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

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1 Do non-executive employees have information? Evidence from employee stock purchase plans. Ilona Babenko and Rik Sen June 30, 2011 Abstract Using a novel data set on employee stock purchase plans (ESPPs), we examine whether lower-level employees have information about future firm performance. We find that high ESPP purchases are associated with a lower likelihood of future adverse events (earnings restatements and earnings breaks), and a higher likelihood of favorable events (the firm becoming a takeover target). Further, firms in the top quartile of aggregate ESPP purchases outperform those in the bottom quartile by 6 to 9% in the year after purchase. The return predictability is unlikely to be driven by trading of top management or greater employee motivation. Our results have implications for firms using employees as a source of capital, role of employees in internal governance, and market effi ciency. Babenko is at Arizona State University; Sen is at Hong Kong University of Science and Technology. We thank Simi Kedia (the AFA discussant), Kai Li (the discussant), Nittai Bergman (the discussant), John O Brien, Jeff Coles, Sudipto Dasgupta, Xiaohui Gao, Michael Lemmon, Laura Lindsey, Roni Michaely, Mark Seasholes, Chester Spatt, Geoffrey Tate, David Yermack, and the participants at American Finance Association 2011 Meetings in Denver, Rothschild Caesarea Center 8th Annual Academic Conference (IDC Israel), and in seminars at Arizona State University, Carnegie Melon University, HKUST, Nanyang Technological University, National University of Singapore, New Economic School, Simon Fraser University, Singapore Management University, and University of Hong Kong for valuable comments. We are grateful to Minjeong Kang, Tao Chen, and Smita Kedia for excellent research assistance. 1

2 Trading by corporate insiders in their company stock commands widespread attention in the financial community. The academic literature in this area 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 lowerlevel employees, and whether employees have price-relevant information is an open question. 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), which are company-run programs that allow participating employees to purchase company shares at a discounted price. To our knowledge, we are the first to provide broad-based evidence that lower-level non-executive employees have information about their companies future stock performance. There are several reasons why purchase decisions by lower-level employees through ESPPs may be more informative about future firm performance than trades by 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 risk attracting allegations of insider trading. In addition, since top executives may buy stock to send a signal to the market or to meet minimum ownership requirements (see, e.g., Core and Larcker (2002)), their trading decisions may convey little information. 2 Finally, since purchases through 1 Before August 29, 2002, Section 16(a) insiders were required to report their trades to the SEC no later than the tenth day of the next calendar month. Since August 29, 2002, trades have had to be reported within two business days. 2 Furthermore, insiders are explicitly precluded from capitalizing on their information advantage since Section 16(b) of the Securities Exchange Act requires them to forfeit all 2

3 ESPPs reflect the aggregation of decisions of thousands of employees, the noise in the individual information sets is averaged away, resulting in a more reliable signal of future performance. 3 For example, Wolfers and Zitzewitz (2004) note that an employee prediction market at Hewlett-Packard produced more accurate forecasts of printer sales than did the firm s internal processes; similarly, employee trading at Siemens accurately predicted that the firm would fail to deliver on a software project on time, even when traditional planning tools suggested that the deadline could be met. We obtain data on ESPP participation by conducting 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 through For firms with ESPPs (2,204 firm-years and 411 unique firms), we obtain the detailed terms of the plan by locating the contract in previous 10-K, 10-Q, 8-K, and S-8 forms or proxy statements. This is, to our knowledge, the first study of ESPPs that covers a sizable cross section. Using a calendar time methodology, we find that firms in the top quartile of employee stock purchases earn approximately 6 to 9% higher annual abnormal returns than firms in the bottom quartile. In a cross-sectional regression setting, ESPP participation forecasts oneyear ahead buy-and-hold abnormal returns. Since participation in ESPPs is typically open to all employees in the firm (often with the exception of top trading profits made on round-trip transactions that take place within six months of each other. 3 Surowiecki (2003) argues that even if most of the people within a group are not especially well-informed or rational, the aggregation of information of independently acting individuals can lead to a collectively wise decision. He provides a wealth of anecdotal evidence of a wisdom of the crowds effect in diverse contexts. A similar argument likely holds in the context of aggregate ESPP purchases, where each individual employee might not be very well informed, but can draw upon some local knowledge when deciding whether to participate in the ESPP. 3

