Asymmetric Information Consolidation and Price Discovery: Inferring Bad News from Insider Sales

Abstract

Due to the paucity of sources of negative firm-specific information, US capital markets have more difficulty identifying and incorporating bad news into stock prices than they do good news. Even though insider selling is a potentially important proxy for undisclosed bad news, researchers have difficulty ex ante identifying information-based sales due to an inability to separate liquidity-motivated from information-based insider trades. We hypothesize that when insiders in multiple firms sell shares of one firm in which they are insiders and at the same time buy shares of other affiliated firms, the sale is more likely to be information-based, since the proceeds are reinvested. Conversely, when insider sells one affiliated firm without purchasing others or sells multiple affiliated firms the sale is likely liquidity-motivated. We find that insider sales identified as information-based using this algorithm are followed by significant negative abnormal returns. Information-based sales are also more likely to be associated with delistings, earnings declines and earnings restatements. Analysts are also more likely to revise their earnings forecasts downwards for these firms. It is thus possible to ex ante identify insider sales with information content. Our results will be of interest to investors and also to regulators designing insider trading rules.

Keywords: insider trading, information asymmetry, information intermediaries, future returns, future performance, adverse events

JEL Classification: G12, G14, G18