In this study, we exploit newly available data to investigate whether trades by SEC employees earn abnormal profits. This analysis relies on a data set, provided by the SEC under a Freedom of Information Act (FOIA) request filed by us, which documents trades of its 3,500 employees during late 2009 and for all of 2010 and 2011.
The mission of the Securities and Exchange Commission (SEC) is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. During the conduct of this mission, SEC employees undoubtedly come across a substantial amount of non-public information about publicly traded companies. Hence, allegations that SEC employees exploit such non-public information for personal profit raise troubling questions about real and apparent conflicts of interest, especially among enforcement officials. Given that the SEC is charged by Congress with enforcing insider trading regulations against corporate officers and other market participants, our findings indicating abnormal risk adjusted profits on trades by SEC employees are arguably troubling.
In March 2009, H. David Kotz, then Inspector General (IG) of the SEC, released a report outlining the insider trading activity of two lawyers employed by the SEC’s enforcement division. IG Kotz admitted in subsequent testimony before Congress that the SEC lacked a compliance system capable of tracking and auditing employees’ trades (Barlyn, 2009). This report and testimony, as well as the accompanying public outrage, spurred Mary Shapiro, then SEC Chairman, to impose new, stricter internal rules, beginning 2009, whereby SEC employees (i) must refrain from buying or selling stocks of firms under SEC investigation; (ii) have their transactions pre-approved, and; (iii) must order their brokers to provide transaction-level information to the SEC. The incident also motivated the SEC (i) to contract with a third party to monitor SEC employee trades for impropriety; and (ii) to create a new internal position to monitor compliance with the newly imposed rules (SEC, 2009).
This improved record keeping enabled us to obtain information about SEC employees’ trades for the years 2009 (partial), 2010, and 2011 after filing a request under the Freedom of Information Act. We document that a hedge portfolio mimicking SEC buys and sells earns positive risk adjusted abnormal returns, beyond the four factor Fama-French model, of about 4% per year for the securities covered by the CRSP universe and 8.5% per year for US common stocks.
To calibrate the magnitude of these returns, it is worth noting that Jeng, Metrick, & Zeckhauser (2003) and Wang, Shin, & Francis (2012) find that a hedge portfolio mimicking corporate insider trades earns risk adjusted abnormal returns of about 6% per year. The decomposition of returns earned by SEC employees suggests that the abnormal returns are earned in the sell portfolio. In particular, the 12 month ahead (252 trading days) abnormal returns, using the four factor Fama-French model as the model of expected returns, of U.S. common stocks that SEC employees buy (sell) is 0.56% (-7.97%). Hence, SEC employees’ stock purchases look no different from those of uninformed individual investors (Barber, Lee, Liu, & Odean, 2009), but their sales appear to systematically dodge the revelation of bad news in the future. This fact pattern is consistent with the greater informational advantage related to potential enforcement activities that employees of a regulator are likely to enjoy over other market participants.
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