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Corporate insiders exploit the audit process — something intended to protect shareholders and ensure investor confidence — to avoid significant losses in their own portfolios, according to a study a University of Minnesota professor co-authored.

Insider selling on the part of top executives and directors at some public companies spikes in the weeks after they receive negative audit reports and before that information becomes public, said Salman Arif, an accounting professor at the U's Carlson School of Management.

Using a forensic accounting approach, Arif and his co-authors detected novel evidence of "opportunistic insider trading," based on the timing of when insiders receive information from auditors. Their research, they said, is the first to document the way some insiders take advantage of an unintended consequence of the audit process and use confidential information for personal gain.

"This is arising from a mechanism to protect the public and protect investors," Arif said. "And here we are, where this protection system is being used to exploit investors. So that's deep irony, I think."

The study looked at hundreds of thousands of insider trades at more than 2,000 companies from 2003-15.

Arif conducted the study with co-authors John Kepler from Stanford University Graduate School of Business, Joseph Schroeder from the Kelley School of Business at Indiana University and Daniel Taylor from the Wharton School at the University of Pennsylvania.

Insider trading — when someone who has material, nonpublic information about a public company buys or sells stock in that company — is illegal under the Securities and Exchange Act of 1934. Material, nonpublic information is private information that could affect a company's share price or a decision to buy or sell its shares. Insiders can trade in company shares legally but must properly register those transactions with the Securities and Exchange Commission.

A key challenge in prosecuting illegal insider trading, Arif said, is pinpointing what managers knew when they initiated their trades. The study focuses on trades that occur around the audit report date, when the auditor briefs managers and directors on its findings but before the company makes the audit results public in its year-end financial statement, or 10-K filing with the SEC. Information from the briefing often is material, especially when it involves negative findings.

"Audit reports are generally disclosed to and discussed with managers before their public disclosure via the 10-K filing," Arif said. "Therefore, the audit report date allows us to infer whether corporate insiders engaged in potentially illegal behavior by trading on nonpublic audit information."

The study found insider selling did rise rapidly in the weeks after firms received negative audit opinions and before those reports became public, Arif said. Insiders benefited as a result, with an average loss avoidance of 7.2.% for trades made in this "window of opportunity."

"For firms which subsequently reveal accounting problems, [such as] a modified audit opinion and accounting restatement, the loss avoidance enjoyed by insiders who trade in the window of opportunity jumps to 11 percent on average," Arif said

Insiders who are trading around an audit report are "going to be really in the doghouse," University of Minnesota law professor Richard Painter said. An expert on corporate governance and chief ethics lawyer for President George W. Bush, Painter has studied and written about insider trading for 30 years.

"This is an invitation to an SEC investigation or possibly a criminal investigation by the United States Attorney's Office, because that's a felony if you're trading on the basis of material nonpublic information," Painter said. "If you hear the earnings are going to have to be restated and adjusted downward, and you start selling your stock before the public knows, you can go to prison for that."

Such opportunistic trades also have predictive value, Arif and his co-authors found. Insider selling around the audit report date results in a 35% higher probability a company later will have to restate its financial results.

The study uses public data, though the researchers run sophisticated statistics tests on it when conducting their study. Individual shareholders can look up the date of an audit report in a firm's 10-K filing and then check whether an abnormal amount of insider selling occurred in that time frame, Arif said.

Arif and his co-authors presented a draft version of their paper in March 2019 to officials at the SEC and the Public Company Accounting Oversight Board in Washington, D.C. Regulators were "surprised and a little disappointed," Arif said, to learn of the insider trading scheme the researchers had uncovered. The final study was published in the September 2022 issue of Review of Accounting Studies.

"Hopefully, there's an effort to stop this from happening," Arif said. "I think that would be the best outcome, if we can prevent this type of opportunism on the part of managers."

Whether regulators took action on the findings is difficult to know, Arif said. The researchers' goal was to support the institutions, as their presentation included information like historical anecdotes where opportunistic trading preceded a firm restating its accounting statements.

"We viewed our primary contribution as providing the SEC a methodology to find questionable insider trading which they could replicate/enhance and add to their mosaic for illegal insider trading detection," Arif said. "We believed showing them the methodology was more useful than us giving them a list of individuals who we academics felt were trading questionably."

Having earnings announcements coincide with the filing of the 10-K and audit report "could mitigate" some of this trouble, Arif said.

Todd Nelson is a freelance writer in Lake Elmo. His e-mail is