Do non-executive employees have information? Evidence from employee stock purchase plans.

Transcription

1 Do non-executive employees have information? Evidence from employee stock purchase plans. ILONA BABENKO and RIK SEN October 24, 2010 ABSTRACT Using a novel data set on employee stock purchase plans (ESPPs), we document that aggregate purchases of company stock by employees predict positive abnormal stock returns. Firms in the top quartile by purchases under ESPP earn approximately 7% higher annual abnormal returns than those in the bottom quartile. Our results hold after we control for stock purchases by top insiders. ESPP purchases are more strongly related to future returns for firms that do not allow participating employees to dispose of the acquired stock immediately after the purchase. We also find that larger purchases through ESPP are associated with a lower likelihood of an earnings restatement and a higher likelihood of a firm being a target of an acquisition in the subsequent year. Our analysis points out an overlooked benefit to lower level employees associated with investing in their own company stock. In addition, we contribute to the current debate regarding the cost to the shareholders of stock-based incentive plans. Babenko is at Arizona State University and HKUST, Sen is at HKUST. We thank Kai Li (the discussant), John O Brien, Mark Seasholes, Chester Spat, Jeoffrey Tate, and the participants of seminars at Arizona State University, Carnegie Melon University, HKUST, New Economic School, and Simon Fraser University for valuable comments. We are grateful to Minjeong Kang, Tao Chen, and Smita Kedia for great research assistance. 1

2 Trading by corporate insiders in their company stock commands widespread attention in the financial community. The academic literature focuses almost exclusively on abnormal returns following trades by top corporate offi cers, directors, and large shareholders (defined as insiders in Section 16 of the Securities Exchange Act), who are required to report their trades to the SEC. In contrast, we know very little about trades by lower level employees since data on their trades is scant. In this paper, we attempt to fill this gap in the literature by using a large novel data set on Employee Stock Purchase Plans (ESPPs) to examine whether purchases of lower level employees convey information about future stock performance. There are several reasons why trading decisions of lower level employees may be more informative about future firm performance than decisions of top executives. Unlike lower level employees, top executives are required to report their trades to the SEC and this information becomes publicly available. 1 Consequently, their trades face intense public scrutiny and have a higher risk of attracting insider trading allegations. In addition, since top executives may buy the stock because of market-signaling considerations or to meet the minimum ownership requirements (see e.g., Core and Larcker (2002)), their trading decisions may convey little information. 2 Finally, since purchases through ESPPs reflect the aggregation of decisions of thousands of employees, the noise in the individual information sets may be averaged away resulting in a reliable signal of future performance. For example, aggregating the signals of all salespeople who interact with firm s clients on a daily basis might provide a more powerful indicator of future demand for the firm s products than information possessed 1 Before August 29, 2002, Section 16(a) insiders were required to report their trades to the SEC no later than the 10th day of the next calendar month. After August 29, 2002, trades have to be reported within two business days. 2 Furthermore, insiders are explicitly precluded from capitalizing on their informational advantage since Section 16(b) of the Securities Exchange Act requires them to forfeit all trading profits made on round-trip transactions that take place within six months of each other. 2

3 by top management. We find that aggregate voluntary stock purchases by employees through ESPPs are positively and significantly related to future abnormal stock returns. Using a calendar-time methodology, we document that firms in the top quartile of employee stock purchases earn approximately 7% higher annual abnormal returns than firms in the bottom quartile. Since participation in ESPPs is typically open to all employees in the firm (often with the exception of top management) our evidence suggests that non-executives have price-relevant information in aggregate. A cross-sectional regression of one-year buy-and-hold abnormal returns on a proxy for extent of ESPP participation reveals that purchases under ESPP have a greater forecasting power for stock returns than do purchases of stock by top management. Our empirical analysis uses data on ESPP participation obtained by a manual search of 10-K forms of S&P 500, S&P 400 midcap, and NASDAQ 100 constituent firms for the fiscal years 2002 to Whenever a firm has an ESPP (approximately 46% of firms), we find the detailed terms of the plan by locating the contract in previous 10-K, 10-Q, 8-K, or S-8 forms. Our sample consists of 411 unique firms and 2,230 firm-year observations with ESPPs. To our knowledge this is the first study on ESPPs that covers a sizable cross section. While it is plausible that the return forecasting power of ESPP participation is driven by information of top management, we provide several pieces of evidence that suggest otherwise. First, we find that ESPP participation is a much stronger predictor of future stock returns than is trading by top insiders. Second, we exploit statutory differences in the design of stock purchase plans. Tax-qualified plans are open to all employees, as required by tax regulation, whereas non-qualified plans are typically offered only to senior management. We find that ESPP participation is a significantly better predictor of future 3

