no prediction on the coefficient estimate on

ARET FD*HIGH LIT in Period 2. We are also hesitant to predict the sign of the co-

efficient estimate on HIGH LIT because on the one hand, we might expect insiders at

33

high litigation risk firms to trade less overall. On the other hand, Table 8 indicates more

of the trades at high litigation risk firms occur in Period 2. These counteracting effects

lead to no clear prediction on whether the amount of trade should be higher or lower in

Period 2. It is even less clear whether there should be more or less (net) purchase activ-

ity.

[Table 9]

Results are reported in Table 9. Turning first to the information variables

ARET FD, and ARET EA, observe that coefficient estimates are consistent with pre-

dictions wherever they are significantly different from zero. Next, consider the interac-

tion variables. There is evidence that insiders at high litigation risk firms engage in more

passive trading with respect to the previously announced earnings: where it is signifi-

cant, the coefficient estimate on ARET EA*HIGH LIT is negative. The pattern of co-

efficient estimates on ARET FD*HIGH LIT is inconsistent with the conjecture that in-

siders at high litigation risk firms trade less aggressively in Period 2 on their private in-

formation about the forthcoming 10-K or 10-Q disclosures.26 Perhaps this is because (i)

trades in Period 2 on average are positively correlated with the news in the forthcoming

filing (as is indicated by Table 3), (ii) the trades by insiders at high litigation risk firms

cluster in Period 2 (as is indicated by Table 8), and (iii) high litigation risk imposes no

differential jeopardy in Period 2 on insiders.

Finally, the generally positive and significant coefficient estimates on HIGH LIT

across specifications in Panel A indicates that the signed frequency of insider trades at

high litigation risk firms is higher (indicating more purchases) in Period 2 than at low

litigation risk firms.

26 We perform a sensitivity check to demonstrate the robustness of the significant results in column (1)of Table 9. Because Huddart and Ke (2006) find that insiders trade more aggressively (both purchases andsales) when there is more variation in the order imbalance of uninformed traders, we include a measureof trading volume variability, SD VOL, and its interactions with ARET FD and ARET EA. SD VOL isthe standard deviation of the ratio of the daily trading volume to the common shares outstanding overa 250-trading-day period ending 30 trading days before the observation quarter’s earnings announcementdate. The coefficients on SD VOL interacted with ARET FD and ARET EA are insignificant. Moreimportantly, the coefficients on ARET FD*HIGH LIT and ARET EA*HIGH LIT remain positive andnegative, respectively, and both are significant at the 5% level.

34

5. Conclusion

This study, which examines insider trades over narrow windows around disclosures

of economically-significant news, presents evidence complementary to studies of insider

trades over long windows.27 Those studies cast light on whether insiders trade on

foreknowledge of earnings but nevertheless avoid the risks from regulatory action,

shareholder class-action suits, and adverse publicity by making their trades several

months before the information is made public. The combined evidence of those studies

is that insider trades are associated with earnings the firm will report in the future, but

the association between insider trades and earnings is strongest when the time between

the insider trade and the earnings announcement is 6 months or longer.

This study presents further evidence on how insiders condition their trades on their

knowledge of upcoming firm disclosures. In contrast to earlier studies that focus on

long-lived private information, we focus on insider trading in short periods before and

after firms make public disclosures. In the 20 days before a quarterly or annual earnings

announcement, there is scant evidence of an association between insider trades and the

announcement return. In striking contrast, insiders do appear to exploit a different piece

of short-term news, namely the forthcoming 10-Q or 10-K: in the period following the

earnings announcement and before the 10-Q or 10-K is filed, there is a strong statistical

association between the frequency and value of insider trades and the filing return. This

association suggests that insiders trade to profit from the information made public at

the filing. There is also a negative association between insider trades in this period and

the return at the preceding announcement. Although contrarian trading cannot be ruled

out, this result is consistent with passive trading (i.e., private information prompting

insiders to delay some trades). In line with another implication of passive trading, we

document that there are fewer trades in Period 1 than in Period 2.

27 Elliot, Morse and Richardson (1984) find an increase in insider sales prior to extreme earningsincreases, but these transactions take place more than two quarters before the announcement. Theyconclude that most insider trading appears to be unrelated to the information events they consider. Ke etal. (2003) find little evidence of an association between earnings announcements that constitute a break ina string of quarterly earnings increases and insider trading in the preceding two quarters, although they dofind an association between the such announcements and insider trades more than two quarters before thebreak. Similarly, while Piotroski and Roulstone (2005) find only weak evidence of a significant correlationbetween insider trades and the innovation in that year’s annual earnings, they also find a highly significantrelationship between insider trades in one year and the innovation in the next year’s annual earnings.