4 management), our evidence suggests that non-executives have price-relevant information in the aggregate. If the empirical relation between ESPP participation and future returns is driven by information of employees, it should be stronger when employees are likely to have greater informational advantage over outside investors. Indeed, we find that return predictability is greater in small firms, firms followed by fewer analysts, and those with a high dispersion of analyst forecasts. 4 However, it should be noted that all of the firms in our sample are relatively large and liquid, with the median firm having over $3 billion in assets. These results provide further evidence that purchases through ESPPs reflect valuable information that has not been incorporated into the firm s stock price. We also document that purchases through ESPPs forecast higher positive returns when they impose a greater cost on employees. Specifically, ESPP participation is a stronger predictor of future abnormal returns for firms that explicitly require employees to hold on to ESPP shares. Since holding comany stock is an undiversified bet for employees, such explicit restrictions impose a particularly high cost on employees when stock return volatility is high. Accordingly, we find that ESPP participation is an even stronger predictor of future returns for firms with explicit sale restrictions and more volatile stocks. We examine and reject a number of possible alternative explanations for the relation between ESPP purchases and future abnormal returns. While it 4 This is similar to findings in the literature about information possessed by top executives (e.g., Seyhun (1986), Lakonishok and Lee (2001), and Jeng, Metrick, and Zeckhauser (2003)) 4

5 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 stronger predictor of future stock returns than is trading by top insiders. Second, ESPP participation is a significantly better predictor of future abnormal returns for tax-qualified plans that are open to all employees, as required by tax regulation, than it is for non-qualified plans that are typically offered to senior management. 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. Another alternative explanation for our results is that ESPP purchases cause rather than forecast higher returns. For example, higher returns following higher ESPP participation could be due to higher effort exerted by the employees after the increase in equity ownership (Kedia and Mozumdar (2002), Hochberg and Lindsey (2010)). To examine 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 employee effort, 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. Further, option grants to employees, which should also induce effort, are not related to future abnormal returns. Another possibility is that high ESPP participation proxies for an unobservable risk factor not captured by matching on size, B/M, and momentum 5

6 characteristics. If this is indeed the case, the relation between abnormal returns and participation is likely to be persistent over time. However, we find that return predictability becomes considerably weaker for the 13 to 24 month period after the 10-K s filing date and disappers completely over longer horizons. Overall, this evidence suggests that it is unlikely that ESPP participation proxies for risk characteristics. Finally, it could be that higher inflows of funds to the firm as a result of higher participation in an ESPP ease the firm s financing constraints and improve stock return performance. We check whether larger employee stock option exercises, which are also a source of significant cash inflows (see Babenko, Lemmon, and Tserlukevich (2011)), predict higher future returns. We find no such evidence, suggesting that it is unlikely that the predictive power of ESPP participation is due purely to the easing of cash constraints. 5 In fact, we find some evidence that option exercises are negatively related to future abnormal returns, which is consistent with employees foreseeing future underperformance of the firm and exiting their exposure. Finally, ESPP participation cannot affect past accounting irregularities by the firm. We find that ESPP participation is associated with the lower likelihood of an earnings restatement, which is not consistent with the interpretation that ESPP participation causes better performance. Taken together, our results do not support the view that higher ESPP participation causes higher stock 5 Prior literature on whether stock option grants relax financing constraints is inconclusive. For example, Yermack (1995), Core and Guay (2001), and Kedia and Mozumdar (2002) conclude that firms option-granting decisions are partly driven by a desire of cashstrapped firms to substitute equity for salary. However, Oyer and Schaefer (2005) argue that it is diffi cult to distinguish between the motives for granting stock options to relax financing constraints or for sorting employees. 6

