THE MARKET RESPONSE TO INSIDER SALES OF RESTRICTED STOCK VERSUS UNRESTRICTED STOCK

• Author: Laurel Franzen,Xu Li,Oktay Urcan,Mark E. Vargus
• DOI: http://doi.org/10.1111/jfir.12030
• Published date: 01 February 2014
• Date: 01 February 2014

THE MARKET RESPONSE TO INSIDER SALES OF RESTRICTED STOCK

VERSUS UNRESTRICTED STOCK

Laurel Franzen

Loyola Marymount University

Xu Li

School of Business, Faculty of Business and Economics,

The University of Hong Kong

Oktay Urcan

London Business School

Mark E. Vargus

Drexel University

Abstract

Insiders holding both restricted and unrestricted stock must decide which type of equity to

trade. We investigate the relation between this choice and the market response to insider sales.

If insiders choose restricted stock, the sale must be preannounced, but if they choose

unrestricted stock, the sale is disclosed after the sale occurs. Preannounced trades are less likely

to reflect informed trades. Consistent with this, in the pre‐Sarbanes–Oxley (SOX) period, we

find a more negative market response to unrestricted stock sales than preannounced restricted

stock sales. The result does not hold for our post‐SOX period when reporting times were

accelerated. Our results suggest researchers who examine data over the pre‐SOX period

should consider the effect of restricted stock sales in tests of informed insider trading.

JEL Classification: G14

I. Introduction

There is a long and extensive body of research that documents that corporate insiders act as

informed traders. In addition to deciding when to trade, many managers’trading decision

rules must also incorporate which type of equity to trade, as managers can often hold both

restricted and unrestricted shares of stock. A potentially important factor in their decision is

that each type of equity has different disclosure requirements: restricted stock sales must be

preapproved by legal counsel and trade‐related filings made before or at the time of sale,

whereas unrestricted stock sale disclosures can be delayed. Prior research indicates that the

insider trading disclosure regime can influence the extent to which managers opportunisti-

cally trade (Grossman and Stiglitz 1980; Huddart, Hughes, and Levine 2001; Etebari,

Tourani‐Rad, and Gilbert 2004; Mendelson and Tunca 2004; Cheng, Nagar, and Rajan

We thank Mark Griffiths (associate editor), Brian Smith (referee), Helen Choy, and Nick Gonedes for their

valuable comments, suggestions and insights.

The Journal of Financial Research Vol. XXXVII, No. 1 Pages 99–118 Spring 2014

99

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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2007). One possible implication of this evidence is that managers could favor one type of

stock and its mandated disclosure environment for their opportunistic trading and use the

alternative form of equity for their noninformative trading associated with liquidity, portfolio

rebalancing, and diversification motives. Given the differing implications for future stock

prices, we investigate whether the market response following the disclosure of insiders’

trades varies systematically with the type of equity sold.

Differences in transaction cycle time and illiquidity across restricted and unrestricted

stock are not readily discernible by market participants, but differences in disclosure

requirements are legally mandated and are therefore observable. Insiders are required to

disclose the intent to sell restricted stock by filing a Form‐144 before or on the date of sale.

After the sale of any class of stock, the transaction must be reported on Securities and

Exchange Commission (SEC) Form‐4, where before the passage of the Sarbanes–Oxley Act

(SOX) in 2002, a “timely”disclosuremaybeupto40daysafterthetrade,withlatefilings

routine. Prior insider trading studies relyoninformationprovidedbyinsiders’disclosures on

SEC Form‐4, which contains various information such as transaction size, transaction date,

and aggregate insider holdings, but omits information regarding the type of equity sold

(restricted or unrestricted). Given evidence that delayed reporting of insider trading disclosures

is associated with more informative trades (Etebari, Tourani‐Rad, and Gilbert 2004; Cheng,

Nagar, and Rajan 2007), we expect that the delayed reporting afforded unrestricted stock

trades would be more conducive to opportunistic trading. Conversely, ceteris paribus, the

immediacy of reporting restricted stock sales implies that they are associated more with

nonopportunistic trading motives such as liquidity, tax, or planned consumption needs.

We examine these conjectures by first segregating insider trades based on the type

of equity sold (restricted or unrestricted stock), and then selecting firms whose executives

own and trade both classes of securities. Our final sample consists of 960,141 unrestricted

sales and 571,579 restricted stock sales from 1996 to 2008.

In the pre‐SOX period, we find that unrestricted stock sales are associated with

significantly more negative market‐adjusted returns than that of restricted stock over the

five‐day period following the announcement of the trade. After controlling for size, book‐

to‐market, momentum, and trade size, we find that market‐adjusted returns to unrestricted

stock sales are 83 basis points (bp) more negative than restricted sales (1.54% vs.

0.71%) Furthermore, we find that the average market response to late reported trades is

an additional 42 bp lower than timely unrestricted stock sales. The more negative market

response to insider sales of equity associated with less timely reporting requirements is

consistent with evidence in Cheng, Nagar, and Rajan (2007) that insiders are more likely

to trade on private information when disclosure of the trade is delayed.

Section 403 of SOX accelerated the timeliness of insider trading reports,

effectively eliminating the disclosure differences for restricted and unrestricted stock. In

this period, we find no economically significant difference in returns, while the overall

return magnitudes are approximately one‐tenth the pre‐SOX levels. The observed smaller

returns are consistent with Brochet (2010) who finds that insiders are less likely to sell

before price declines and negative earnings surprises in the post‐SOX period, presumably

because their trades are subject to greater scrutiny and heightened legal jeopardy.

Our study contributes to the literature on insider trading in several ways. We find

evidence, in the pre‐SOX period, that the market reacts differently torestricted and unrestricted

100 The Journal of Financial Research