Sarbanes-Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures

Transcription

1 Sarbanes-Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures Eli Bartov New York University Leonard N. Stern School of Business 44 West 4 th St., New York, NY ebartov@stern.nyu.edu Lucile Faurel University of California, Irvine Paul Merage School of Business Irvine, CA lfaurel@uci.edu Key words: Employee stock options; Form 4 filings; private information; Sarbanes-Oxley Act; insider trading JEL classification: M41; G14; J33 We acknowledge helpful comments from seminar participants at Bocconi University, California Polytechnic State University, INSEAD, MIT, University of British Columbia, University of California Irvine, University of Notre Dame, University of Washington, the 2010 American Accounting Association (AAA) annual meeting, the 2010 AAA Financial Accounting and Reporting Section midyear meeting, the 2010 Annual Academic Corporate Reporting & Governance Conference, the 2010 University of Technology Sydney Australian Summer Accounting Symposium, and the 2011 NYU Summer Research Camp.

2 Sarbanes-Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures ABSTRACT We document negative stock returns and elevated trading volumes around executives early option exercise disclosures post-sox but not pre-sox. This stock price reaction is incomplete, and the negative stock price drift is smaller post-sox compared to pre-sox. We also show effects of media coverage in the stock price response to exercise disclosures in the post-sox period. These findings provide evidence that the requirement mandated by SOX to disclose executives stock option exercises within two business days, and the increased media coverage, improve investors ability to incorporate into stock prices in a timely fashion the information conveyed by these exercises.

3 1. Introduction Sarbanes-Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures Stock option exercises before their expiration dates (i.e., early stock option exercises) may involve a substantial loss of option value to the option-holder. This follows because, upon exercising, the option-holder sacrifices the options fair value and in return receives the (lower) options intrinsic value (i.e., the stock price on the exercise date minus the exercise price). Therefore, option-holders looking to cash out their investments are better off selling the options rather than exercising them early. Indeed, traded options are seldom exercised early. However, executive stock options, which are not tradable or transferable, are often exercised early. Extant literature (see, e.g., Carpenter and Remmers, 2001) mentions three primary explanations for early exercises of stock options and sales of the acquired stock by corporate insiders: portfolio diversification, liquidity needs, and private information. The first two explanations, portfolio diversification and liquidity needs, are self-explanatory. The third explanation, the one related to private information, deserves further discussion. According to this explanation, early exercises of stock options and sales of the acquired stock by corporate insiders may follow from private knowledge of bad news about the future stock price because an option represents a long position in the underlying stock, and exercising options and selling the acquired stock prior to a stock price decline allows the option-holder to receive higher value for his/her holdings. We note that this private-information explanation relates to early exercises and (immediate) sales of the acquired stock. Throughout this study, for the sake of brevity, we sometimes omit the latter part of the sentence, and sales of the acquired stock. Early exercises that are not accompanied by stock sales are unlikely to be motivated by private information; they may follow from a company s bylaws or an executive s exercise-and-hold strategy to save 1

4 income taxes. 1 Based on post-exercise long return windows, inferences from prior empirical work are mixed on whether this private-information explanation for early exercises is descriptively valid. One way to enhance statistical power and shed more light on this question is to examine the stock price reaction in a short window around the early option exercise date. Until recently, however, this type of test was not feasible, as corporate insiders option exercise transactions were not disclosed in a timely fashion. Regulatory changes that became effective on August 29, 2002, altered this situation by requiring corporate insiders to report option exercises to the Securities and Exchange Commission (SEC) within two business days. These regulatory changes now allow investors to learn about corporate insiders option exercises in a timely fashion, and enable researchers to ascertain the precise date at which the information becomes publicly available. They thus offer an opportunity to explore three related research questions: (1) Do investors respond to announcements of corporate insiders early option exercises and sales of the acquired stock? (2) Does this response alleviate, or perhaps even eliminate, the negative post-exercise returns documented in the pre-sox era? (3) To what extent the increased media coverage of executive option exercises observed in the post-sox period contributes to this phenomenon? We investigate the first question by examining pre- and post-sox abnormal stock returns, as well as abnormal trading volume, in a four-trading-day window around 19,041 firm-filing date observations, representing 39,786 transactions of early stock option exercises by the five top-level executives (CEO, CFO, COO, President, and Chairman of the Board) at 2,685 distinct firms in the 15-year period from January 1, 1997 to October 1, We focus on the five top-level executives 1 While we exclude early exercises not followed by stock sales from our analysis, their inclusion slightly weakens the magnitude of our results, as expected, but still leads to qualitatively similar findings, and has no effect on our conclusions. 2