7 returns. We next try to shed some light on the kind of information that employees possess. One possibility is that employees sense when the reported accounting numbers do not reflect the actual firm performance. As a result, they may be able to identify periods when their stock is overvalued. For example, prior literature shows that earnings restatements are associated with large negative market reactions (e.g., Dechow, Hutton, and Sloan (1996) and Palmrose, Richardson, and Scholz (2004)). We find that ESPP purchases are negatively associated with the likelihood of an earnings restatement in the next year. This relation is statistically and economically significant. We also find that greater employee participation in a firm s ESPP is associated with a lower likelihood of a break in a string of consecutive earnings increases and a higher likelihood that the firm will be the target of a takeover. Overall, these results suggest that employees have information about the accuracy of past accounting statements and about the firm s future prospects. The fact that employees have price-relevant information about their firms has a number of implications. First, it can be optimal for firms to use informed employees as providers of capital (Garmaise (2008)). Consistent with this, Fama and French (2005) document that firms in the U.S. issue more equity to their employees than they do to outside investors through seasoned equity offerings. Second, informed employees who care about their firm s future can potentially act as a form of internal governance in the spirit of Acharya, Rajan, and Myers (2011). Since employees are important stakeholders in the firm and have power to withdraw their human capital, they can force the CEOs to take actions consistent with the long-term value 7

8 maximization. This argument requires that employees are informed since otherwise they would not be able to make judgements about CEO s actions. Third, it might be worthwhile for the management to try and extract the aggregate information that employees have about the firm s prospects when taking important decisions. Additionally, if the information in ESPP participation is not quickly and effi ciently incorporated into prices, it might be possible to design profitable trading strategies. Further, if shareholders do not realize that higher purchases through ESPPs tend to be followed by better stock price performance, they will systematically underestimate the compensation cost. Thus, it is possible for firms to use ESPPs as a form of hidden compensation. Finally, our results are consistent with the argument by Van Nieuwerburgh and Veldkamp (2010) that investing in their own stock can be beneficial for employees if they can choose to learn about their firm s future. Our paper is the first to provide broad-based evidence that lower-level employees hold relevant information about their firms. Huddart and Lang (2003) analyze option exercises by lower-level employees at seven large firms and find that the stock returns are 10% higher in the six months following low option exercises. Our results are consistent with those of Huddart and Lang (2003), but use a much larger sample. Additionally, there are important differences between the exercise of stock options and ESPP participation. First, ESPPs are typically open to everyone in the firm, whereas stock options (even in broad-based plans) are given primarily to senior employees. Second, Aboody et al. (2008) and Cicero (2009) point out that a significant fraction of employees do not sell their stock following the exercise, 8

9 which complicates the tests of the information hypothesis. We also contribute 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), and Ravina and Sapienza (2010)). Several papers also find evidence that executives successfully time stock option exercises (Huddart and Lang (2003), Aboody et al. (2008), and Cicero (2009)), whereas Carpenter and Remmers (2001) find no such evidence in the post-1991 period. However, surveys indicate that entry and mid-level managers systematically overvalue their stock options (Hodge, Rajgopal, and Shevlin (2009)), which suggests that managers have an informational advantage. Our results on participation by employees in stock purchase plans are broadly consistent with these findings. The rest of this paper is structured as follows. Section I describes employee stock purchase plans. Section II presents our data sources and section III discusses empirical results. Section IV concludes with a brief summary. 1 Background An Employee Stock Purchase Plan (ESPP) is a company-run program that allows participating employees to purchase company shares at a discounted price. money. Some plans simply allow employees to buy stock using their own Most plans, however, are designed so that employees contribute through payroll deductions, which build up between the offering date and the purchase date. From time to time, employees are allowed to increase 9