35

Analysis of the magnitude of trade in relation to the magnitude of the abnormal

return at the filing and the announcement suggests that insiders trade less in periods

when jeopardy is high. Trading intensity before the earnings announcement generally

is decreasing in the magnitude of the abnormal return at the announcement, consistent

with the notion that small price movements imply lower risks to trade even in periods

where jeopardy is high.

Further analysis of trade in the period between the earnings announcement and the

filing indicates that signed insider trading frequency and value are positively related to

the net trade in the 90-day period ending at the earnings announcement. Moreover,

net insider trading frequency and value are increasing in the interaction between the

abnormal return at the filing and trade in the 90-day period ending at the earnings

announcement, so that past trade intensifies insider trading in anticipation of the news

in the filing. The insider trades that are most highly correlated with the price response

at the filing occur shortly after the preceding earnings announcement, i.e., at the time

when jeopardy is arguably lowest. There is no evidence that foreknowledge of good news

has a different marginal effect on insider trading than foreknowledge of bad news.

Lastly, cross-sectional variation in the risk of securities class action lawsuits is asso-

ciated with the distribution of insider trades across Periods 1, 2, and 3. Moreover, insid-

ers at high litigation risk firms trade more intensely on foreknowledge of the forthcom-

ing filing in Period 2, perhaps because jeopardy is low in that period and their scope for

trading in other periods is more limited than for insiders at low litigation risk firms.

This paper offers evidence consistent with the notion that variation in the risks of

legal action and adverse publicity attending trade affect the timing of trades in relation

to periodic disclosures of financial information. In the setting we consider, insiders

have little scope to alter the timing or content of disclosures, but have discretion over

whether to trade. From several different perspectives, the observed trading pattern

is consistent with the interpretation that insiders trade to avoid risks stemming from

jeopardies established by past regulatory actions, shareholder class-action suits and

adverse publicity. Insiders nevertheless appear to profit actively and passively from their

private information about proximate financial disclosures when jeopardy is low. These

findings contribute to our understanding of the elements of firm financial information

that are known in advance to insiders and the use they make of them for personal profit

within the constraints of a regulatory framework mandating periodic disclosures and

imposing jeopardies that plausibly vary over the fiscal quarter and across firms.

36

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Table 1Value and absolute value of abnormal returns over the earnings announcement and filingwindowsa

StandardVariable Mean Deviation 5% Median 95%

Panel A: Event window returns

RET EA 0.0078 0.1033 −0.1378 0.0000 0.1650RET FD 0.0027 0.0724 −0.0950 0.0000 0.1059ARET EA 0.0058 0.1017 −0.1366 0.0017 0.1584ARET FD −0.0025 0.0708 −0.0978 −0.0047 0.0977

Panel B: Absolute value of abnormal event window returns

abs(ARET EA) 0.0640 0.0793 0.0033 0.0396 0.2029abs(ARET FD) 0.0438 0.0557 0.0025 0.0280 0.1361

a Panel A reports returns over the Announcement Window and Filing Window for110,305 firm-quarters in the period 1996:1 to 2002:4 with available data. RET EA isthe return over days −1 to +1 relative to the earnings announcement date. RET FDis the return over days 0 to +2 relative to the 10-K or 10-Q filing date. ARET EA andARET FD are the corresponding abnormal returns, computed as the difference betweenthe buy-and-hold raw return and the buy-and-hold value-weighted market index. Theabsolute value of abnormal returns over the earnings announcement and filing datewindows are abs(ARET EA) and abs(ARET FD), respectively.