5 since they typically receive the largest amount of options and possess better information about their firms future prospects than other insiders. If investors consider early option exercises and sales of the acquired stock by top-level executives as signals for their private knowledge of bad news about future stock performance, a negative (positive) stock price response should be observed around the disclosure of unusually high (low) early exercises. Indeed, exercising options and selling the acquired stock prior to a stock price decline, or delaying such activity prior to a stock price appreciation, allows the option-holder to receive higher value for his/her holdings. To identify unusual early exercises, we consider the magnitude of the option value forgone due to early exercises defined as the option s fair value less its intrinsic value on the exercise date when designing our tests. Considering the option value forgone due to early exercises should increase our ability to detect a negative stock price response to early exercises, if it exists. Indeed, early exercises may stem not only from private information but also from diversification or liquidity needs, which are not expected to be associated with a stock price response. The higher the potential loss from an early exercise, however, the more likely an option-holder to satisfy any cash needs by borrowing rather than exercising early his/her stock options and selling the acquired stock. Evidence from prior literature supports this intuition. Core and Guay (2001, Table 8) find that early option exercises are greater when the realizable value of the option portfolio captures a greater percentage of the Black-Scholes value. They interpret this finding as indicating that employees recognize it is costly to exercise options early because it involves forfeiting the time value of the option. This discussion thus suggests that the higher the loss in option value associated with an early exercise, the stronger the signal conveyed by the disclosure of early exercise about the executives negative private knowledge, and consequently the stronger the expected stock price response. 3

6 Findings from a variety of portfolio and regression tests provide support for the hypothesis that investors view executives early exercises as signals for bad news about firms future stock price performance in the post-sox period. Results show a statistically significant immediate stock price reaction to executives stock option exercise disclosures in the post-sox period that varies in the predicted direction with our proxy for the private information conveyed by these early exercises (i.e., the loss in option value associated with these exercises), and an insignificant stock price reaction in the pre-sox period. In addition, consistent with the stock return results, trading volume tests around the exercise disclosures indicate abnormally high trading activity (net of insider sales) in a short period following the disclosures, but again only in the post-sox period. Next, to test our second research question, we examine the post-exercise-filing stock returns to shed light on whether investors fully incorporate into stock prices the information conveyed by executives early option exercises, or partially overlook this information, when making investment decisions at the time of the exercise disclosures. Results from portfolio tests show that our sample exhibits statistically significant mean returns in the three-month period after the exercise disclosures, with more negative returns for the portfolio with the highest option value forgone. While this negative stock price drift is significant in both the pre- and post-sox periods, it is statistically significantly smaller in the post-sox period compared to the pre-sox period. One interpretation of the significant immediate stock price reaction observed only in the post-sox period, together with the significantly smaller stock price drift in the post-sox period, is that the regulatory changes introduced by SOX improve investors ability to incorporate into stock prices in a timely fashion the information conveyed by executives early option exercises. Finally, to further investigate this phenomenon, and to test our third research question, we examine whether the increased media coverage of executives option exercises observed in the 4

7 post-sox period contributes to investors reaction to exercise disclosures and their ability to incorporate the information conveyed by these exercises. The results provide evidence of media coverage effects in our sample in the post-sox period. Specifically, early exercise disclosures with media coverage exhibit stronger immediate market response than exercise disclosures with no media coverage. Moreover, exercise disclosures with media coverage exhibit little evidence of stock price drift in the post-exercise-filing period. The primary contribution of this study lies in our investigation of the immediate market response to Form 4 filings. Our findings show significantly negative immediate stock price response to early exercise disclosures in the post-sox period, implying that selling stock by insiders acquired via early option exercises is informative in that period. In contrast, prior studies document that Form 4 filings of insider sales are generally not informative and only Form 4 filings of insider purchases are informative (e.g., Lakonishok and Lee, 2001; Brochet, 2010; Veenman, 2012; Rogers et al., 2013). Indeed, Lakonishok and Lee (2001) find that the informativeness of insiders activities follows from purchases, not sales. Related to our study, Brochet (2010) reports that abnormal returns around the filings of insider stock sales are more negative in the pre-sox period than in the post-sox period (-0.28 percent and percent, respectively, over a threeday window, see Brochet, 2010, Table 3). Brochet (2010) concludes that all results except for stock returns around filings of insider sales suggest that SOX has increased the information content of Form 4 (p. 420). Finally, recently, Veenman (2012) and Rogers et al. (2013) drop insider stock sales from their sample (and instead focus on insider purchases) due to limited information content of insider sale disclosures. Importantly, our findings offer an explanation for this apparent contradiction in results concerning the informativeness of insider sales. With early option exercises and sales of the 5

