Undisclosed Investigations

Most corporate investigations by the US Securities and Exchange Commission (SEC) unfold in secrecy—their proceedings privy only to the investigators, the target firms’ senior executives and their attorneys.

A study by Phillip Quinn, an associate professor of accounting and Lane A. Daley Endowed Fellow at Foster, reveals that corporate insiders often exploit the undisclosed nature of these investigations for personal gain—or to protect against personal loss.

Quinn and his co-authors—Terrence Blackburne of Oregon State University, John D. Kepler (BA 2011) of Stanford University and Daniel Taylor of the University of Pennsylvania Wharton School—analyzed recently declassified data from nearly 13,000 SEC investigations closed between 2000 and 2018. Only 19 percent of these investigations were initially disclosed to the public.

Opportunistic trading

The researchers detected no evidence of abnormal trading around the opening of an SEC probe of the average non-disclosing firm. But they found a pronounced spike in insider selling among firms with investigations that subsequently led to a restatement or enforcement proceedings—actions that have a material effect on the future value of a firm.

“Moreover,” Quinn says, “we find that abnormal selloff at the outset of the investigation allows insiders to avoid significant losses.”

This is because investigations that find irregularities often lead to changes in a firm’s market value over the short term. So, senior executives dump shares before anyone else gets wind that there is something amiss for the SEC to discover.

Pay attention

Based on this new evidence, Quinn and his co-authors advise regulators to:

• scrutinize securities trading by corporate insiders during undisclosed investigations, and
• consider issuing a set of rules on whether and when a regulatory investigation is considered sufficiently material that it would trigger mandatory disclosure.

They suggest that corporate boards revisit their “disclose or abstain” rules, which may be failing to consistently govern officers’ and directors’ fiduciary duty during active regulatory investigations.

And, given the economic materiality of most SEC probes, they urge firms that choose not to disclose an investigation to oblige their executives and directors with knowledge of the investigation to refrain from trading.

“Our findings highlight the need for insider trading policies that restrict the trades of key personnel during ongoing investigations,” Quinn says.

“Undisclosed SEC Investigations” was published in the June 2021 issue of Management Science. It has received an Outstanding Paper Award from the Jacobs Levy Center at the Wharton School of Business at the University of Pennsylvania.