10 or decrease their contributions to the plan during the offering period, and most firms allow employees to withdraw from the plan up to the date of a purchase. 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 varies by the plan, but most often it is set at 15% off the market price. Most ESPPs also have a built-in option, called a lookback feature. The lookback feature allows employees to purchase stock at the discounted price based on the lower of the prices at the beginning and the end of the offering period, thereby increasing the average gain from participating in the plan. Most ESPPs are tax-qualified (423 plans) and require shareholder approval. 6 To satisfy the requirements of Section 423 treatment, a plan must (1) allow all employees to participate, except executives who own more than 5% of the 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 more than $25,000 per year to the plan; and (4) set the offering period at no more than 27 months if there is a lookback feature. 6 For tax-qualified plans, the company does not receive any tax deduction as long as employees sell the shares more than 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 are taxed at the 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. 7 In addition a company is allowed (but not required) to exclude employees with less than two years tenure, employees working less than 20 hours per week, and highly compensated employees, as defined in section 414(q) of the Code. 10

11 2 Data and Summary Statistics We obtain our data set on employee stock purchase plans by manually searching 10-K forms for the sample of firms in the S&P 500 index, the NASDAQ 100 index, and the S&P 400 midcap index for the fiscal years 2002 through For companies with ESPPs, we obtain detailed descriptions of each plan. Such contracts are typically located in past 10-K, 10-Q, 8-K, or S-8 forms or in firm proxy statements. To our knowledge, this is the first data set on employee stock purchase plans covering a large cross section and time series. Previously Englehardt and Madrian (2004) used detailed time-series data for a single health care company, while Bhagat, Brickley, and Lease (1985) studied the market reaction to authorizations of 130 stock purchase plans from 1970 through Our data set has information on whether a company has an ESPP, whether the plan is tax-qualified (a 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 the plan during a fiscal year, the length of the offering period, whether the plan has a lookback feature, the discount at which shares can be bought, and the length of the period (if any) during which the employees cannot dispose of the acquired shares. We start with the initial sample of 838 firms and 4,847 firm-year observations. Approximately 45.5% of the firm-years have an active ESPP, so our final sample contains data on 411 firms with ESPPs over the period , a total of 2,204 firm-year observations. Some firms in the sample have 11

12 fewer than six years of coverage because of the unavailability of 10-K forms or because of firm entry or exit. We also obtain data on employee stock option grants and exercises for firms in our sample. Most of these data are available through the RiskMetrics database; if the information is missing, we hand-collect it from firms 10-Ks. Since the maximum contribution to an ESPP is sometimes set as a percentage of an employee s annual compensation, we also need to collect employee wage data. The Compustat database records a staff expense item that has been used in the prior literature as a proxy for employee wages (e.g., Hanka (1998)). However, these data often include non-salary items, such as expenses associated with pension plans, and are available for fewer than 15% of firm-year observations in our sample. To avoid these issues, we obtain employee wage data from the website Glassdoor.com. These data are anonymously reported by firm employees and cover most of our firms. Additionally, there is a significant correlation of 0.53 between Compustat staff expense and the average reported wage. 8 We obtain analyst forecast information from I/B/E/S. Finally, we supplement our data with 2009 ESPP survey data purchased from the National Center of Employee Ownership (NCEO). 9 The data on stock purchase plans are merged with financial data from the Compustat database using company name and ticker ID. 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 (see Table I). For 8 A disadvantage of the Glassdoor.com data is that the average response rate is 2.49%. However, a low response rate is unlikely to introduce substantial bias since there is no correlation between the reported average wage and the response rate. 9 Additional information about the 2009 Employee Stock Purchase Plan Survey can be obtained from the NCEO website ( 12

13 example, the 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. Although there is always a concern whether inferences can be made beyond one sample, to the extent that employees should have a greater 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 0.30% of outstanding shares for the purchases by employees in these plans. Each year employees contribute on average $22.4 million to the firm, or approximately $1,723 per employee. 10 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 less than 40% on average. Employees might not choose to participate in ESPPs to the full extent due to transaction costs, liquidity constraints, and portfolio risk in cases where employees are explicitly or implicitly required to hold on to the shares for some time after purchase. Interestingly, participation rates vary substantially from year to year even within a single firm when the terms of the plan do not change. For example, the average coeffi cient of variation of ESPP participation rate, calculated for each firm using the time-series data, is over 30%. The contract features of stock purchase plans are also provided in Table 10 This estimate assumes (counterfactually) that all employees participate in the plan. 13

