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Review of Accounting Studies

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02-09-2022

Geographic connections to China and insider trading at the start of the COVID-19 pandemic

Authors: Erin Henry, George A. Plesko, Caleb Rawson

Published in: Review of Accounting Studies | Issue 1/2024

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Abstract

The sudden and exogenous nature of the COVID-19 crash provides a unique identification opportunity to study insiders’ informational advantages. We find that the sales of insiders at firms with connections to China were significantly more profitable during the COVID-19 crisis than the sales of insiders at firms without connections to China. Consistent with greater attentiveness to public information about the COVID-19 pandemic, this result is driven by China connected insiders executing larger (smaller) sales in the early (late) COVID-19 period than non–China connected insiders. We find our results are driven by trades that are not preplanned under Rule 10b5–1 and are consistent with anticipation of the systematic market effects of COVID-19 on an insider’s firm as opposed to firm-specific effects. Aggregate China connected insider trades also predict market returns during the COVID-19 period. Our study contributes to the insider trading literature by introducing geographic connection to market-wide information as a source of public information advantage and to regulatory efforts to investigate and understand corporate insider behavior related to the COVID-19 pandemic.

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On March 16, 2020, Attorney General William Barr instructed the DOJ to remain vigilant in its detection, investigation, and prosecution efforts related to the pandemic and instructed all US attorneys’ offices to prioritize a focus on criminal activities related to the pandemic. On March 23, 2020, the codirectors of the SEC made a public statement emphasizing the importance of market integrity and corporate controls and procedures throughout the pandemic. A summary of these announcements in the context of insider trading may be found here: https://www.thompsonhine.com/publications/insider-trading-compliance-during-covid-19-pandemic.

See https://apnews.com/68a9e1b91de4ffc166acd6012d82c2f9 for further discussion of the information flow, or lack thereof, from official Chinese sources in the early stages of the pandemic.

We view attentiveness gained from geographic connection as one facet of insiders’ overall informational advantage. Our arguments are consistent with Alldredge and Cicero (2015), who find that insiders can profit from public financial statement disclosures made by their firm’s customers when other investors are inattentive.

A description of Wuhan’s significance as a transportation hub and its effect on supply chains originating throughout China can be found here: https://www.scmp.com/economy/china-economy/article/3047426/explained-why-wuhan-so-important-chinas-economy-and-potential.

We measure the profitability of insider sales using raw buy-and-hold returns because we expect COVID-19’s effect to be primarily systematic in nature. Further, the use of market-adjusted returns is often based on the implicit assumption that the insider sells their firm’s stock for diversification purposes and reinvests the proceeds into the market, which is unlikely to occur in anticipation of a market-wide disruption. However, it is possible that insiders reinvested their proceeds in the market; thus, our profitability analysis may be interpreted as an upper bound of the effects of China connections on COVID-related informed trading.

In other words, the catalyst for the stock market crash is clear and identifiable, as is the window in which insiders could possess an information advantage. We do not examine insider activity as the stock market recovered because it was gradual and characterized by significant uncertainty about why it recovered.

We do not suggest that we can identify whether the insider knows the information is idiosyncratic or systematic in nature. Rather, our tests are intended to identify whether the insider trading behavior we document is based on information not yet incorporated into the returns of only China connected firms or the overall market return.

One potential implication of this result is that China connected insiders were better positioned to anticipate the broader market decline and would also sell other stock that they held in their personal investment portfolios. Such an analysis cannot be performed, as the personal portfolio trades of corporate insiders are not observable. However, we do believe insider trades are representative of executives’ total personal trades because the personal portfolios of corporate insiders are not fully diversified and are weighted heavily toward own-firm stock (Ben-David et al. 2019).

For further discussion, see https://www.wsj.com/articles/secs-gary-gensler-speaks-at-wsj-event-11623070099.

For example, the Senate Intelligence Committee was not briefed on the extent of the outbreak until January 24, 2020. See https://www.nytimes.com/2020/03/20/us/politics/kelly-loeffler-richard-burr-insider-trading.html.

Ahern (2017) analyzes the effects of social relationships on illegal insider trading and finds that geographic proximity is a moderating variable in the relation between social interactions and insider trading. We focus on geographic connection as the primary source of insider attentiveness to public information and do not examine social ties among insiders. Further, we do not explicitly examine illegal insider trades.

The World Health Organization reported a cluster of pneumonia cases in Wuhan on January 4, 2020, and published their first Disease Outbreak News (their publication disseminated to the health communities and media) on COVID-19 on January 5, 2020. China also publicly shared the genome mapping of COVID-19 on January 12, 2020.

https://qz.com/1654798/these-are-the-products-the-us-is-most-reliant-on-china-for/

In untabulated analysis, we further test whether the incremental profitability of the trades of China connected insiders over non–China connected insiders is concentrated in trades that occur before or after firms’ COVID-19 related disclosures. We find that profitable China connected insider trades are executed after COVID-19 disclosures in both our full sample of trades occurring over the pre-COVID-19 and COVID-19 periods and in the subsample of trades occurring only in the COVID-19 period. We thank a referee for this suggestion.