4 abnormal returns for plans open to all employees, suggesting that it is unlikely that management participation can explain return predictability. Finally, we do not find any evidence that top insiders (who may have information but be reluctant to trade themselves) tailor the terms of a stock purchase plan to make it more attractive to lower level employees ahead of good news. In particular, ESPP participation forecasts returns even after we explicitly control for terms of the plan. We also examine how return forecasting ability of ESPP participation varies in the cross section. Approximately 28% of firms in our sample require employees to hold on to shares for a specified period of time after a purchase. For such firms, we expect ESPP participation to be a stronger predictor of future stock returns. Since holding shares in their own company is an undiversified bet for employees and their human capital is likely to be positively correlated with payoff on the stock, holding requirements impose a cost on the employees. This implies that only employees with strong positive information should buy the shares through ESPP. Indeed, we find that ESPP participation is a much stronger predictor of future abnormal returns for firms that have explicit sale restrictions. In line with prior findings for top executives (e.g., Seyhun (1986), Lakonishok and Lee (2001), and Jeng, Metrick, and Zeckhauser (2003)), we also find that the relation between lower level employee purchases and future abnormal returns is stronger for smaller firms. This is consistent with an intuition that smaller firms receive less attention from analysts and media, resulting in a greater information advantage to employees. However, it should be noted that all firms in our sample are relatively large, with the median firm having over three billion dollars in assets. We next try to shed some light on the kind of information that employees possess. One possibility is that employees have a sense when the reported ac- 4

5 counting numbers are not reflective of the actual firm performance. As a result, they may be able to identify periods of overvaluation of their stock due to inflated earnings. For example, prior literature shows that earnings restatements are associated with a large negative market reaction (e.g., Dechow, Hutton, and Sloan (1996) and Palmrose, Richardson, and Scholz (2004)). To check whether our intuition is borne in the data, we examine the relation between ESPP purchases and the likelihood of observing earnings restatements in the future. We find that a one standard deviation decrease in the ESPP participation is associated with an increase in the probability of restatement in the next fiscal year of approximately 4.3%, which is statistically and economically significant, since the average likelihood of a restatement is 5.2% in our sample. We also find that greater employee participation in ESPP is associated with a lower likelihood of a break in a string of consecutive earnings increases and a higher likelihood of the firm being the target of a takeover. Overall, these results suggest that employees have information about the accuracy of past accounting statements and about future prospects of the firm. Finally, we explore whether our evidence may be consistent with employees causing rather than forecasting higher returns. For example, it is possible that higher inflows of funds to the firm as a result of higher participation in ESPP relax firm s financing constraints and improve stock return performance. To address this issue, we check whether larger employee stock option exercises that are also a source of significant cash inflows predict higher future returns (see Babenko, Lemmon, and Tserlukevich (2011)). We find no such evidence, suggesting that it is unlikely that predictive power of ESPP participation is purely due to the relaxation of cash constraints. Another possibility is that higher future returns following high ESPP participation are due to higher effort exerted by the employees resulting from the increased equity ownership. To examine 5

6 this hypothesis, we extract the expected and unexpected portion of ESPP participation by projecting it on a number of firm specific and plan characteristic variables. Both expected and unexpected participation should lead to higher effort exertion, whereas information would only be reflected in the unexpected portion of ESPP participation. We find that all of the return forecasting ability is due to the unexpected participation. Additionally, option grants that also lead higher employee ownership do not predict future abnormal returns. Finally, higher motivation is an unlikely explanation because most employees dispose of their ESPP stock within a year. Thus our results do not support the view that higher ESPP participation causes high stock returns. The results in this paper have a number of implications. First, if market prices do not fully reflect the information in ESPP participation, it might be possible to design profitable trading strategies. Current regulations require disclosure of trades only by Section 16 insiders. If trades by other employees contain additional information about future firm performance, regulations requiring disclosure of aggregate purchases and sales by employees are likely to improve market effi ciency. Second, if shareholders do not realize that higher purchases through ESPP tend to be followed by better stock price performance, they will systematically underestimate the compensation cost. For example, our crude estimates suggest that given 7% of abnormal returns in the next fiscal year, an employee contribution of $1, 900 per year, and the number of employees of 28, 000, the compensation expense will be underestimated by approximately $4 million per year for an average firm in our sample. Thus, it is possible that firms that have ESPPs may use it as a form of providing hidden compensation. Interestingly, our analysis of the survey data on satisfaction with ESPPs is broadly consistent with this view. We find that although firms satisfaction with the plan increases with wider employee participation, there is no relation 6

