The 8-K Trading Gap
Tel Aviv University – Eitan Berglas School of Economics; Harvard Law School; National Bureau of Economic Research (NBER)
Michael Mauboussin: Here’s what active managers can do
Columbia Law School
Columbia Law School; Columbia University – Columbia Business School
September 7, 2015
When a significant event occurs at a publicly traded company, federal law requires the firm to disclose this information to investors in a securities filing known as a Form 8-K. But the firm need not disclose immediately; instead, SEC rules give companies four business days after the event occurs within which to file an 8-K. These rules thus create a period during which market-moving information is known by those inside the firm but not most public-company investors — a period we call the “8-K trading gap.” In this Article, we study how corporate insiders trade their company’s stock during the 8-K trading gap.
We develop a unique dataset of 15,419 Form 8-Ks with trades by insiders during this gap. We identify systematic abnormal returns of 42 basis points on average, per trade, from trades by insiders during the 8-K gap. When insiders engage in an unusual transaction during the gap — open-market purchases of their own company’s stock — they earn even larger abnormal returns of 163 basis points. We also show that, when they engage in such purchases, insiders are correct about the directional impact of the 8-K filing more often than not — and that the probability that this finding is the product of random chance is virtually zero.
To examine whether it is the expertise of the insiders, or the value associated with the information, that drives insider returns, we then focus on a type of 8-K that reveals positive information: those that announce new agreements with the company’s business partners. We show, without reference to any specific insider transaction, that a trading strategy of buying on the date such an agreement is struck and selling immediately before the agreement is disclosed yields, on average, abnormal returns of 35.4 basis points. We also demonstrate that insiders are more likely to engage in open market purchases of their own company’s stock when the firm is about to reveal new agreements with customers and suppliers. In light of the potential concerns raised by these findings, lawmakers should reconsider the effects of information-forcing rules such as those governing Form 8-K on the incidence and profitability of trading by insiders.
The 8-K Trading Gap – Introduction
Trading by corporate insiders has long been the subject of heated debate among lawmakers and commentators. Although Manne (1965) forcefully questioned whether the law should allow such trading, for more than sixty years the Securities and Exchange Commission (SEC) has devoted significant resources toward enforcing the rules designed to reduce insiders’ profits from trading in their company’s stock. The precise contours of those rules can be difficult to discern.1 What is clear, however, is that SEC Rule 10b-5, the principal source of liability for improper trading, prohibits an insider from trading with those to whom she owes a fiduciary duty on the basis of so-called material nonpublic information. Another group of SEC rules govern whether and when public companies must disclose this kind of information to the public. While a significant body of work has examined insider trading more generally, relatively little attention has been given to the interaction between these information-forcing rules and insider trading.
In this Article, we examine a unique type of trading by corporate insiders: trading during the period when SEC rules allow companies to delay the public disclosure of significant corporate events. When such an event occurs, SEC rules require that the firm disclose it in a securities filing known as Form 8-K. But those rules do not require the 8-K to be filed until the fourth business day after the event. Thus, SEC rules create a period when market-moving information is known by insiders but not by most investors—a period we call the “8-K trading gap.” In this Article, we provide the first study of how insiders trade their company’s stock during the 8-K trading gap.
After identifying more than 15,000 8-Ks with trades by the company’s insiders during the 8-K gap, we examine the profitability of those trades based on the direction of the insiders’ transactions. We show that insiders enjoy systematic abnormal returns of 42.3 basis points on average per trade. We then review each 8-K by hand to identify the type of corporate event that will be disclosed by the firm shortly after these trades. We document abnormal returns from the insiders’ transactions across a wide range of types of information—including forthcoming details of merger agreements, changes in the company’s capital structure, key customer or supplier agreements, and notices of stock-listing compliance violations.
Having documented these profits, we then address a possible concern. The results described above show only that insiders do, in fact, trade profitably during the 8-K gap—a finding that some might regard as unsurprising given insiders’ deep information about the firm and its value. Put another way, one might expect that insiders, when they trade their own company’s stock, consistently turn a profit—regardless whether an 8-K filing is imminent. We thus examine whether an individual who knew only about the forthcoming 8-K filing, but had no other access to non-public information about the firm, could trade profitably during the 8-K gap. To answer that question, we focus on a particular type of 8-K that is on average likely to generate a positive response in share prices: the announcement of a significant agreement with the company’s customers or suppliers.2 Abstracting away from particular transactions by insiders, we show that a simple trading strategy—buying on the date when such an agreement is struck and selling on the date when that agreement is disclosed to the public—would yield abnormal returns of about 35.4 basis points. Thus, a person who knew only that the company had signed such an agreement could earn abnormal profits using this strategy. Finally, we consider whether insiders are more likely to engage in a relatively unusual3 transaction—the open-market purchase of their own company’s stock—between the time major agreements with customers or suppliers are struck and when those agreements are disclosed. We find that insiders are more than 20% more likely to engage in open-market purchases during this period than at other times.
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