Each Form 4 can contain information about multiple trades that may occur on different days, and multiple Form 4 s can be filed on the same day. We collapse multiple trades made on the same day into one insider-day observation.

The Hoberg and Moon data is organized within two datasets: 1) OffshoringDatabase_V3_Coverage and 2) OffshoringDatabase_V3_countries. If a firm is included in the “coverage” file but not in the “countries” file, then this firm is a true “zero,” in that the firm mentions no foreign activity whatsoever within their Form 10-K. Firms that aren’t included in the “coverage” dataset were not manually analyzed by Hoberg and Moon and, as a result, cannot reliably be categorized as China connected or non–China connected. As a result, we include only the insiders of firms represented in the Hoberg and Moon coverage file in our sample.

It is not uncommon for insider sales to occur over multiple days in a short time window. To alleviate concerns that our results are driven by clustered transactions, in untabulated analysis, we collapse all insider sales to the firm-day level and exclude sales with another sale in the following four days. We also examine the profitability of insider sales at the firm-week level, including an indicator for weeks exhibiting positive net insider sales and interacting it with the COVID-19 and China indicator variables. We also perform analogous analyses that do not utilize a three-way-interaction. Our results are robust across all specifications. We thank a referee for this suggestion.

It is very rare for an insider to be an insider at both a China connected firm and a non–China connected firm, and our results are robust to excluding such executives from our analysis.

We are grateful to Gerard Hoberg and S. Katie Moon for providing this data, available for download from their data library here: http://faculty.marshall.usc.edu/Gerard-Hoberg/HobergMoonDataSite/index.html. Further details regarding their process may be found in Hoberg and Moon (2017).

In untabulated analysis, we also proxy for a China connection if a firm as at least one mention of imports from or exports to China and find consistent results.

In untabulated analysis, we find that 93% of firms in the Hoberg and Moon (2017) dataset maintained their China/non-China classification from 2016 to 2017. We use the 2017 Hoberg and Moon classification for all years in our sample because it is the last year for which data is available to identify a China connection. It is possible that the US-China trade war tariffs that were enacted in 2018 caused some firms in our sample to abandon their China connection during our sample period. While we cannot identify these firms with the available data, the misclassification of China connections we describe would bias against our finding a significant difference between China and non–China connected firms in the COVID-19 period.

See http://www.wal-martchina.com/english/walmart/.

We thank a referee for this interpretation.

In untabulated analysis, we also control for upcoming earnings announcements and find robust results.

Column 4: 0.180/1.664 = 10.8%, −0.236/1.664 = −14.2%. Column 6: 0.256/1.664 = 15.4%, −0.127/1.664 = −7.6%.

See Seyhun (1988) for a detailed explanation of how insider trades can occur in response to firm-specific versus macroeconomic information.

In untabulated analyses, we also confirm the robustness of our conclusions to using the aggregate percentage of China connected insider sales to total insider sales in dollars.

The SEC’s chairman, Gary Gensler, announced that he and the SEC staff are currently considering several potential reforms to rules surrounding 10b5–1 plans: https://www.jdsupra.com/legalnews/sec-chairman-s-comments-signal-likely-8810114/https://www.sec.gov/news/speech/gensler-cfo-network-2021-06-07. We do acknowledge that criticism of Rule 10b5–1 plans is not a new phenomenon; however, COVID-19 provided a catalyst for evaluation and reform of these plans.

To verify the accuracy of our algorithm, we manually classify 500 random trades and find that our algorithm has a 98.2% accuracy rate.

Specifically, we perform nearest neighbor matching on the pre-sale price runup holding the period (pre-COVID-19 and COVID-19) constant. We restrict our analysis to our two binary China proxies to allow for cleaner matching.

Specifically, we drop trades by insiders at firms in the two or three digit SIC codes 38 and 384.

See Cohen and van der Meulen Rodgers (2020) for further discussion.

See, for example, articles published by the Wall Street Journal (https://www.wsj.com/articles/the-stock-market-is-finally-beginning-to-accept-reality-11589535001), Fortune (https://fortune.com/2020/02/24/coronavirus-stock-market-winners-losers/) and MarketWatch (https://www.marketwatch.com/story/stock-winners-and-losers-in-the-post-covid-19-work-from-home-world-2020-04-24).

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Title: Geographic connections to China and insider trading at the start of the COVID-19 pandemic
Authors: Erin Henry
George A. Plesko
Caleb Rawson
Publication date: 02-09-2022
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 1/2024
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-022-09715-y

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