7 between firm satisfaction and longer retention of shares by employees. Finally, our paper contributes to the debate about the rationality behind the decisions of non-executive employees to hold significant amounts of firm s stock in their portfolios (for example, through a company-sponsored 401(k) plan). It would seem that investment in company s stock is not warranted given that under-diversification significantly reduces the risk-adjusted value of employees portfolio, sometimes by more than 50% (Meulbroek (2002)). In addition, Poterba (2003) and Benartzi and Thaler (2007) argue that investing in company s stock involves additional risk since employees human capital is undiversified and positively correlated with the firm s stock returns. On the other hand, Van Nieuwerburgh and Veldkamp (2006) argue theoretically that investing in their own stock can be optimal for employees if they can choose to learn about their firm s future and thereby have an information advantage. The results in this paper suggest that voluntary purchases of company stock through ESPPs might partially be driven by information advantage, which is broadly consistent with their view. The rest of this paper is structured as follows. Section I describes employee stock purchase plans and provides a brief literature review. Section II describes our data sources and section III presents empirical results. Section IV concludes with a brief summary. 1 Background 1.1 Related Literature Our paper is related to the insider trading literature that documents that executives and directors earn abnormal returns on their stock purchases (Seyhun (1986), Lakonishok and Lee (2001), Fidrmuc, Goergen, and Renneboog (2006), 7

8 and Ravina and Sapienza (2009)). Several papers analyze whether the timing of stock option exercises is driven by private information and report mixed evidence. 3 Finally, the indirect evidence provided by the survey data indicates that managers systematically overvalue their stock options relative to the Black- Scholes value (Hodge, Rajgopal, and Shevlin (2006)), which may suggest that they have informational advantage. While our results on participation by employees in stock purchase plans are broadly consistent with these findings, we focus on decisions by non-executive employees rather than firm insiders. The three papers that analyze whether non-executives have private information are Huddart and Lang (2003), Benartzi (2001), and Cohen (2009). In particular, Benartzi (2001) and Cohen (2009) investigate the discretionary contributions by employees to their 401(k) plans and find that employee contributions to company stock do not predict future returns. 4 Huddart and Lang (2003) examine option exercises by lower-level employees at seven large firms and document that when option exercises are low the stock returns are 10% higher in the next six months than when option exercises are high. One difference between employee stock options and ESPPs is that the latter are typically open to everyone in the firm, while stock options (even in broad-based plans) are mostly given to senior level employees. Another difference is that employees have to make an active decision of whether to participate in ESPP, while stock options are granted to employees by the firm. Finally, Aboody, et al. (2008) point out the diffi culty with tests of information hypothesis that use stock option exercise data since a significant fraction of exercising employees do not sell 3 Carpenter and Remmers (2001) find no abnormal returns following stock options exercises in the post-1991 period, while Huddart and Lang (2003), Aboody et al. (2009), and Cicero (2009) document that executives possess timing ability with respect to option exercises. 4 One important difference between 401(k) plans and ESPP is that the discount provided in 401(k) plans is very large (typically 50%) encouraging the participation even by those employees who have negative information. In addition, many employees treat participation in 401(k) plans as forced saving for retirement and thus may be less likely to act on their information. 8

9 the stock following the exercise. Our paper also contributes to the literature related to the own-company stock puzzle. A number or articles focus on participation by employees in 401(k) retirement plans and document that participants violate the basic principle of diversification by investing significant fractions of their savings in company stock (see e.g., Benartzi (2001), Benartzi and Thaler (2001), Huberman and Sengmueller (2004), Cohen (2009), and Poterba (2003)). While the previous literature attributes such behavior to employee inertia, absence of well-defined preferences, familiarity, loyalty, or other biases in decision making, our paper provides first evidence that employees may have private information about their company, which makes the investment in their own company s stock more attractive. Finally, since we document generally low participation rates in ESPP and the positive correlation between participation and contemporaneous stock returns, our work also contributes to the literature on employee inertia (Benartzi (2001), Benartzi and Thaler (2007), Choi, Laibson, Madrian and Metrick (2002), Englehardt and Madrian (2004)), 5 and a long-standing puzzle of a low participation of households in the stock market (see e.g., Mankiw and Zeldes (1991) who report that over 70% of households held no stocks at all in 1984). The most appealing explanation of limited stock market participation rests on the notion of fixed costs of participation (see e.g., Basak and Cuoco (1998) and Vissing-Jorgensen (2002)). In our setting of ESPPs, the fixed costs do not offer an appealing explanation to low participation rates since companies often pay the transacation costs and make it extremely easy to set up the brokerage accounts. 5 Englehardt and Madrian (2004) document for a particular company a participation rate in the ESPP of the order of 40% despite the fact that all employees could increase their gross compensation by participating. They find that participation rates tend to increase with income, employee tenure at the job, and are higher for males than for females. Englehardt and Madrian (2004) do not analyze however, whether participation rates predict future stock return performance. 9

