RESEARCH CORNER

Beware of Chicken Little

It is well accepted that corporate insiders have an information advantage over outside investors. Indeed, statutes and case law limiting insider trading have been designed to protect outsiders from insiders who exploit this advantage. Under these rules, some insider trades are deemed legal and others are not. In a study that will be published in the December issue of the Journal of Accounting Research, my colleague Qiang Cheng and I examine the extent to which insiders use their information advantage, and the degree to which the risk of litigation constrains such activity.1

For this study, we examined over 100,000 good news and bad news forecasts provided by management over an eight-year period (1995-2002). We then related the frequency of these forecasts with the direction of insider trades (buys/sells) over quarterly periods to see whether insiders used management forecasts to maximize their trading gains.2 We found that the desire to profit from insider trading did have a significant influence on disclosure activity, but only when insiders planned to purchase shares themselves. That is, insiders tended to disseminate bad news announcements about a stock to reduce its price prior to making a purchase. On the flip side, our findings revealed that the threat of litigation did deter insiders from spreading the word about good news announcements prior to stock sales.

Why are the two results so different? It's because, in practice, virtually no litigation risk is involved when management provides bad news before purchasing stock. In the end, though, outsiders lose regardless of the way in which insiders gain.

There's no easy solution for this problem. People have come to consider conservatism desirable, as we, in accounting, know well. The fact that bad news sometimes later proves to be not so bad does not provide a strong basis for a lawsuit. Another legal hurdle is that courts do not award damages based on the amount of profit investors may have foregone by not investing in a particular stock.

The moral of this story is: Don't believe all the bad news you hear-chances are the sky isn't actually falling.

© 2006 Institute of Chartered Accountants of British Columbia Provided by ProQuest LLC. All Rights Reserved.