14 II, Panel A. Typically plans allow employees to purchase stock at a 15% discount from the market price, although some firms offer no discount at all and some provide a whopping 75% discount. Approximately 70% of all purchase plans have a lookback feature, although because of expensing changes there has been a recent tendency to eliminate this feature (76% of plans had it in 2002, and only 60% in 2007). The average offering period is slightly less than 7 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 employees to hold stock following the purchase for any specific period of time. We find that only 26% of firm-year observations explicitly specify that employees cannot dispose of company stock immediately. The minimum holding period in companies that do not allow immediate disposition ranges from 6 to 48 months, with an average of 17 months. Panel B of Table II shows the summary statistics for the survey sample. Since the survey is anonymous, it cannot be linked directly to our data. Nevertheless it allows us to make several interesting observations. Notably, 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 prominent feature of the data is that a higher proportion of senior employees tend to retain the stock following the stock purchase. For example, 74.1% of executives hold on to purchased stock, while only 39.4% of hourly workers refrain from selling the stock immediately. These differences may be because higher-paid employees have less pressing liquidity 14

15 needs or because the tax benefits of not disposing of the stock immediately are higher for employees with higher ordinary tax rates. 3 Empirical Results 3.1 Abnormal Returns and ESPP Participation To determine whether employees have private information about their firm s prospects we regress twelve month buy-and-hold abnormal returns (BHARs) for the period starting in the month after the filing month of the 10-K form on the percentage participation in ESPP. We calculate BHAR as the return on the stock over these twelve months minus the return on a portfolio of stocks with similar size, book-to-market and momentum characteristics during the same period. The assignment of firms into characteristic portfolios is described in detail in Appendix A. The participation is measured as the aggregate amount in dollars contributed by employees to a plan during the year, normalized by the maximum allowed annual contribution (typically $25,000) stipulated by the company. Our main results are robust to using alternative measures of participation, such as the number of shares issued through ESPP normalized by the number of shares outstanding, the dollar contribution per employee, the number of shares issued through the ESPP per employee, and the dollar contribution per employee normalized by the percentage of compensation the employees are allowed to contribute multiplied by the average employee wage. The results in Table III show that wider participation by employees in an ESPP is associated with statistically higher abnormal returns in the 15

16 next year (column 1). For example, a one standard deviation increase in participation is associated with 3.54% higher annual risk-adjusted returns. The results are similar when we use shares issued to ESPP during the year normalized by the number of shares outstanding as the measure of employee participation in the plan (column 2). When a firm imposes an explicit holding period requirement for purchases made under an ESPP, the cost of such a purchase would be higher from the employees perspective. For example, Benartzi (2001) and Cohen (2009) argue that employees who invest in their own company s stock take on additional risk since their human capital is positively correlated with the firm s stock returns. In such cases ESPP participation should be more closely related to future information. Further, since the average holding period is about 17 months, ESPP participation in these cases is likely to reflect relatively longer term information, which would correspond better to the time window over which the BHARs are measured. Column 3 presents the results of a regression, in which we include the interaction of a dummy variable that captures whether an employee is explicitly restricted from selling the shares after purchase with the aggregate level of employee participation in the plan. We find that in companies that explicitly restrict employees from selling stock immediately after purchasing it through an ESPP, participation is related to much higher future abnormal returns. A one standard deviation increase in participation for such firms is associated with an increase of approximately 5.31% in annual abnormal returns. We expect the cost associated with sales restrictions to be higher for more volatile stocks. Therefore the above effect would be amplified for such stocks. We test this hypothesis 16