Table 2Descriptive statistics on insider trade and independent variablesa

StandardVariable N Mean Deviation 5% Median 95%

Panel A: Measures of insider trade

FREQ1 110, 305 −0.0239 2.0263 0.0000 0.0000 0.0000FREQ2 110, 305 −0.5743 6.4797 −5.0000 0.0000 2.0000FREQ3 110, 305 −0.3256 4.2983 −3.0000 0.0000 1.0000VALUE1 110, 305 −0.0840 4.1484 0.0000 0.0000 0.0000VALUE2 110, 305 −0.8638 26.6586 −1.4178 0.0000 0.0488VALUE3 110, 305 −0.6763 74.4262 −0.5688 0.0000 0.0230Panel B: Independent variables

PRIOR RET1 106, 291 0.0797 0.5599 −0.5398 0.0294 0.8077PRIOR RET2 106, 842 0.0778 0.5512 −0.5513 0.0239 0.8246PRIOR RET3 107, 418 0.0769 0.5905 −0.5543 0.0253 0.8110MV 110, 305 2.3920 13.4163 0.0177 0.2542 8.0530BM 110, 305 0.6165 0.5542 0.0745 0.4959 1.6209

aPanel A reports firm-quarter descriptive statistics on insider trade measured in threenon-overlapping periods within each firm-quarter in the period 1996:1 to 2002:4 withavailable data. The first period is the twenty days ending two days before a quarterlyearnings announcement. The second period, which may be up to twenty days long,begins on the second day after a quarterly earnings announcement and ends no laterthan the day before the corresponding 10-K or 10-Q is filed. The third period is thetwenty days beginning on the third day after the 10-K or 10-Q filing date. These periodscorrespond to the periods depicted in Figure 1 and are denoted p = 1, p = 2, andp = 3, respectively. FREQp is the number of insider purchase transactions less thenumber of sale transactions in period p. VALUEp is the value, in millions of dollars, ofinsider purchase transactions less the value of insider sales transactions in period p. Ifthere were no insider trades in the firm-quarter-period, then FREQp and VALUEp areset to 0. Panel B describes the independent variables additional to the test variablesdescribed in panel Table 1. PRIOR RETp is the buy-and-hold return for the six-monthperiod ending on the last day of: for period 1, the second month prior to the month ofthe earnings announcement; for period 2, the month prior to the month of the earningsannouncement; for period 3, the month prior to the month of the filing. MV is themarket value of equity, in billions of dollars. BM is the ratio of book value to the marketvalue of equity. MV and BM are computed as of the end of the quarter to which theannouncement and filing relate.

Table 3Regressions of signed frequency and signed value of insider trade on signed event returnsa

Predicted Period 1: Period 2: Period 3:coefficient Before the earnings announcement After the earnings announcement After the filingsign by and before the filingperiod

1 2 3 All Quarters Quarter All Quarters Quarter All Quarters Quarterquarters 1–3 4 quarters 1–3 4 quarters 1–3 4

Specification (1a) (1b) (1c) (2a) (2b) (2c) (3a) (3b) (3c)

Panel A: Dependent variable is the signed frequency of trade, FREQp

ARET FD 0 + − 0.006 0.014 0.038 0.579 *** 0.545 *** 0.562 ** −0.833 *** −0.824 *** −0.565 ***ARET EA 0 − − 0.039 ** 0.044 ** 0.006 −2.181 *** −2.152 *** −2.392 *** −0.523 *** −0.640 *** −0.162 **PRIOR RETp −0.013 *** −0.014 *** −0.019 ** −0.392 *** −0.333 *** −0.598 *** −0.175 *** −0.248 *** −0.062 ***ln(MV) −0.022 *** −0.023 *** −0.017 ** −0.298 *** −0.291 *** −0.330 *** −0.159 *** −0.189 *** −0.050 ***BM 0.017 *** 0.018 *** 0.015 0.053 ** 0.080 *** 0.005 0.041 *** 0.043 ** 0.039

Firm-quarters 104, 687 78, 621 26, 066 105, 428 79, 191 26, 237 105, 481 78, 858 26, 623R2 0.004 0.004 0.003 0.036 0.035 0.043 0.022 0.024 0.009

Panel B: Dependent variable is the signed value of trade, VALUEp

ARET FD 0 + − 0.018 0.013 0.035 0.290 ** 0.201 0.266 −0.602 *** −0.470 *** −0.325 **ARET EA 0 − − 0.008 0.016 −0.031 −1.389 *** −1.243 *** −1.828 *** −0.412 *** −0.482 *** −0.072PRIOR RETp −0.009 *** −0.009 *** −0.010 ** −0.276 *** −0.248 *** −0.425 *** −0.158 *** −0.240 *** −0.052 ***ln(MV) −0.011 *** −0.010 *** −0.013 *** −0.368 *** −0.314 *** −0.542 *** −0.241 *** −0.297 *** −0.085 ***BM 0.004 0.007 * −0.004 −0.136 *** −0.100 *** −0.265 *** −0.083 *** −0.120 *** −0.013