8 acquired stock, the option s fair value is higher than the net proceeds from selling the acquired stock, whereas an ordinary sale of stock is not associated with such a loss in value. The informativeness of Form 4 disclosures follows not from the sale of the underlying stock itself, but rather from the loss associated with the early option exercise. Quantifying this loss in our setting, allows us to identify stock sales that are most likely driven by private information, and therefore most likely to be informative. 2 Consequently, our findings complement the prior research on the informativeness of Form 4 filings. We also contribute by demonstrating that investors fail to fully respond to the private information conveyed by corporate insiders early exercises, notwithstanding the new regulations requiring accelerated and easily accessible option exercise disclosures and the increased media coverage. Still, relative to the pre-sox period, the post-exercise-filing drift is smaller after SOX, suggesting that the new legislation, as well as the increased media coverage, improve investors ability to incorporate into stock prices in a timely fashion the information conveyed by these exercises. The remainder of the paper is organized as follows. The next section delineates findings of prior research and outlines recent regulatory changes. Section 3 describes the sample selection and the data, and defines the variables. Section 4 outlines the empirical tests and reports the results. Section 5, the final section, summarizes our findings and conclusions. 2 Additionally, since May of 1991, selling stock acquired via option exercises (but not selling stock acquired via purchases) is exempt from the Short-Swing Profit Rule, a SEC regulation that requires company insiders to return any profits made from the purchase and sale of company stock if both transactions occur within a six-month period. The rule was implemented to prevent insiders, who have greater access to material company information, from taking advantage of information for the purpose of making short-term profits. 6

9 2. Prior Literature and Regulatory Environment Prior research provides mixed empirical evidence on whether corporate insiders private information underlies early stock option exercises. Carpenter and Remmers (2001) find little evidence of top-level executives ability to time stock option exercises and conclude that exercises are driven primarily by diversification or liquidity needs. In contrast, by studying a subsample of unusually large exercises designed to isolate exercises most likely to reflect the use of private information, Bartov and Mohanram (2004) provide evidence of top-level executives ability to time option exercises. They find that option exercises by top-level executives predict both future stock price performance and future earnings performance, and conclude that exercises predictive ability of stock returns represents private information about disappointing earnings in the postexercise period. Huddart and Lang (2003) find that the timing of when employees exercise their stock options is predictive of future stock returns, suggesting that employees of all levels (partially) base their exercise decisions on private information. Aboody et al. (2008) investigate the gains to executives from their decisions to sell or hold the shares acquired from stock option exercises prior to the ensuing stock price decline. Using a sample dominated by exercises from the pre-sox period, they find that gains to executives sell or hold decisions are positively associated with the opportunity costs of the exercises. Finally, Cicero (2009) examines stock option exercise strategies of executives and finds that executives use private information to maximize their gains from exercises. These prior studies employed samples from the pre-sox period, in which a timely disclosure of executive stock option exercises was not required. Therefore, these studies were unable to examine whether investors immediately react to corporate insiders early option exercises and sales of the acquired stock, and they focused instead on executives option exercise 7

