PDF Ebook The Effect of the Threat of Litigation On Insider Trading and Earnings Management
The paper provides evidence that, prior to periods of poor corporate performance, managers condition their earnings management and insider trading choices on the probability of litigation. We observe two distinct patterns of abnormal selling (as defined later) that are associated with correspondingly separate earnings management behavior. In both cases, managers’ trading and accounting choices are consistent with seeking to reduce the probability of litigation. We show that managers manage earnings upwards after they engage in abnormal levels of selling so as to distance their selling from the revelation of bad news. Alternatively, we find that managers refrain from managing earnings in the prior period when they trade in proximity to a bad news event in order to reduce the likelihood of allegations that they misled investors. Our evidence that managers consider the threat of litigation as effective is consistent with findings in Beneish and Vargus (2002), Ke et al. (2003), and Rogers (2004). Our findings suggest that, in firms with deteriorating financial performance, those with oversight authority (e.g., boards of directors, auditors, and regulators) monitor prior rather than contemporaneous insider trading activity as an indicator of incentives to manage earnings.
The threat of litigation we consider in this study arises from the combination of both earnings management and insider selling. We believe that managers’ concerns relate to potential liabilities arising from civil actions directed at their firms for misleading investors, rather than criminal actions aimed at individuals for illegal trading.1 We assume that managers’ incentives to avoid litigation stem from the actions they rationally expect plaintiff’s lawyers to bring under 10b-5 suits. We argue that plaintiff’s lawyers are more likely to initiate a lawsuit after observing an event that reveals bad news, when they can persuasively allege that (1) earnings management occurred prior to the bad news event (we assume allegations are more persuasive the greater the magnitude of the earnings management) and (2) that managers acted with scienter, often established by showing that managers profited from opportunistic trading over the period in which their earnings management actions allegedly misled investors.2 One implication from this is managers that sell their equity can reduce the probability of litigation by refraining from earnings management. Alternatively, because evidence of scienter is critical to the success of a plaintiff’s lawsuit, managers could engage in earnings management and rely on legal precedent that (1) selling in “normal” amounts, (2) selling at a distance from bad news events, and (3) selling relatively smaller percentages of equity holdings, are successful defenses against the presumption of scienter from insider selling. If the threat of litigation is effective, these defenses have testable implications for the timing and magnitude of insider selling and income-increasing earnings management.
Our tests are based on a sample of 462 firms that experience technical defaults in the period 1983-1997. The period preceding default is an appropriate setting for studying the role of the threat of litigation for two reasons. First, managers’ expect the revelation of technical default to draw the interest of plaintiff’s lawyers because technical default occurs due to deteriorating firm performance (Beneish and Press 1993, 1995; Dichev andSkinner 2000).3 Second, given prior research findings of income-increasing earnings management preceding the announcement of default, plaintiff’s lawyers are more likely to scrutinize such firms.
Our results include the following. First, consistent with DeFond and Jiambalvo (1994, hereafter DJ), we find that, in general, sample firms engage in income increasing earnings management in the year preceding default (Year -1): on average abnormal accruals increase reported return on assets (ROA) by 300 basis points (3 percent). Second, we partition the sample depending on whether firms engage in abnormal selling over the two years prior to default (Years -1 and 0). We find that abnormal accruals enable abnormal selling firms to report ROAs that are on average 5.9 percent higher in Year -1, and that these abnormal accruals are temporary as they reverse in Year 0. However, we find no evidence of earnings management for non-abnormal selling firms.
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PDF Ebook The Effect of the Threat of Litigation On Insider Trading and Earnings Management
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