Firm-quarters 106, 088 79, 668 26, 420 106, 673 80, 107 26, 566 107, 341 80, 474 26, 867R2 0.002 0.002 0.002 0.017 0.016 0.025 0.010 0.012 0.003

Table 3 (continued)

aFor the regressions in Panel A, the dependent variable is FREQp for the regressionscorresponding to period p; for the regressions in Panel B, the dependent variable isVALUEp for the regressions corresponding to period p. All variables are as defined inTables 1 and 2, except that ln(MV) is the natural logarithm of MV. Regressions controlfor firm, calendar year quarter, and fiscal quarter fixed effects. Cook’s (1977) distancestatistic is used to eliminate influential observations. Significance levels of 10%, 5%, and1%, based on two-tailed tests, are denoted by *, **, and ***, respectively.

Table 4Regressions of signed frequency and signed value of insider trade on signed event returnsin Period 2—observations partitioned by whether the trade was disclosed before thefiling datesa

Predicted sign Trade disclosed Trade disclosedbefore the filing after the filing

Specification (1) (2)

Panel A: Dependent variable is the signed frequency of trade, FREQ2

ARET FD + 0.383 *** 0.348 ***ARET EA − −1.402 *** −1.261 ***PRIOR RET2 −0.264 *** −0.224 ***ln(MV) −0.158 *** −0.199 ***BM 0.007 0.038 *

Firm-quarters 88, 361 91, 829R2 0.024 0.024

Panel B: Dependent variable is the signed value of trade, VALUE2

ARET FD + 0.198 * 0.147 *ARET EA − −0.991 *** −0.724 ***PRIOR RET2 −0.183 *** −0.154 ***ln(MV) −0.246 *** −0.202 ***BM −0.113 *** −0.059 ***

Firm-quarters 88, 928 92, 548R2 0.014 0.011

a In Panel A, the dependent variable is FREQ2. In Panel B, the dependent variable isVALUE2. The regression specification (2a) of Table 3 is re-estimated on (i) the subsetof observations that excludes firm-quarters for which the trade disclosure date is afterthe filing date for more than half of the trades in the quarter and (ii) the subset ofobservations that excludes firm-quarters for which the trade disclosure date is beforethe filing date for more than half of the trades in the quarter. Firm-quarters in whichthere is no insider trade are included in both specifications. Firm-quarters where thereare multiple trades are classified according to whether the majority of the trades aredisclosed before or after the filing data. Cook’s (1977) distance statistic is used toeliminate influential observations. Regressions control for firm, calendar year quarter,and fiscal quarter fixed effects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by *, **, and ***, respectively.

Table 5Tobit regressions of unsigned frequency and unsigned value of insider trade on absolute event returnsa

Predicted Period 1: Period 2: Period 3:coefficient Before the After the After thesign by earnings earnings filingperiod announcement announcement

and beforethe filing

Specification 1 2 3 (1a) (2a) (3a)

Panel A: Dependent variable is the absolute frequency of trade, SUM FREQp

abs(ARET FD) − + + −3.580 *** 2.759 ** 5.431 ***abs(ARET EA) − + + −5.104 *** 10.090 *** 3.118 ***abs(PRIOR RETp) −0.369 ** 1.099 *** 0.651 ***ln(MV) 0.285 *** 1.327 *** 0.632 ***BM −0.287 * −0.983 *** −1.053 ***Constant −13.666 *** −30.402 *** −11.042 ***

Firm-quarters 106, 291 106, 842 107, 418

Panel B: Dependent variable is the absolute value of trade, SUM VALUEp

abs(ARET FD) − + + −3.906 ** 0.382 31.386 *abs(ARET EA) − + + −9.252 *** 28.260 *** 19.049abs(PRIOR RETp) 0.132 3.215 *** 2.747 ***ln(MV) 0.553 *** 4.832 *** 3.806 ***BM −0.308 −2.182 ** −5.413 **Constant −23.153 *** −130.018 *** −88.082 **

Firm-quarters 106, 291 106, 842 107, 418

aFor the regressions in Panel A, the dependent variable is SUM FREQp, defined as the number of in-

sider stock transactions (both purchases and sales) in the period-firm-quarter; for the regressions in

Panel B, the dependent variable is SUM VALUEp, defined as the total value of insider stock trans-

actions (both purchases and sales) in the period-firm-quarter. The absolute values of ARET FD,

ARET EA, and PRIOR RETp, are abs(ARET FD), abs(ARET EA), and abs(PRIOR RETp), respec-

tively. Other variables are as defined in Table 2, except that ln(MV) is the natural logarithm of MV.