10 behavior and the gains from decisions to sell shares acquired from early exercises. However, recent regulatory changes introduced by the SEC have altered this situation. Specifically, in response to changes to disclosure requirements mandated by Section 403 of SOX, and the corresponding changes in Section 16(a) of the Securities Exchange Act of 1934, the SEC changed the reporting regulations for stock option exercises. Prior to the change, corporate executives reported stock option exercises to the SEC on Form 4 (Statement of Changes of Beneficial Ownership of Securities) within 10 calendar days after the close of each calendar month in which an exercise occurred, and in some instances on Form 5 (Annual Statement of Beneficial Ownership of Securities), which was not due until 45 calendar days after the company s fiscal year-end. 3 In addition, the forms were mailed to the SEC and had to be processed before becoming publicly available. Since this process may have taken several days or even weeks after the filing date (the SEC s receipt date), the precise date at which the disclosure became available to investors was hard to ascertain. The legislative change that became effective on August 29, 2002, however, requires corporate insiders to report option exercises to the SEC on a (slightly) redesigned Form 4 within two business days. 4 In addition, since June 30, 2003, corporate insiders are required to submit forms electronically through the SEC s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. The SEC is required to make this information available on a publicly accessible 3 Stock option exercises were reported on Form 5 if three conditions were met: (i) the option grant was made pursuant to a shareholder-approved written plan; (ii) the options were to be held for at least six months from the grant date; and (iii) the option plan was administered by a board or committee composed of independent directors. 4 To implement the new requirements of SOX, the SEC had to slightly amend Form 4 and its instructions. For example, the old Form 4 stated the month and year covered by the form, as it was filed monthly, whereas the new Form 4 states the month, day, and year of the earliest transaction covered by the form as it must be filed within two business days from that transaction. Still, both the old and the new forms provide month, day, and year of each transaction. Clearly, these minor changes should have no effect on our findings. 8

11 website one day after receiving the electronic filings. 5 Companies that maintain websites are also required to post the forms by the end of the next business day after filing them with the SEC. These regulatory changes now allow investors to learn about corporate insiders option exercises in a timely fashion, and the precise date at which this information becomes publicly available is known. These changes thus provide a quasi-experimental setting to focus on investor behavior, exploring whether and to what extent investors respond to corporate insiders option exercises and sales of the acquired stock. A related study, Brochet (2010), examines stock returns and trading volume in a short window around filings of insider stock purchases and sales in the pre- and post-sox periods. Our setting and research design differ from Brochet (2010) in important ways, providing key new insights. First, in our setting, early stock option exercises involve losses in option value, which are quantifiable and thus allow us to identify insider trades that are likely to follow from private information as opposed to liquidity or diversification needs. In contrast, in Brochet s (2010) setting, like all studies on the informativeness of insider stock sales and purchases (e.g., Lakonishok and Lee, 2001; Veenman, 2012), there is no value forgone. Second, Brochet (2010) restricts his investigation to short windows (up to six trading days) around the filing of insider trades, whereas we also examine stock price behavior over long windows following the filing of option exercises (from four to 63 trading days after the filing of exercises). This allows us to shed light on whether investors (partially) overlook or fully incorporate the information conveyed by executives early option exercises. Finally, we also consider media coverage effects on the market response to exercise disclosures and the behavior of post-exercise-filing stock returns. 5 Prior to June 30, 2003, insiders could choose, but were not required, to file electronically. In addition to timely disclosure and easy access, electronic filing has the advantage, from a research design standpoint, that the date at which the disclosure becomes available to investors is easy to ascertain. 9

12 3. Data 3.1. Sample selection Our sample covers the 15-year period, January 1, 1997 October 1, The cutoff date between the pre- and post-sox periods is August 29, 2002, the date at which the regulatory changes requiring corporate insiders to report stock option exercises to the SEC within two business days became effective. The sample period commences on January 1, 1997 because the option exercise data from the Thomson Financial database are available from January 1996 and 12 months of data are necessary to classify sample observations into portfolios of option value forgone. 6 The data are obtained from the Thomson Financial database and the CRSP daily returns database. Details regarding the sample selection is provided in Table 1. We begin by retrieving all top-level executives stock option exercise transactions from the Thomson Financial database in the sample period, January 1, 1997 October 1, This yields 85,593 transactions from 5,775 distinct firms, corresponding to 43,284 firm-filing date observations, after aggregating transactions by firm and filing date. We next eliminate observations due to the following reasons: i) missing stock return data on the CRSP database; ii) stock option exercise occurred near expiration (within 90 days of the expiration date), making it less likely that the exercise was due to private information; iii) missing dividend data on the Compustat database, required to estimate the expected dividend yield, a parameter underlying the Black-Scholes model used to proxy for the stock options fair value; iv) stock options fair value (i.e., Black-Scholes value) on the exercise 6 As a sensitivity analysis, we replicate our tests using June 30, 2003 as the cutoff date because it is the date electronic filing of corporate insider trades became mandatory. The results, not tabulated for parsimony, are indistinguishable from the tabulated results. 10