10 Other proposed explanations to low stock market participation stress the importance of individual preferences, such as the asymmetric aversion to gains and losses (Ang, Bekaert, and Liu (2005)), the lack of trust (Luigi, Sapienza, and Zingales (2008)), and the general awareness about stock market (Hong, Kubik, and Stein (2004), and Brown, et al. (2008)). In case of ESPPs, it seems that employees are in a social environment that makes it easy to discuss the benefits and costs of the plan with other employees, making the lack of awareness explanation less plausible. 1.2 Employee Stock Purchase Plans Employee Stock Purchase Plan (ESPP) is a company-run program in which participating employees can purchase company shares at a discounted price. Some plans simply allow employees to buy stock using their own money. Most plans, however, are designed so that employees contribute through payroll deductions, which build up between the offering date and the purchase date. At the purchase date, the company uses the accumulated funds (typically without interest) to purchase shares in the company on behalf of the participating employees. The amount of the discount depends on the specific plan but most often it is set at the 15% off the market price. From time to time employees are allowed to increase or decrease their contributons to the plan during the offering period, andd most firms allow to withdraw from the plan up to the date of the actual purchase. Most of the ESPPs are tax-qualified (423 plans). 6 To satisfy the requirements of the section 423 treatment, a plan has to (1) allow the participation 6 For tax-qualified plans, the company does not get any tax deductions as long as employees sell the shares two years after the offering date and at least one year after the purchase date (qualified disposition). Employees do not pay any tax at the time of purchase. At the time of sale, employees at taxed at ordinary income tax rate on the amount of either (1) discount they received at the time of grant or (2) the total gain, i.e., the spread between the purchase price and sale price, whichever is lower. 10

11 by all employees, with exception of executives who own more than 5% of firm s stock 7 (2) set the discount at no more than 15% of the price on the grant date or purchase date, whichever is lower (3) guarantee that no single employee contributes to a plan more than $25,000 per year and (4) set the offering period at no more than 27 months if there is a lookback feature. 2 Data and Summary Statistics We obtain our data set on employee stock purchase plans from the hand-search of 10-K forms for the sample of firms in the S&P 500 index, NASDAQ 100 index, and the S&P 400 midcap index over the fiscal years from 2002 through If the company has an ESPP, we also pull out a detailed ESPP contract put forth by firm s shareholders; such contracts are typically located in the past 10-K, 10- Q, 8-K, or S-8 forms. To our knowledge, this is the first comprehensive data set on employee stock purchase plans. Previously Englehardt and Madrian (2004) used detailed time-series data on a single health care company, while Bhagat, Brickley, and Lease (1985) studied the market reaction to authorizations of 130 stock purchase plans during 1970 through Our data set has information on whether the company has an ESPP, whether the plan is tax-qualified (423 plan), the percentage of compensation that employees are allowed to allocate to stock purchases, the maximum number of shares that can be purchased each year, the number and price of shares issued through a plan during a fiscal year, the length of the offering period, whether the plan allows for a lookback feature, the discount at which shares can be bought, and the length of the minimal period during which the employees can not dispose of the acquired shares. The initial sample contains data on 411 firms with ESPPs over the period 7 In addition a company is allowed (but not required) to exclude employees with less than two years of tenure, employees working less than 20 hours per week, and highly compensated employees, as defined in section 414(q) of the Code. 11

12 , a total of 2,230 firm-year observations or approximately 46.3% of firm-years that we hand-searched. Some firms in the sample have fewer than six years of coverage because of the unavailability of 10-K forms or because of firm entry or exit. The data on stock purchase plans are merged with financial data from the Compustat database using company name and ticker. Since we focus on S&P 500, S&P 400 midcap, and NASDAQ 100 firms, our sample is naturally tilted toward larger and more mature firms (Table I). For example, total assets of an average firm in our ESPP sample are more than two times those of an average firm in Compustat over the same period. Firms in our sample also tend to have smaller research and development expenses and smaller Tobin s Q than Compustat firms, and are more likely to pay dividends. While there is always a concern whether inferences can be made beyond our sample, to the extent that employees should have higher informational advantage in smaller firms with more growth options, we expect our results to be even more pronounced in a broader sample. The summary statistics for our sample with ESPPs are reported in Table II. Over 82% of stock purchase plans are considered qualified for tax purposes. Companies issue on average 0.31% of outstanding shares for the purchases by employees in these plans. Each year employees contribute on average $24.5 million to the firm, or approximately $1,882 per employee. 8 While we do not have comprehensive data on participation in ESPPs (other than share issuance or survey data), the participation rates for companies that voluntarily report them are low at less than 33% on average. Interestingly, participation rates vary substantially from year to year even within a single firm when the terms of the plan do not change. The contract features of stock purchase plans are also provided in Table II, Panel A. Typically plans allow to purchase stock at a 15% discount from the 8 This estimate assumes (counterfactually) that all employees participate in the plan. 12

