Opportunism crosses decision domains--the many sins of opportunistic insider traders

What is it about?

Does knowing that a manager is opportunistic in one decision domain, such as insider trading, tell us much about whether the manager will cheat in some other domain? Are some managers just `bad apples.’ And are there bad firms that act opportunistically in various ways? In the paper Opportunism as a Managerial Trait: Predicting Insider Trading Profits and Misconduct (forthcoming in the Journal of Financial Economics), Usman Ali and I use insider trading as a lens for investigating these issues. We test whether managers who profit by insider trading in their firms’ stocks do other bad things, and also test for the effect of having more such managers at a firm. An insider who is deciding whether to profit by trading on information needs to be careful, since such trading may be detected by regulators such as the SEC. On the other hand, there are innocuous reasons for selling shares, which makes it hard for outside observers to know how to interpret insider trades. Previous research has shown that opportunistic insider trading does leave tracks in the data; buying by insiders of their own firm’s stock positively predicts subsequent stock returns. However, the evidence that insider sales predicts returns has been weak. This is not surprising, since there are innocuous reasons for sales, such as financing a down payment on a house. We provides a new way to identify opportunistic insider trading. Based on this our new measure of opportunism, we find that opportunistic insiders are subsequently opportunistic in both similar and other ways. For example, their subsequent trades earn higher profits than those of other insiders. Furthermore, we find that opportunism is a general trait that extends to other very different decision domains, such as manipulating financial statements and extracting high compensation. Our method of identifying opportunistic trading is to examine the profits made by insiders at the time of Quarterly Earnings Announcements. (We explain in the paper why this helps reduce noise while providing a large sample of opportunistic insiders.) A trading strategy constructed using the trades of insiders with a history of profitable insider trading generates a value-weighted abnormal return that is more than double the average return achieved by all insiders as a group—a very substantial 1.12% per month. Furthermore, even the stock sales of opportunistic insiders strongly (negatively) predict future returns. One might wonder whether this persistent opportunism is a managerial trait, or derives from a lax corporate culture that tolerates opportunism. To distinguish these possibilities, we compare how well opportunistic insiders do compared to other insiders at the same firm and during the same year. We find that the managers we identify as opportunistic subsequently outperform other managers at the same firm during any given year. This suggests that lax corporate culture is not the sole explanation; some managers are `bad apples.’ We also test whether opportunistic insider traders engage in other types of firm-level opportunism. We find that opportunistic insiders are associated with firms that engage in misconduct in financial reporting (as proxied by levels of restatements, SEC enforcement actions, shareholder lawsuits, and earnings management), after appropriate controls. For example, the probability that a firm restates earnings is 15.5% higher when a firm has an opportunistic CEO (Chief Executive Officer) or CFO (Chief Financial Officer). Furthermore, firms that have an opportunistic CEO/CFO, or have a high fraction of opportunistic insiders, were much more likely to be involved in option backdating (during the period in U.S. regulatory history when there was substantial potential benefit to backdating). The presence at a firm of an opportunistic CEO/CFO increased the likelihood of backdating by 18.7%. Furthermore, opportunism is associated with high compensation (in excess of what would be expected based on other firm characteristics) of top-5 executives and CEOs.

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Why is it important?

Our findings indicate that opportunism is a general trait that spans various decision domains of corporate managers and firms. Knowing that a manager has engaged in opportunistic insider trading is a warning about other types of manager and firm misconduct. These findings suggest that the profitability of insider trading can be useful for the monitors (such as the press, regulators, or directors) of opportunistic behavior.

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