13 date is lower than their intrinsic value; 7 v) beginning-of-year total assets less than $1 million or with a stock price on the day prior to the stock option exercise of less than $1, to eliminate thinly traded stocks; and vi) stock option exercises in a given day not followed by immediate sale of all acquired shares within a three-day period. 8 Thus, the final sample for our stock-return tests consists of 19,041 firm-filing date observations covering 5,697 executives at 2,685 distinct firms. Our abnormal trading volume tests require that trading volume information be available on the CRSP daily returns database. This requirement reduces the sample by one observation (one distinct firm) to 19,040 firm-filing date observations covering 5,696 executives at 2,684 distinct firms Variable definitions We measure the option value forgone due to early exercises as the difference between the fair value and the intrinsic value of all options exercised on the exercise date, scaled by beginningof-year total assets. 9 It is arguable, however, that an executive s total compensation or wealth would be a more appropriate deflator than total assets. Unfortunately, the latter is not available and the former is available for only approximately half of our sample, as the ExecuComp database, our data source for executive compensation, covers only companies in the S&P To avoid 7 This follows because these observations may correspond to either i) observations for which the parameters underlying the Black-Scholes value are measured with a significant error; e.g., the historical dividend yield is too high to be an appropriate proxy for the expected dividend yield, resulting in an artificially low Black-Scholes value, or ii) observations where the stock options Black-Scholes value on the exercise date is truly lower than their intrinsic value, leading the executive to exercise the stock options early based on publicly available information, not private information. 8 As previously mentioned, including stock option exercises not followed by immediate sale of all acquired shares within a three-day period slightly weakens the magnitude of our results, but still leads to qualitatively similar findings, and has no effect on our conclusions. 9 Prior research (e.g., Heath et al., 1999; Core and Guay, 2001; Huddart and Lang, 2003; Aboody et al., 2008) uses the options fair value (estimated using the Barone-Adesi and Whaley, 1987, model or the Black-Scholes model) as the deflator rather than beginning-of-year total assets. The latter seems more appropriate in our context because it captures the relative total dollar amount forgone due to early exercises reflecting both the number of options exercised and the amount forgone per option, whereas the former captures only the percentage forgone per option, ignoring the number of options exercised. Still, we replicate our analyses using the options Black-Scholes value as the deflator and find similar results (not tabulated for parsimony). 11

14 losing such a large portion of our sample resulting in a significant selection bias (see Cadman et al. 2010), we scale by total assets because this variable is correlated with total compensation and wealth of top-level executives. 10 The intrinsic value of an option is defined as the stock price on the exercise date less the option s exercise price. We use the Black-Scholes option value to proxy for the option s fair value for two reasons. First, it is standard in the literature to use this measure. Second, U.S. companies regularly use this measure for internal and financial reporting purposes, indicating that executives consider Black-Scholes a valid measure for option value. 11 Still, we note that the Black-Scholes model produces a noisy measure of option value because executive stock options do not satisfy the assumptions of standard option pricing models (i.e., a risk-neutral holder, no vesting period, and the ability to transfer the option to another party). This may add noise to our option-valueforgone variable, which may weaken our tests. Considering diversification needs (due to risk aversion) and liquidity needs (because the options are nontransferable) in our regression analyses may (partially) purge this noise, thereby attenuating this problem. Along the lines of prior research (see, e.g., Core and Guay, 1999, 2001), we calculate the Black-Scholes option value employing the formula for valuing European call options developed by Black and Scholes (1973) and generalized by Merton (1973) to account for dividend payouts as expressed in Equation (1): 10 For a subset of sample firms covered by the ExecuComp database, we find high correlations, ranging from 0.73 to 0.82, between our measure of option value forgone due to early exercises scaled by beginning-of-year total assets and measures scaled by i) the executive s total stock and options holdings at the beginning of the year or ii) the executive s total compensation for the fiscal year prior to the exercise. A sensitivity check (not tabulated for parsimony) reveals that our primary findings are robust to these two alternative measures. 11 Finnerty (2014) reports that most publicly traded firms use the Black-Scholes model by simply adjusting the time to expiration to calculate the cost of their employee stock options. Finnerty (2014) documents that, from 2006 to 2010, approximately 80 to 85 percent of the S&P 500 firms that issued employee stock options used the Black-Scholes model, 11 to 15 percent used a lattice model, while 1 to 5 percent did not identify a specific model. Note that SFAS No. 123(R) does not require a specific valuation model in deriving employee stock options fair value; rather it mentions the binomial model and the Black-Scholes model as examples of recommended models. 12