13 market price, although some firms offer no discount at all and some provide a whooping 75% discount. Approximately 70% of all purchase plans have a lookback feature, although because of expensing changes there has been a recent tendency in elimination of this feature (76% of plans have it in 2002, and only 60% in 2007). The lookback feature allows employees to purchase stock at the discounted price based on the lower of prices at the beginning and the end of the offering period, thereby increasing the average gain from participating in the plan. The average offering period is slightly over 6 months in our sample, but the variation in offering periods is large ranging from 1 to 27 months. Interestingly, most stock purchase plans do not require employee to hold stock following the purchase for any period of time. We find that only 27.6% of firm-year observations specify that employees can not dispose of company s stock immediately. The minimum holding period in companies that do not allow immediate disposition ranges from 6 to 48 months, with the average of 17 months. We supplement our data with 2009 ESPP survey data purchased from the National Center of Employee Ownership (NCEO). 9 Since the survey is anonymous, it cannot be linked directly to our data. Nevertheless it allows us to make several interesting observations. Panel B of Table II shows the summary statistics for this sample. Interestingly, the participation rates are considerably higher for managers and salaried employees (37.6% and 34.5%) than they are for hourly workers (23.8%). In addition, managers and salaried employees contribute a larger percentage of their compensation to a plan (7.2% and 5.9%) than do hourly workers (4.2%). The other notable feature of data is that a higher proportion of senior employees tends to retain the stock following the stock purchase. For example, 74.1% of executives hold on to their stock, while only 9 Additional information about 2009 Employee Stock Purchase Plan Survey can be obtained from the NCEO web site ( 13

14 39.4% of hourly workers do not flip the stock immediately. These differences may be attributed to higher-paid employees having less-pressing liquidity needs or to the fact that the tax benefits of not disposing of the stock immediately are higher for employees with high ordinary tax rates. 3 Empirical Results 3.1 Abnormal Returns and ESPP Participation To see whether employees have private information about their firm s prospects we regress the annual buy-and-hold abnormal returns (BHARs) for the one-year period starting the first July following the filing date of the 10-K form on the percentage participation in ESPP in the previous fiscal year. The participation is measured as the amount of dollars contributed by employee to a plan during the year, normalized by the annual dollar limit (typically $25,000) stipulated by the company. Our results are robust to using the alternative measures of participation, such as the number of shares issued through ESPP normalized by the number of shares outstanding, the dollar contributions per employee, and the number of shares issued through ESPP per employee. Results in Table III show that wider participation by employees in the ESPP is associated with statistically higher abnormal returns in the next year (column 1). For example, a one standard deviation increase in the participation is associated with 2.50% higher annual risk-adjusted returns. Similar results emerge if we use the dollar contributions per employee as the measure of employee participation in the plan (column 2). Column 3 presents results of regressions where we interact the sale restrictions dummy with employee participation in the plan. Our reasoning is that absent minimum holding requirements employees should participate in the plan regardless of whether they are optimistic about the fu- 14

15 ture s company prospects, so that participation variable should have a much smaller predictive power in absence of sale restrictions. We find that indeed in companies that do not allow employees to sell stock immediately after purchasing it through ESPP a one standard deviation in participation is associated with approximately 7.05% in abnormal annual returns. Results in column 4 provide further support for the information hypotheses since the predictability is significantly stronger in smaller firms. The results corroborate evidence on insider trading that top executives are able to predict stock returns in small companies but do not earn any abnormal returns in large companies (Lakonishok and Lee (2001)). 3.2 Alternative Explanations We next explore several alternative explanations to our results. First, we examine whether return predictability is primarily driven by participation of the top management in ESPP. Note, however, that under the majority of stock purchase plans, executives cannot contribute more than $25,000 per year. This implies that the combined contributions by top 20 executives account, on average, for only about 2% of total plan contributions for that year. To further examine this issue, we exploit the variation in the plan structure. Since tax-qualified (423) plans are open to all full-time employees with exception of top management, while non-qualified plans are typically open to only senior level employees, we expect that predictability should be larger for non-qualified plans if it is driven by purchases of executives and senior managers. In fact, we find the opposite effect with stronger predictability of returns in plans that are open to all employees in the firm (column 5). In addition, we explicitly control for the insider purchases made during the previous fiscal year (column 6) and during the same fiscal year (column 7) and find that economic effect of stock 15