Regressions control for calendar year quarter and fiscal quarter fixed effects. Significance levels of 10%,

5%, and 1%, based on two-tailed tests, are denoted by *, **, and ***, respectively.

Table 6

Regression of insider trade frequency and value in Period 2 on the abnormal return at the filing

interacted with past insider trade frequencya

Predicted signSpecification (1) (2)

Panel A: Dependent variable is the signed frequency of trade, FREQ2

IND ARET FD + 0.041 **POS ARET FD + 0.401 **NEG ARET FD + 0.302LAG FREQ + 0.077 ***ARET FD*LAG FREQ + 0.196 ***ARET FD + 0.574 ***ARET EA − −2.184 *** −2.133 ***ARET EA*LAG FREQ + 0.308 ***PRIOR RET −0.398 *** −0.308 ***ln(MV) −0.299 *** −0.211 ***BM 0.049 ** 0.067 **

Firm-quarters 105, 425 90, 382R2 0.036 0.078

Panel B: Dependent variable is the signed value of trade, VALUE2

IND ARET FD + −0.009POS ARET FD + 0.259NEG ARET FD + 0.435 *LAG VALUE + 0.062 ***ARET FD*LAG VALUE + 0.321 ***ARET FD + 0.567 ***ARET EA − −1.387 *** −1.267 ***ARET EA*LAG VALUE + 0.110 ***PRIOR RET −0.276 *** −0.229 ***ln(MV) −0.365 *** −0.314 ***BM −0.135 *** −0.118 ***

Firm-quarters 106, 674 91, 576R2 0.017 0.048

a In Panel A, the dependent variable is FREQ2. In Panel B, the dependent variable is VALUE2.

Variables are defined as follows: IND ARET FD is an indicator variable that is 1 if ARET FD > 0,

and 0 otherwise. POS ARET FD is defined as max(0, ARET FD) and NEG ARET FD is defined

as min(0, ARET FD). LAG FREQ is computed like FREQp, except that the period over which

LAG FREQ is computed begins on the day after the earnings announcement date in the previ-

ous quarter and ends on the day before the earnings announcement date for the current quarter.

LAG VALUE is computed analogously. Other variables are defined in Tables 1 and 2, except that

ln(MV) is the natural logarithm of MV. Cook’s (1977) distance statistic is used to eliminate influen-

tial observations. Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects.

Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by *, **, and ***, re-

spectively.

Table 7Regression of signed insider trade frequency and value in the first and second halves ofPeriod 2′ on the announcement and filing date abnormal returnsa

Specification (1) (2)First Second

Half of Half ofPeriod 2′ Period 2′

Panel A: Dependent variable is the half-period signed frequency of trade, FREQ2′

ARET FD 0.368 *** 0.187 ***ARET EA −1.620 *** −0.621 ***PRIOR RET2 −0.257 *** −0.112 ***ln(MV) −0.237 *** −0.106 ***BM 0.017 0.038 ***

Firm-quarters 103, 562 103, 153R2 0.032 0.019

Panel B: Dependent variable is the half-period signed value of trade, VALUE2′

ARET FD 0.267 *** 0.049ARET EA −0.981 *** −0.484 ***PRIOR RET2 −0.197 *** −0.101 ***ln(MV) −0.272 *** −0.180 ***BM −0.108 *** −0.074 ***

Firm-quarters 104, 868 105, 138R2 0.019 0.011

a Period 2′ is the period from the end of the Announcement Window to the beginningof the Filing Window. Period 2′ is divided into two sub-periods of equal length. Inspecifications (1) and (2), the dependent variables FREQ2′ (Panel A) and VALUE2′

(Panel B) are computed like FREQ2 and VALUE2 in earlier tables except that they arebased on trades occurring in the first and second halves of Period2′, respectively. Othervariables are defined in Tables 1 and 2, except that ln(MV) is the natural logarithmof MV. Cook’s (1977) distance statistic is used to eliminate influential observations.Regressions control for firm, calendar year quarter, and fiscal quarter fixed effects.Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by *, **,and ***, respectively.