15 dt rt C Se N( Z) Xe N( Z T ) (1) where, C is the Black-Scholes value of the option, S is the price of the underlying stock retrieved from the CRSP database, d is the expected dividend yield over the life of the option estimated as cash dividends per share (adjusted for stock splits) paid in the fiscal year prior to the exercise divided by beginning-of-year stock price as reported in the Compustat database, T is the time-tomaturity of the option in years reported on Form 4, retrieved from the Thomson Financial database, N is the cumulative probability function for the normal distribution, X is the exercise price of the option reported on Form 4, retrieved from the Thomson Financial database, σ is the expected stock return volatility over the life of the option estimated as the standard deviation of daily stock returns over the 120-trading-day period preceding the exercise retrieved from the CRSP database, r is the risk-free interest rate (i.e., the treasury bill annualized rate corresponding to the option s time-tomaturity), and 2 log( S / X ) T( r d / 2) Z (2) T We define the net proceeds from the exercise of stock options as the intrinsic value of the options on the exercise date (i.e., the stock price on the exercise date less the option s exercise price), scaled by beginning-of-year total assets. We measure the reporting lag of a stock option exercise transaction as the number of trading days between the exercise date and the SEC filing date. We compute buy-and-hold abnormal returns for the firm i over n trading days, as follows: t=1,n (1 + Rit) t=1,n (1 + ERit) (3) where, Rit is the return for firm i in day t, inclusive of dividends and other distributions, and ERit is the expected return in day t for that firm. If a firm delists during the return accumulation window, we compute the remaining return by using the CRSP daily delisting return, reinvesting any 13

16 remaining proceeds in the appropriate benchmark portfolio, and adjusting the corresponding market return to reflect the effect of the delisting return on our measures of expected returns (see Shumway, 1997; Beaver et al., 2007). 12 We compute daily expected returns based on Carhart s (1997) four factor model. We first estimate the following model using a 250-trading-day hold-out period, ending 125 trading days prior to the SEC filing date of the stock option exercise: Rit RFt = ai + bi(rmrft) + si(smbt) + hi(hmlt) + pi(umdt) + eit (4) where, Rit is defined as before, RFt is the one-month treasury bill daily return, RMRFt is the daily excess return on a value-weighted aggregate equity market proxy, SMBt is the return on a zeroinvestment factor mimicking portfolio for size, HMLt is the return on a zero-investment factor mimicking portfolio for book-to-market value of equity, and UMDt is the return on a zeroinvestment factor mimicking portfolio for momentum factor. 13 We then use the estimated slope coefficients from Equation (4), bi, si, hi, and pi, to compute the expected return for firm i in day t as follows: ERit = RFt + bi(rmrft) + si(smbt) + hi(hmlt) + pi(umdt) (5) Finally, along the lines of prior research (e.g., Yermack, 1997; Heron and Lie, 2007; Brochet, 2010) we measure abnormal trading volume using the following log market model based on Ajinka and Jain (1989) as extended by Meulbroek (1992): log( V ) log( V ) log( V ) log( V ) Mon Tues Wed i, t mkt, t 1 i, t 1 2 i, t 2 1 t 2 t 3 t Thur Holiday Holiday Earnings 4 t 1 t 2 t 1 i, t Dividends SECFiling i, t i, t i, t (6) Vi,t is the percentage trading volume for firm i on day t relative to the total shares outstanding of 12 Poor performance-related delistings (delisting codes 500 and ) often have missing delisting returns in the CRSP database (Shumway, 1997). To correct for this bias, we set missing performance-related delisting returns to 100 percent as recommended by Shumway (1997). 13 RF, RMRF, SMB, HML, and UMD are obtained from Professor Kenneth French s web site ( 14