16 purchases on future returns is greater for employees than it is for Section 16 insiders. Our results may be taken to imply that insiders are more reluctant to use their informational advantage because they are subject to greater public scrutiny, have more trading restrictions imposed by a firm, such as blackout periods (Roulstone (2003) and Bettis, Coles, and Lemmon (2000)), and face greater risk of prosecution for illegal insider trading. Another possibility is that informed top management of the firm is changing the terms of the employee stock purchase plan in such a manner as to make it more attractive to junior employees when management expects the stock to perform well. Although, such strategy on the part of the management may increase the total compensation of the employees, it is possible that when employees are initially hired this effect is already factored in their contract. For example, Roulstone (2003) finds that firms where insiders are restricted in their trading (e.g., have blackout periods), pay approximately 4 13% premium in total compensation to their insiders. Alternatively, if managers perceive an increased likelihood of a hostile takeover, they may want to put more stock in the friendly hands of employees by changing the terms of the stock purchase plan. It is possible that future stock returns will be higher when manager s information about a potential takeover becomes public. There are two reasons to believe why employees may react to changes in the plan. One reason is that when employees determine whether to participate in the plan they take into account their opportunity costs (e.g., time required to figure out the details, or alternative uses of cash required for purchases) and participate only when the plan is suffi ciently profitable. Another reason is motivated by the work of Benartzi (2001) and Madrian and Shea (2001) on the endorsement effect. Whenever employees see the change in the plan they view it as an implicit investment advice. 16

17 To determine whether there is any evidence of dynamic adjustment of stock purchase plans terms, we examine whether future stock returns are predicted by the changes in the discount rate offered by the firm, changes in the lookback feature, the maximum allowable number of shares that can be purchased in a plan, and the availability of the plan itself. We do not find any evidence of such predictability and conclude that it is unlikely that stock purchase plan terms are adjusted dynamically with the foresight of improvements in firm performance. In addition, our results remain virtually unchanged if we explicitly control for the characteristics of the plan in cross-sectional regressions (column 8). 10 Finally, we explore the alternative hypothesis that the stock purchases cause (rather than forecast) the improvements in firm performance. Earlier work on employee stock purchase plans primarily focused on the hypothesis that employees exert higher effort after owning more stock and found mixed evidence for non-executive employees (Bhagat, Brickley, and Lease (1985)). To address this concern, we regress the future abnormal returns on the expected and unexpected components of employee participation in ESPP. If our results are primarily driven by better motivation or effort of employees, we should see that any increase in participation rates leads to improvements in performance. For example, if the company increases the offered discount from 5% to 15%, it is expected that the participation of employees increases as well. In this case, we should see that the performance improves if the greater stock ownership motivates employees, whereas we should see no effect if the link between returns and purchases is due to employees information. To disentangle these effects, we decompose the ESPP participation into the expected and unexpected components. The expected component is defined as 10 Our results do not rule out a possibility that management conveys information to employees without changing the terms of the plan. In fact, the NCEO (2009) survey indicates that many firms with ESPPs organize periodic information sessions, in which employees can talk to top management and ask them questions. 17

18 the fitted value from the regression of participation rate on firm size, dividend payer dummy, R&D, market-to-book ratio, leverage, volatility, year and industry dummies, and the terms of the stock purchase plan (discount, sale restrictions dummy, lookback dummy, length of the offering period, tax status, and the percentage of compensation employees are allowed to contribute). The unexpected component is the residual from this regression. Results in columns 9 and 10 reveal that the predictability of returns is driven primarily by the unexpected component of ESPP participation, which is consistent with the information hypothesis. For example, a one standard deviation in the unexpected contributions per employee is associated with a 4.27% in future abnormal returns, whereas the coeffi cient on the expected component is virtually zero. Another test to distinguish between the information and effort hypotheses would be to check whether option grants forecast future returns. Unlike ESPP participation, option grants are not a choice made by employees and hence should not generally convey information. If ESPP participation forecasts returns because of higher employee motivation or effort, then option grants should also exhibit similar results. Using the data on all employee stock option grants from the RiskMetrics database, we show that option grants do not forecast future returns, whereas ESPP participation forecasts returns even after controlling for option grants and exercises by employees. Option exercises, which reflect choices made by employees, weakly forecast negative abnormal returns. This suggests that future positive abnormal returns following high ESPP participation are not caused by higher employee motivation resulting from higher equity exposure. Additionally, the evidence on option exercises indicates that it is unlikely that the return predictability of ESPP participation is due to the relaxation of financing constraints (Kraus (1972), Babenko, Lemmon, and Tserlukevich (2010)). 18