17 by including a triple interaction term between ESPP participation, sales restriction dummy, and volatility of daily log-returns over the prior year (see column 4). We include the three double interaction terms and the three individual variables as controls. The coeffi cient on the triple interaction term is positive and statistically significant. This supports the hypothesis that in the presence of explicit sale restrictions ESPP participation is more strongly related to future firm performance for more volatile stocks. Our next set of test compares differences in predictability across firms with differences in the information advantage of employees relative to outsiders. Since information about large firms is more readily available to outsiders, we conjecture that employees of smaller firms enjoy a greater information advantage. The results show that the predictability of future returns using ESPP participation is significantly stronger in smaller firms (column 5). These results are in line with prior evidence on information in purchases by top executives. For example, Lakonishok and Lee (2001) show that top executives are able to predict stock returns in small companies but do not earn abnormal returns in large companies. When the firm is followed by a large number of analysts, market participants have regular access to information about the firm. Consequently the number of analysts following a firm should be negatively related to the information advantage of employees. Indeed we find that the relation between participation and future returns weakens significantly as the number of analysts increases (column 6). Similarly, when the dispersion of analysts forecasts is high, market participants are likely to have imprecise information about the future performance of a firm and employees might have a 17

18 greater information advantage. Therefore, the relation between ESPP participation and future returns should be stronger when analysts forecasts are widely dispersed. We measure analyst forecast dispersion by the calculating the standard deviation of earnings forecasts and scaling it by mean forecast. Column 7 shows that the interaction term of participation and analyst forecast dispersion is positive and statistically significant. Taken together, our results suggest that ESPP participation is a better predictor of future returns when employees are likely to have an information advantage over market participants. 3.2 Alternative Explanations We next explore several alternative explanations for the relation between ESPP participation and future abnormal returns. First, we examine whether return predictability is primarily driven by participation of the top management in ESPPs. Note that under the majority of stock purchase plans, executives cannot contribute more than $25,000 per year. This implies that the combined contributions by the top 20 executives account, on average, for only about 2% of total plan contributions for that year. To further examine this issue, we exploit variation in plan structure. Since tax-qualified plans are open to all full-time employees except top management and non-qualified plans are typically open only to senior employees, we expect to find greater return predictability for non-qualified plans if results are driven primarily by purchases of executives and senior managers. In fact, we find the opposite effect: stronger predictability of returns in plans that are open to all employees in the firm (see column 1 of Table IV). In ad- 18

19 dition, explicitly controlling for the insider purchases made during the same fiscal year (column 2), we find that the economic effect of stock purchases on future returns is greater for employees than it is for Section 16 insiders. 11 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; they have more trading restrictions imposed by a firm, such as blackout periods (Roulstone (2003) and Bettis, Coles, and Lemmon (2000)); and they face greater risk of prosecution for illegal insider trading. Another possibility is that firm s top management establishes 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 a strategy on the part of the management may increase total employee compensation, it is possible that when employees are initially hired this effect is already factored into their contracts. For example, Roulstone (2003) finds that firms where insiders are subject to trading restrictions (such as blackout periods) pay a 4-13% premium in total compensation to their insiders. Alternatively, if managers perceive the 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 managers information about a potential takeover becomes public. There are two reasons to believe that employees react to changes in ESPP plans. One is that they take into account their opportunity costs of 11 Similar results are obtained if we control for insider purchases made during the previous fiscal year or for insider sales. 19

20 plan participation (e.g., time required to figure out the details, or alternative uses of the cash required for purchases) and participate only when a plan is suffi ciently profitable. Another reason is the so-called endorsement effect (Madrian and Shea (2001)): employees view changes in the ESPP plan as providing implicit investment advice. To determine whether there is any evidence of dynamic adjustment of the terms of stock purchase plans, we examine whether future stock returns are predicted by the discount rate offered by the firm, the lookback feature, the length of the offering period, and the presence of sale restrictions. We do not find any evidence of such predictability and conclude that it is unlikely that the terms of stock purchase plans are adjusted dynamically when of improvements in firm performance are expected (see column 3). 12 Firms sometimes have limits on ESPP purchases linked to the number of shares employees can buy and/or to the annual compensation of the employee. Since we do not consider this in our base measure of ESPP participation, it is possible that our variable inadvertently captures some aspect of wages that is related to future returns. To address this concern, we define wage-adjusted participation as the contribution per employee normalized by the most stringent participation limit, which is the minimum of (1) percentage of compensation employees are allowed to contribute to the ESPP multiplied by the average employee wage, as reported by Glassdoor.com, (2) the maximum number of shares employees are allowed to buy multiplied 12 Our results do not rule out the 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. 20