17 firm i on day t, after subtracting the percentage of shares sold by the firm i s top-level executives on day t. Vmkt,t is the trading volume as a percentage of total shares outstanding for all firms listed on the same exchange mkt as firm i on day t, retrieved from the CRSP database. Lagged values of daily trading volume, Vi,t-1 and Vi,t-2, are included to reduce serial correlation of the residuals. Mont, Tuest, Wedt, and Thurt are day-of-the-week dummy variables for day t. Holidayt is a dummy variable equal to one if day t precedes a three-day holiday weekend or corresponds to the Friday following Thanksgiving, zero otherwise. Earningst (Dividendst) is a dummy variable equal to one if day t is in a [-3; +3] window around earnings (dividends) announcements of firm i, retrieved from the Compustat (CRSP) database, zero otherwise. Finally, the variable of interest, SECFilingi,t, is a dummy variable equal to one if day t corresponds to a SEC filing date of toplevel executive stock option exercises for firm i, zero otherwise. One important difference in our model vis-à-vis prior research is that a company s daily trading volume, Vi,t, is measured after excluding the trading of the company s top-level executives on that day. We exclude the shares sold by the firm s top-level executives to ensure that these trades do not confound our abnormal trading volume measure. The other variables included in the model are similar to the ones used in prior research. Model (6) is estimated separately for each sample observation using daily data from 50 trading days before until 50 days after each top-level executive stock option exercise. The coefficient γ, estimated for each sample observation, represents the daily percentage deviation from normal trading volumes around the SEC filing of top-level executive stock option exercise, as modeled in Equation (6) Descriptive statistics Table 2 reports selected descriptive statistics for the pre- and post-sox periods separately 15

18 for the full sample (Panel A) and for two subsamples of small firms (Panel B) and large firms (Panel C). Sample observations are classified into small and large firms using the Fama-French size classification, where small (large) firms have a beginning-of-year market value of equity in the bottom (top) 50 percent of all NYSE firms. 14 The mean (median) total stock option value forgone by top-level executives due to early exercises is percent (0.005 percent) and percent (0.002 percent) of beginning-of-year total assets in the pre- and post-sox periods, respectively. These values are decreasing with firm size, and more so in the pre-sox period. The mean (median) market capitalization of our sample firms is approximately 7.55 (1.27) $billion and 3.44 (1.17) $billion in the pre- and post-sox periods, respectively, which is larger than that of the Compustat universe, 1.49 (0.09) $billion and 2.50 (0.17) $billion in the pre- and post-sox periods, respectively. The mean (median) share turnover, our proxy for stock liquidity is (0.132) and (0.202) in the pre- and post-sox periods, respectively, which is larger than that of the CRSP universe (mean of and 0.244, and median of and 0.101, in the pre- and post-sox periods, respectively), and these values vary only slightly with firm size. Overall, these differences between our sample and the Compustat and CRSP universes demonstrate there is little evidence to suggest that our sample is dominated by small or illiquid firms. The mean (median) buy-and-hold abnormal returns in the 60-trading-day period prior to exercise disclosures are 11.6 percent (6.9 percent) and 8.5 percent (5.7 percent) in the pre- and post-sox periods, respectively. This stock price run up is larger for small firms with high levels of option value forgone where the mean (median) returns are 22.3 percent (13.9 percent) and 14.4 percent (9.2 percent) in the pre- and post-sox periods, respectively. That exercises tend to follow a strong stock price performance is not surprising and has been documented in prior research (see, 14 The market-value-of-equity breakpoints for the size classification are obtained from Professor Kenneth French s web site ( 16

19 e.g., Carpenter and Remmers, 2001; Bartov and Mohanram, 2004). This is consistent with insiders following an exercise policy that entails exercising once the stock price rises sufficiently high. Also, most option exercises occur long before expiration in both the pre- and post-sox periods, as the average number of years to maturity of stock option exercises is approximately four to five years (result untabulated). Finally, as expected, the reporting lag differs between the pre- and the post-sox period, i.e., before and after the requirement to disclose insiders option exercises within two business days. The mean (median) reporting lag is approximately 20 (16) trading days in the pre-sox period and 2 (1) trading days in the post-sox period. Interestingly, we find that 96.0 percent of our sample filed within two days or less of the exercise date in the post-sox period, consistent with the SEC s two-day reporting requirement, compared to 0.3 percent in the pre-sox period. 4. Tests and Results 4.1. Market response to executives early stock option exercise disclosures To test our first research question of whether investors respond to corporate insiders option exercise disclosures in a timely fashion, we investigate abnormal stock price changes and abnormal trading volume in a four-trading-day window around top-level executives option exercises and sales of the acquired stock, [0; +3], where day zero is the SEC filing date of the stock option exercise. We use a four-trading-day window because the SEC posts exercise transactions on its publicly accessible website within 24 hours of filing and because we consider stock option exercises with sales of the acquired stock within three days of the filing date. 15 We perform two 15 As a sensitivity analysis, we replicate our tests using the return windows [0; +2] and [0; +4], where day zero is the SEC filing date of top-level executive stock option exercises. The results, not tabulated for parsimony, are similar to the tabulated results. 17