19 3.3 Calendar Time Tests Since higher participation rates may be higher across all firms in certain periods of time (e.g., employee sentiment about stock market increases), it is possible that there is clustering of participation rates that affects the statistical inference in our cross-sectional tests. Therefore, we cluster standard errors in regressions presented in Table III by industry and year. However, to check the robustness of our results, we also test whether there is return predictability using a calendar time approach similar to that recommended by Lyon, Barber, and Tsai (1999). At the end of every June from 2003 to 2008, we identify all firms in our sample that filed form 10K within the last 12 months. Using information contained in these forms, we construct two variables - shares issued under ESPP as a proportion of shares outstanding, and contributions per employee. Firms are then sorted into quartiles based on both these variables and assigned to quartile portfolios from July of that year to June of the subsequent year. The returns for all firms in a quartile portfolio are averaged for each calendar month to obtain a monthly return series for each quartile portfolio. We then regress the time series of portfolio returns for each quartile portfolio on the three Fama-French factors. This method can be viewed as testing whether a trading strategy that goes long in the firms in the highest quartile based on ESPP participation and short in the lowest quartile, with annual rebalancing, yields positive abnormal returns during our sample period. Table IV shows the coeffi cients and intercept from regressing the monthly returns for the four quartile portfolios and the longshort strategy. We see that the long-short trading strategy yields a positive abnormal return of 0.58% per month, if firms are sorted based on contributions per employee. The abnormal returns for each of the four quartile portfolios are shown in the first to fourth columns. If firms are sorted into quartiles based on shares issued as a proportion of shares outstanding, the resultant trading 19

20 strategy yields a positive abnormal return of 0.72% per month. These values are statistically significant, and translate to more than 7% annual abnormal returns. A possible concern is that the above trading strategy systematically purchases stocks with certain characteristics that tend to have a high return on an average and shorts stocks with characteristics that tend to have lower returns. To address this issue, we modify the above calendar time methodology as follows. For every firm, we identify a portfolio of firms with similar size, book-to-market, and momentum characteristics. The assignment of firms into characteristic portfolios is described in detail in Appendix A. We next obtain characteristic-adjusted abnormal returns for all firms and all months by subtracting the return on the portfolio of firms with similar characteristics from the return of the firm. We use these characteristic-adjusted abnormal returns instead of raw returns in the above calendar time methodology. This test can be thought of as a trading strategy that does the following. Buy all stocks in the top quartile. For each stock in this portfolio, short a portfolio of stocks with similar characteristics. Next, short all stocks in the bottom quartile. For each stock in this portfolio, go long a portfolio of stocks with similar characteristics. Therefore, this strategy does not have a systematic long or short exposure to stocks with any particular characteristics. Alphas from regressing the monthly returns on this trading strategy on Fama-French factors are presented in the fifth column of Panel C of Table IV. The strategy yields abnormal returns of 0.61% per month during our sample period, which is statistically significant. These results lend further support to the forecasting power of ESPP participation for future returns. 20

21 3.4 Earnings Restatements, Earnings Breaks, and Acquisitions To gain some understanding of what kind of information the non-executive employees have examine future earnings and corporate events. First, we look at the sample of earnings restatements. Our hypothesis is that greater ESPP participation by (informed) employees should be associated with lower likelihood of restatements. The anecdotal evidence suggests that employees are sometimes able to identify the accounting problems at the firm. For example, Tenet Healthcare corporation disclosed in July 2005 that the SEC had asked the company to investigate allegations the commission had received from a former company employee. The former employee had alleged that inappropriate managed care reserves may have been taken at three Tenet hospitals in California through at least fiscal Our goal is to investigate whether employees are indeed able to systematically predict earnings restatements. The restatements data is collected and maintained by the U.S. Government Accountability Offi ce (GAO) for the period from July, 2002 through June, Previous research has documented that earnings restatements are met with a significant negative market reactions (see e.g., Palmrose, Richardson, and Scholz (2004) who report that two-day abnormal announcement return is -9%). We focus on restatements in which the company either incorrectly recognized revenue or cost or expense items since according to GAO these two categories of restatements result in greatest losses of market value. There are 46 such earnings restatements in our sample, most of them are initiated by the company. 11 Results in Table V suggest that larger participation by non-executive employees in the ESPP is associated with a 3.75% lower likelihood of a future 11 Previous research has identified that restatements that are initiated by auditor or SEC are assiciated with larger negative market price reaction. We do not confine our attention to such announcements because there are only 9 of them in our sample. 21

22 earnings restatement by a company (column 1). This is an economically significant number since the average likelihood of earnings restatement is only 5.23% in our sample. The results largely remain the same if we control for the firm size, market-to-book ratio, insider trading, firm s cash flow and stock returns over the previous year (column 2). Next, we investigate whether employees have information about the upcoming earnings announcements. We use the methodology similar to that of Ke, Huddart, and Petroni (2003), who focus on insider sales prior to the break in earnings increases. Ke, Huddart, and Petroni document that breaks in earnings are associated with significant negative market price reactions. To identify a break in earnings, we use the basic earnings per share (EPS) data from the quarterly Compustat. We set the break equal to one if the quarterly earnings have been increasing in the past and the current earnings are below the last year s earnings of the same quarter. The model is estimated by logit, where the dependent variable is equal to one if there is a break in earnings in the next fiscal year following the year of ESPP participation. Results in columns 3 and 4 indicate that greater participation by employees in ESPP is associated with a lower likelihood of earnings break. For example, a one standard deviation in ESPP participation translates in approximately 2.51% lower chance of firm decreasing earnings after a string of previous increases. The magnitude of this effect remains very similar once we control for firm characteristics. Finally, we explore whether employees are able to predict whether the firm becomes a target of an acquisition in the next fiscal year. Since targets typically experience significant positive returns at the announcement of the deal, it is possible that employees private knowledge about a future potential merger or an acqusition may translate into information about future stock returns. Results in columns 5 and 6 indicate that indeed employee s higher participation in the 22