Table 8Tobit regression of the fraction of insider trade occurring in the period on a litigationrisk indicator variablea

Specification (1) (2) (3)Period 1: Period 2: Period 3:Before the Between the After theearnings announcement filing

announcement and filing

Panel A: Dependent variable is the fraction of insider trades by frequency, F FREQp

HIGH LIT −0.215 *** 0.126 *** 0.003Constant −1.177 *** 0.124 *** −0.162 ***

Firm-quarters 45, 605 45, 041 45, 041

Panel B: Dependent variable is the fraction of insider trades by value, F VALUEp

HIGH LIT −0.217 *** 0.129 *** 0.006Constant −1.188 *** 0.121 *** −0.179 ***

Firm-quarters 45, 605 45, 041 45, 041

a Dependent variables are defined as follows. F FREQp is the sum of insider purchasesand sales frequencies over period p divided by the sum of all insider purchases andsales frequencies between the two earnings announcement dates in which period p falls.F VALUEp is defined similarly using dollar values. HIGH LITfq is an indicator variablethat is 1 if the risk of litigation is more than 2.0% for firm f in the year in which quarterq’s earnings announcement falls and zero otherwise. Significance levels of 10%, 5%, and1%, based on two-tailed tests, are denoted by *, **, and ***, respectively.

Table 9Regressions of signed frequency and value of insider trade in Period 2 on litigation risk,signed event returns, and interaction termsa

Predicted All Quarters Quartercoefficient sign quarters 1–3 4

Specification (1) (2) (3)

Panel A: Dependent variable is the signed frequency of trade, FREQ2

ARET FD*HIGH LIT ? 0.484 ** 0.494 * 0.155ARET EA*HIGH LIT − −0.356 ** −0.317 * −0.212HIGH LIT ? 0.237 *** 0.241 *** 0.170 ***ARET FD + 0.429 *** 0.461 *** 0.392ARET EA − −2.164 *** −2.152 *** −2.404 ***PRIOR RET −0.379 *** −0.321 *** −0.585 ***ln(MV) −0.300 *** −0.290 *** −0.350 ***BM 0.035 0.060 ** −0.025

Firm-quarters 84, 189 63, 014 21, 175R2 0.040 0.041 0.045

Panel B: Dependent variable is the signed value of trade, VALUE2

ARET FD*HIGH LIT ? 0.253 0.308 −0.504ARET EA*HIGH LIT − −0.588 *** −0.605 *** −0.968 *HIGH LIT ? 0.241 *** 0.228 *** 0.219 ***ARET FD + 0.164 0.076 0.277ARET EA − −1.219 *** −1.050 *** −1.567 ***PRIOR RET −0.268 *** −0.236 *** −0.452 ***ln(MV) −0.381 *** −0.317 *** −0.583 ***BM −0.143 *** −0.105 *** −0.294 ***

Firm-quarters 85, 121 63, 700 21, 421R2 0.018 0.017 0.028

a HIGH LITfq is an indicator variable that is 1 if the risk of litigation is more than2.0% for firm f in the year in which quarter q’s earnings announcement falls and zerootherwise. Other variables are as defined in Tables 1 and 2, except that ln(MV) is thenatural logarithm of MV. Cook’s (1977) distance statistic is used to eliminate influentialobservations. Regressions control for firm, calendar year quarter, and fiscal quarter fixedeffects. Significance levels of 10%, 5%, and 1%, based on two-tailed tests, are denoted by*, **, and ***, respectively.

Figure 1Definition of stock return windows and trading periodsa

Period 1

20 days

Period 2

up to 20 days

Period 3

20 days

AnnouncementDate

FilingDate

–1 +1 0 +2

AnnouncementWindow

FilingWindow

0

aPeriods 1, 2, and 3 are measured in calendar days. The Announcement Window andFiling Window are measured in trading days. Firm-quarters in which the filing date is0, 1, or 2 trading days after the announcement date are excluded from the analysis. Pe-riod 1 is the 20 calendar days before the start of the Announcement Window. Period 2begins on the second trading day after the announcement date and ends on the earlier of(i) the 20th calendar day after this day and (ii) the calendar day before the filing date.Period 3 is the 20 calendar days after the end of the Filing Window.