21 by the beginning-of-year stock price, and (3) the annual dollar limit. This variable is strongly related to future abnormal returns (column 4). A one standard deviation increase in wage-adjusted participation is related to a 3.90% increase in annual abnormal returns. This is of similar magnitude to our results using our main ESPP participation variable. In unreported regressions, we find that all results in Table III are qualitatively similar if we use this variable instead of our main ESPP participation variable. We explore the alternative hypothesis that ESPP purchases cause (rather than forecast) improvements in firm performance. Earlier work on employee stock purchase plans has focused primarily on the hypothesis that employees exert higher effort when they own more stock and found mixed evidence of this for non-executive employees (Bhagat, Brickley, and Lease (1985)). To address this concern, we regress future abnormal returns on the expected and unexpected components of employee participation in ESPPs. If our results are primarily driven by greater motivation or effort on the part of employees, we should see that any increase in participation rates leads to improvements in firm performance. For example, if a company introduces the lookback feature, it is expected that the participation of employees will increase as well. In this case, we should see that firm performance improves if greater stock ownership motivates employees, and 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 expected and unexpected components. The expected component is defined as the fitted value from the regression of participation rate on firm size, dividend payer dummy, R&D, market-to-book ratio, leverage, volatility, survey 21

22 wage, 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 adjusted R-squared of 53% in this regression allows us to conclude that we can predict the expected component of participation reasonably well. The unexpected component is the residual. The results in column 5 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 unexpected contributions per employee is associated with 3.27% in future abnormal returns, whereas the coeffi cient on the expected component is statistically insignificant. Another test to distinguish between the information and effort hypotheses would be to check whether option grants forecast future returns. Unlike ESPP participation, the decision to offer option grants are made by the firm s management and hence should not normally convey information. If ESPP participation forecasts returns because employees are more motivated, then option grants should also produce 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 the exercises of stock options (see column 6). The exercise of stock option, which reflects a choice made by employees, does forecast negative abnormal returns. This suggests that future positive abnormal returns following high ESPP participation are not caused by higher employee motivation resulting from 22

23 higher equity exposure. Additionally, the evidence on option exercises indicates that it is unlikely that the predictability of returns based on ESPP participation is due to the relaxation of financing constraints. There could also be a concern that higher participation in ESPP could be related to employee smartness and could be correlated with innovations in employee wages. To address this issue, we include a measure of employee wages in the regression and find that wages do not predict stock returns and our results are virtually identical (column 7). We also verify that higher stock returns are not attributed to the well-documented post-repurchase price drift (Ikenberry, Lakonishok, and Vermaelen (1995)). For example, we find that although firms with higher ESPP participation rates tend to buy back more stock, explicitly controlling for the amount of share repurchases does not change our results (unreported). Finally, we study how long into the future ESPP participation predicts stock returns. The purpose of this longevity analysis is twofold. First, we would like to know how long-lived is the information that employees possess in aggregate. Second, it is possible that high ESPP participation proxies for an unobservable risk factor not captured by matching on size, B/M, and momentum characteristics. If participation captures some other firm characteristic that produces positive alphas, this is likely to be persistent, and we should see that the abnormal returns persist for a long period of time. Table V shows that the relation between abnormal stock returns and ESPP participation is strong and economically significant for the horizon of 1 to 12 months following the filing date of 10-K. It becomes considerably weaker during the 13 to 24 month period, as is evident from the decrease 23

