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Supreme Court's SOX decision spares rule that benefits investors

At risk in this case was a little-known provision that speeds reporting of insider trades

The June 28 US Supreme Court decision affirming the constitutionality of most of the Sarbanes-Oxley Act, including section 403, is good news for the average investor, if a study in a prestigious accounting journal is to be believed.

The recent study in The Accounting Review, a quarterly scholarly journal published by the American Accounting Association, represents the most thorough analysis undertaken of section 403, a little-known provision of SOX that greatly speeds up reporting of insider stock transactions.

The research finds that section 403 has brought a significant measure of "timeliness and transparency" to insider trades. The rule has enhanced the average investor's response to insider purchases, the study finds, and it appears to inhibit insiders' sales in anticipation of bad news, the kind of maneuver that, most famously, led  to woes for Martha Stewart.

Not only does the provision "potentially reduce information asymmetry between corporate insiders and investors," according to the report, but "the costs of compliance appear to be lower than the cost of other provisions of SOX, and the benefits are most likely to accrue to small firms, for which insider transactions are most informative."

Comments Francois Brochet of Harvard Business School, the author of the report, "Had the Supreme Court nullified SOX, it would have been worthwhile to restore Section 403 on its own."

Section 403 requires corporate officers, directors, and major shareholders to report changes in their ownership of company stock to the Securities and Exchange Commission within two business days of transactions. Previously, disclosure was required within 10 days of the end of the calendar month in which the trade took place, meaning that it might take as long as 40 days for the transaction to be reported.

Brochet's research, drawing on a sample of more than 50,000 filings of insider trades over the 10-year period 1997 through 2006, reveals the average time it took insiders to file purchases and sales with the SEC was 19.35 days pre-SOX and 1.38 days post-SOX.

And this expediting of reporting has made a substantial difference to investors, the study suggests.

When insiders made stock purchases before SOX, the price of company shares rose an average of 0.59% more than market norms over the three-day period consisting of the filing date and two subsequent business days; after SOX the abnormal return over those same three days was 1.89%, more than triple the pre-SOX return. Meanwhile, the three-day trading volume rose from 1.03% above normal before SOX to 12.03% above normal post-SOX.

"Clearly, average investors have been in a much better position to react to insider purchases since SOX's enactment than they were before,"  Brochet says. "Before SOX, much of the boost in stock prices from insider purchases had already been dissipated, probably through information leaks, before the transactions  became public knowledge."

When it comes to insider sales, the pattern of volumes and stock-price movements is somewhat more complex than it is for purchases.

The three-day volume, as expected, is substantially greater post-SOX, rising from a pre-SOX mean that is no greater than the market norm to a mean that is 1.7% above the norm. But the three-day decline in share price is actually slightly more modest after SOX (-0.11%) than it was before SOX (-0.28%). In fact, when stock prices are monitored from the date of insider sales to as much as 10 days after the filing date, the returns were much less negative post-SOX than they were pre-SOX -- about -0.4% post-SOX compared to about -2.4% formerly.

Why should this be? Brochet offers several reasons, each reflecting credit on section 403.

One reason is that abnormal stock-price movements following insider sales are inversely related to the amount of time between the actual sales and their filing with the SEC: the longer the time, the more negative the returns. Brochet comments in explanation: "The more time passes between transactions and filings, the more likely it becomes, as word leaks out, that investors will think bad news is being kept under wraps. By considerably shortening this period of uncertainty, section 403 greatly reduced this effect."

Another reason for smaller post-SOX price declines following insider sales, Brochet concludes, is that SOX made managers more wary than they previously were of opportunistic sales, such as those prompted by bad earnings numbers or other negative news. In other words, there has likely been less insider selling in advance of bad news post-SOX than there was beforehand.

Brochet buttresses this conclusion through an analysis of firms' litigation risks, as determined by a range of factors including market value of equity, daily stock turnover, and stock volatility. In companies with a low risk of litigation, Brochet finds, insider sales produced three-day price declines post-SOX that were on average about 0.5% greater than was previously the case, reflecting the more rapid dissemination of news post-SOX. But in firms with a high risk of litigation, the three-day returns were about the same before and after the bill's passage, which suggests that insiders in such firms tended to be particularly wary of opportunistic sales post-SOX.

Asked to elaborate, Brochet adds: "By making opportunistic sales clear to the average investor much more quickly than was previously the case, provision 403 probably helped bring about a reduction of the kind of insider sales most likely to occasion sharp stock-price drops. This development, most pronounced in companies with a high litigation risk, has tended to dilute the overall negative effects that insider sales have on market returns."

Asked for an illustration of how expedited reporting of insider trades can be of benefit to investors, Brochet cites the case of Jeffrey Skilling, former CEO of Enron, who made nine sales totaling 168,668 shares of the company between November 1 and November 29, 2000. Over the course of these trades, the report of which was received by the SEC on December 8, the stock fell from $83.24 on November 1 to $74.19 on November 29, meaning that an investor who bought the stock on November 1 for about $83 would probably not have known about the CEO's heavy selling until the stock had dropped about 11%.

"If SOX had been in force in 2000, that investor would have known within two days, during which the stock hardly fell at all, that the CEO had sold more than 72,000 shares on November 1," Brochet says. "That certainly seems a considerable improvement, particularly given the subsequent fate of the company, over being in the dark for more than five weeks."

The study, entitled "Information Content of Insider Trades before and after the Sarbanes-Oxley Act," is in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.


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