Legal Insider Trading…?

9 Sept

What better way to kick off the series than with a paper that made media headlines and had ASIC members knocking on doors? Dr Dean Katselas was my Investments lecturer at the Australian National University and my Academic Mentor under the Bachelor of Finance, Economics & Statistics (Honours) degree.

His controversial 2019 paper, ‘Strategic Insider Trading around Earnings announcements in Australia’, shows directors of ASX listed firms often trade in the opposite direction of surprise earnings announcements. They sell the good news and buy the bad news.

Reading this paper, I was reminded of a particular scene in the 2011 financial thriller “Margin Call”. The CEO of the investment bank — whilst discussing the idea of selling the firm’s entire stock of worthless Mortgage-Backed Securities — states:

“There are three ways to make a living in this business: be first; be smarter; or cheat. Now, I don’t cheat. And although I like to think we have some pretty smart people in this building, it sure is a hell of a lot easier to just be first.” “Sell it all, today.”

Katselas draws out many parallels between this decision and the behaviour of Australian directors. He suggests directors know they can’t cheat; instead, they use their inside knowledge to be first.

“Now, I don’t cheat”

Any readers who have watched the US hit tv show “Billions” will be very familiar with the concept of ‘Insider Trading’. It is the practice of trading stocks or other securities based on non-public information to profit or avoid losses. Financial regulators and law enforcement agencies worldwide have criminalised insider trading to protect financial markets’ efficiency and fair functioning.

To prevent insider trading, companies self-impose ‘blackout periods’ — a set time period leading up to a firm’s earnings release in which directors and other company insiders cannot trade their firm’s shares. This stops these insiders from profiting off likely movements in the stock price following the public release of earnings.

“It sure is a hell of a lot easier to just be first”

Katselas shows that there is a spike in director trades immediately after earnings are released, a practice that is legal and not distinguished from normal trading by directors. He argues that this is still a purposeful attempt to profit off insider knowledge. He calls it “Indirect Insider Trading” and believes it to be incredibly harmful to the market.

To illustrate Katselas’ accusation, let’s say a company posts a surprise positive earnings announcement. A director may have the insider knowledge that this announcement is an outlier and does not reflect the future profitability of the firm she runs. The market may overvalue this stock, at least in the short run.

Now, how can she trade off this information? She’ll profit from an upswing in the stock’s price by selling some of her stock at the higher price, and then buying back that stock when the price drops down sometime in the future. She has taken advantage of the private and privileged information she holds before the rest of the market. In other words, she comes first.

So what does the paper say?

We’re interested in activity around earnings announcements, so it’s natural to fix all buy and sell trades relative to the release date (day 0).

Time series of Australian directors’ trades relative to earnings announcements between 2005–2015 from Morningstar’s DatAnalysis Premium database. Note: The solid line are trades around final earnings announcement and the dashed line are for half-year results.

The first obvious thing we see is the massive spike at the date of earnings announcements. Very few people are buying or selling before the spike because of either blackout periods or simply the legal risk of trading. After all, we don’t want to look like we are cheating now, do we?

He goes on to show that directors are disproportionately buying immediately before and selling immediately after earnings announcements. We would expect the ratio of buys to sells to be constant. Trading behaviour around an announcement shouldn’t change.

“Sell it all, today.”

Like me, you may be thinking directors are just waiting for the blackout period to end and sell shares that were part of a compensation scheme or even just rebalance their portfolio. Katselas doesn’t think so.

In a 2018 paper, Katselas shows that after surprisingly negative earnings announcements, directors disproportionately buy. This is strongly correlated with subsequent increases in return-on-assets and return-on-equity. The opposite correlation is observed for surprisingly positive earnings announcements. Katselas goes even further and argues this correlation exists because directors are trading on a longer term view of their firm’s value — they understand the stock is under (or over) valued following surprise announcements and trade accordingly.

Where does this leave us?

Katselas shows that insiders in Australia delay trading until after earnings releases, partly because of blackout periods. He believes directors intentionally benefit from a lower purchase price in the case of bad news and a higher sale price in the case of good news, finding

“When looking at the profits made by these seemingly inverse trades, the companies with the more dire sounding future showed the greatest profitability.”

His take is incredibly controversial and hasn’t gone without criticism. An ASIC spokesperson believes the paper relies on a “very different concept” of insider trading.

“That is, that directors are trading on inside information whenever they trade and are breaching the law simply by virtue of having an intimate understanding of the business.”

Katselas holds his ground, arguing “It was the exact opposite of what you’d expect to see after either kind of news” and “You name it, the directors of most companies on the Australian Stock Exchange are engaging in this illegal practice.”

It is all well and good to claim this practice is illegal. However, note that Katselas doesn’t prove these contrarian trades are profitable or even a detailed rationale of why these trades would be profitable.

Final thoughts

So are these directors committing legal insider trading whenever they execute trades after earnings announcements? Well, it certainly isn’t clear cut. Whether it’s ‘unethical’ is up to personal judgement. Katselas would say these insiders are cheaters, others would say they are simply being first. Many would say they are merely rebalancing their portfolios. On the whole, Katselas doesn’t prove illegality or intent, but he does spark new discussion.

We have to remember that director trades are public, and markets use this information as a signal for the true value of the company. The only problem is the trades become public after they are executed. So, regardless of whether or not insiders are ‘indirectly insider trading’, it seems reasonable to have them pre-announce their trades days or even weeks beforehand. Directors wouldn’t be able to profit off of any private information because the pre-announcement should move the stock price to the true value well before they trade. But taking directors out of the race doesn’t mean there isn’t a first place.