24 in statistical significance and adjusted-r 2. If we consider longer horizons (25-36 and months), the relation between returns and participation completely disappears. Overall, this evidence suggests that it is unlikely that ESPP participation proxies for risk characteristics and that the information that employees have is for one to two years horizon. This is in line with the average minimum holding period of 17 months for firms that place such restrictions. Our results can are also comparable to insider trading literature that documents that insiders possess, and trade upon, their knowledge of economically significant information starting more than two years prior to its disclosure (Ke, Huddart, and Petroni (2003)). 3.3 Calendar Time Tests Since participation rates may be higher across all firms at certain periods of time (e.g., when employee sentiment about the stock market increases), it is possible that a clustering of participation rates affects the statistical inference in our cross-sectional tests. We therefore cluster standard errors in regressions by industry and year (see Tables III and IV). 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 10-K within the previous 12 months. Using information contained in these forms, we construct two variables: participation, defined as contribution per employee normalized by the annual dollar limit, and shares issued through an ESPP as a proportion of shares outstanding. Firms are then sorted into quartiles based on both 24

25 of these variables and assigned to quartile portfolios from July of that year through 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 VI shows the coeffi cients and intercepts from regressing the monthly returns for the four quartile portfolios and the long-short strategy. We see that the long-short trading strategy yields a positive abnormal return of 0.50% per month, if firms are sorted based on participation. The abnormal returns for each of the four quartile portfolios are shown in columns 1 through 4. If firms are sorted into quartiles on the basis of shares issued as a proportion of shares outstanding, the resultant trading strategy yields a positive abnormal return of 0.75% per month. These values are statistically significant, and translate to 6 to 9% annual abnormal returns. A possible concern is that someone with the above trading strategy systematically purchases stocks with certain characteristics that tend to have a high return on 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 25

26 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 on a portfolio of stocks with similar characteristics. Such a 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 column 5 of Panel C of Table VI. The strategies yield monthly abnormal returns of 0.49% when participation is used, and 0.62% when shares issued under ESPP as a proportion of shares outstanding is used as the sorting variable, which are statistically significant. These results lend further support to the forecasting power of ESPP participation for future returns. 3.4 Earnings Restatements, Earnings Breaks, and Acquisitions To gain some understanding of what kind of information non-executive employees have, we examine the predictability of future earnings and corporate events. First we look at earnings restatements of the firms in our sample. Our hypothesis is that greater ESPP participation by (informed) employees should be associated with a lower likelihood of restatements. Anecdotal 26

27 evidence suggests that employees are sometimes able to identify accounting problems in their firm. For example, Tenet Healthcare corporation disclosed in July 2005 that the SEC had asked the company to investigate irregularities reported by 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 are 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 significant negative market reactions (see, e.g., Palmrose, Richardson, and Scholz (2004), who report that the two-day abnormal announcement return is 9%). We focus on restatements in which the company either incorrectly recognized revenue or cost or expense items, because, according to the GAO, these two categories of restatement result in the greatest loss of market value. There are 46 such earnings restatements in our sample, most of them initiated by the company. 13 The results presented in Table VII suggest that larger participation by non-executive employees in an ESPP is associated with a 3.63% lower likelihood of a future 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. Our findings that employee pur- 13 Previous research has found that restatements initiated by an auditor or the SEC are associated with larger negative market price reactions. We do not restrict our attention to such announcements because there are only 9 of them in our sample. 27

28 chases can predict past accounting errors do not seem to support the view that return predictability arises because of greater employee motivation. The results remain largely the same if we control for firm size, market-tobook ratio, dividend payer, insider trading, firm cash flow, and stock returns over the previous year (column 2). Next we investigate whether employees have information about upcoming earnings announcements. We use a methodology similar to that used by 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 quarterly earnings had been increasing and current earnings are below the previous year s earnings in 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 ESPPs is associated with a lower likelihood of an earnings break. For example, a one standard deviation in ESPP participation translates to an approximately 2.85% lower chance of lower firm earnings after a string of previous increases. The magnitude of this effect remains very similar when we control for firm characteristics. Finally, we explore whether employees are able to predict whether the firm will become the target of an acquisition in the next fiscal year. Since targets typically experience significant positive returns at the announcement 28