23 ESPP is associated with a higher likelihood of a firm becoming an acqusition target in the next year. The economic magnitude of the effect is modest. For example, a one standard deviation in ESPP participation increases likelihood of a takeover by approximately 1.05% (column 6). This is reasonable since our sample consists of large profitable firms which have a low unconditional probability of being taken over. Overall our evidence suggests that employees in aggregate possess pricerelevant information and it seems that their decisions to purchase equity of their firm are more informative than those of the top management about future stock returns. 3.5 Determinants of ESPP Participation and the Own- Company Stock Puzzle Having established that employees have informational advantage for trading in their company s stock we now turn to examine what factors (aside from expectations about future stock returns) determine the participation of employees in the stock purchase plans. We would like to shed some light on why so many employees leave a considerable amount of money on the table by not participating in the ESPP. For example, a well-paid employee who can contribute up to $25,000 per year to a plan an decides not to participate, forfeits approximately $1,750 because of the informational advantage (assuming 7% abnormal return), $3,750 because of the discount offered by a company (assuming 15% discount), and approximately $1,500 because of the lookback feature (assuming there is one), a total of $7,000 per year. We regress ESPP participation on variables that capture different reasons for participation. Cohen (2009) argues that loyalty results in employees investing in the equity of their own firm in their 401-K accounts. This could also 23

24 be a factor in ESPP participation. To proxy for this we include two variables used by Cohen (2009): i) whether the firm is in the list of Fortune magazine s best employers, and ii) the leverage of the firm. Employees might extrapolate from past performance of the firm. Alternatively they might follow a contrarian strategy, like suggested in Jenter (2005). To capture this, we include past and contemporaneous stock returns in the regressions. When employees are less liquidity constrained, they might purchase more stock of their firm. We attempt to capture relaxing and tightening of liquidity constraints through past returns of the market index. Ambiguity averse employees might be less willing to purchase stock of their own firm. We try to capture this by including stock return volatility in the regressions. Perceived or actual information advantage is another factor that might affect ESPP purchases. To proxy for this we include R&D intensity, dividend payer dummy, market-to-book ratio, and firm size in the regression. In another specification, we control for stock purchase planspecific variables (tax-qualified dummy, discount, lookback, sale restrictions, offering period, and the percentage of compensation allowed by the company). Our findings are summarized in Table VI and offer support to several possible explanations. Specifically, we provide support for the information hypothesis since participation rates tend to be positively related to R&D investment, market-to-book ratios, and are negatively related to being a dividend payer. Interestingly, we find no evidence of ambiguity aversion since employees tend to participate more vigorously in ESPPs in firms with high stock return volatility. This evidence may also be taken to imply that employees perceive to have greater informational advantage in companies with volatile stock returns. We also find some support for momentum trading or extrapolation of previous returns by employees, since contemporaneous returns are positively correlated with participation rates. However, since our data is aggregated at the annual 24

25 level, these results may also be consistent with contributions to ESPP at the beginning of the year predicting the returns at the year end. In addition, unlike Benartzi (2001) who studies retirement plans, we find no correlation between past stock returns and ESPP participation rates. Interestingly, the participation is positively related to past market stock returns. These results may be consistent with individual biases in decision making such as regret-aversion. However they are more likely to be indicative of liquidity-constraints being relaxed following good performance of the stock market. We also find support for the loyalty-based explanation proposed by Cohen (2009) since ESPP participation rates tend to be significantly higher in firms that are classified as best 100 employers to work for by the Fortune magazine, and are negatively related to firm leverage. Finally, as expected, the participation rates tend to respond to the characteristics of the stock purchase plan itself. To this end, participation is positively related to discount, the length of the offering period, and the lookback feature that make the ESPP more attractive investment choice. The sale restrictions that prohibit the immediate disposition of stock following the purchase are a negative predictor of participation rates, albeit not statistically significant. 3.6 Company s Satisfaction with ESPP Since our results offer new evidence that participating in ESPPs is profitable to employees, we also examine why firms encourage such participation. One possible explanation is similar to an argument in Hall and Murphy (2003) for why firms use stock options. The expense for compensating employees through ESPP appears to be relatively small to shareholders, since the accounting expense does not take into account informational rents. At the same time, the employees who are able to pocket significant realized gains from ESPP par- 25