Drexel University – Department of Finance
At the end of October, the value investor Mohnish Pabrai gave a presentation and took part in a Q&A session at Boston College and Harvard Business School on the Uber Cannibal Investor Framework, which he has developed over the past decade. Uber Cannibals are the businesses “eating themselves by buying back their stock,” the value Read More
University of Texas at Austin – Department of Finance
Anh L. Tran
City University London – Sir John Cass Business School
July 10, 2015
We investigate the determinants of gains to CEOs from large stock sales. Consistent with the literature, we find that some CEOs benefit from inside information by strategically timing sales. We also find that internal accounting information can be used to predict such timing. Furthermore, sales executed under plans that conform to SEC Rule 10b5-1 tend to follow positive abnormal stock returns, but do not, on average, precede abnormal declines. In contrast, sales that do not conform to the requirements of Rule 10b5-1 tend to follow smaller positive abnormal stock returns, but, on average, precede large abnormal declines. Board and CEO characteristics are related to the magnitude of the post-transaction abnormal returns. Overall, the evidence suggests that Rule 10b5-1 plans do not prevent CEOs from timing large sales or the release of discretionary information around them.
Managers generally have better information about the prospects for their firms than outside investors. To protect stockholders from opportunistic trading on the part of managers, Securities and Exchange Commission (SEC) regulations prohibit managers from actively trading their firms’ shares during periods in which they are most likely to be in possession of soon-to-be-disclosed material non-public (inside) information, such as financial results or information about an impending acquisition or merger. However, even outside of these periods in which the “trading window” is closed, managers possess private information about the prospects for their businesses that provides them with advantages in trading their personal shares. Consequently, managers can be subject to allegations that they are trading on inside information any time they buy or sell their firms’ shares.
In October 2000, the SEC enacted Rule 10b5-1 which enables managers to reduce their exposure to allegations of trading on material non-public information by announcing pre-planned stock sales up to two years in advance. Presumably, since these sales are planned well in advance, managers schedule them without knowledge of the prices at which the shares will be sold and before relevant time-sensitive inside information becomes available to them.
While stock sales which occur under Rule 10b5-1 are less susceptible to opportunistic behavior by CEOs, they are not immune to such behavior. A CEO has the ability to cancel planned sales through the use of limit orders or make decisions which can affect the market price of the firm’s shares before a pre-scheduled sale is completed. These latter decisions might involve investment, operating, financing, and reporting choices, or the timing of the release of information. Also, even in the absence of such decisions, a CEO who sells shares within a 10b5-1 plan can profit if he or she has sufficient foresight regarding the resolution of uncertainty about the value of a firm’s shares.
In this study we investigate whether CEOs systematically profit from sales of large blocks of their personal shares which we define as sales involving at least one percent of the firm’s market capitalization. We focus on the effectiveness of Rule 10b5-1 in limiting opportunistic sales and in the CEO- and firm- specific characteristics associated with such trades.
Evidence from a sample of 610 large stock sales by CEOs of public U.S. firms during the 2003 through 2009 period indicates that some selling CEOs earn abnormal returns with or without Rule 10b5-1 restrictions. Average cumulative abnormal stock returns (CARs) equal approximately 6 percent over the 40 trading days preceding and -6 percent over the 40 trading days following the sale of a large block of shares by the CEO. Examination of firm financial characteristics reveals substantial declines in key metrics such as sales, capital expenditures, accounting accruals, and earnings from the four quarters before the stock sales to the four quarters after the sales. Furthermore, evidence on the nature of news about the firms at which the selling CEOs are employed suggests that at least some executives are able to time their trades so that they occur prior to the disclosure of negative news by external sources. There is also evidence that managers have the ability to time the release of discretionary news about the firm.
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