20 types of stock return tests: portfolio tests (Table 3) and regression tests (Table 4). The results from the abnormal trading volume tests are displayed in Table 5. Table 3 reports portfolio-return results for the window [0; +3]. Panel A displays the stock return results for the full sample and for three portfolios formed based on the amount of value forgone due to early exercises (our proxy for executives negative private information). Panel B reports the stock return results by firm size for the Low Forgo portfolio and the High Forgo portfolio (bottom and top 30 percent of the value forgone distribution, respectively). For the full sample, the results in Panel A show virtually no reaction to option exercise disclosures in the pre- SOX period and a statistically significant, yet relatively economically modest, reaction of percent in the post-sox period. 16,17 When partitioning the sample into three portfolios based on option value forgone, we find that the market reaction remains insignificant in the pre-sox period for all three portfolios. In the post-sox period, however, the negative stock price reaction is statistically significant for the Middle and High Forgo portfolios. The High Forgo portfolio has the most negative (yet still modest) stock price reaction of percent. Next, we replicate the tests in Panel A of Table 3 after partitioning our sample into small and large firms using the Fama-French size classification. Information asymmetry is likely to vary with firm size: the smaller the firm, the greater the information asymmetry between insiders and outsiders. The results, reported in Panel B of Table 3, reveal little sensitivity of the abnormal returns for the window [0; +3] to firm size. A (mild) size effect is only observed in the High Forgo portfolio in the post-sox period, where small and large firms exhibit returns of percent and 16 We consider a stock price reaction of percent relatively economically modest because a substantially stronger reaction of -1 percent to -3 percent for a similar return window has been documented for other signals of negative future earnings (e.g., dividend decreases). 17 When examining all insider stock sales, Brochet (2010) reports abnormal returns of (-0.11 percent) over a three-day window around the filings of insider stock sales in the pre-sox (post-sox) period and mentions that, after controlling for confounding factors such as preplanned trades and litigation risk, returns around filings of insider sales are more negative after SOX. 18

21 -0.36 percent, respectively, which are (marginally) statistically, but not economically, different. To gain more insight into these results, we estimate the following model using Huber- White robust standard errors clustered by firm (see, e.g., Petersen, 2009; Gow et al., 2010): BHAR Large Forgo Forgo * Large BHAR NetProceeds i,[0; 3] i 2 i 1 i,[-60;-1] 2 i (7) NetProceeds * Large ReportingLag Industry Year 3 i 4 i j j k k i,[0; 3] where, the dependent variable, BHARi,[0; +3], is buy-and-hold abnormal stock returns of the firm that corresponds to the i th option exercise for the window [0; +3], where day zero is the SEC filing date of the i th option exercise. Forgoi, our test variable, is the decile ranking of the stock option value forgone associated with the i th option exercise, measured as the Black-Scholes value of the options on the exercise date less the intrinsic value of the options on the exercise date (i.e., the stock price less the option s exercise price), scaled by beginning-of-year total assets. 18 Large is an indicator variable equal to one if the firm is classified as a large firm using the Fama-French size classification, zero otherwise. The model also includes three control variables. BHARi,[-60; - 1], a control variable for the pre-exercise stock price run-up, is buy-and-hold abnormal returns of the firm associated with the i th option exercise in the three-month window [-60; -1], where day zero is the SEC filing date of the i th option exercise. NetProceedsi, a control variable for the net cash payout associated with the exercise, is the decile ranking of the intrinsic value associated with the i th option exercise, computed as the stock price on the exercise date less the option s exercise price, scaled by beginning-of-year total assets. ReportingLagi, a control variable for reporting lags, is the number of trading days between the exercise date and the SEC filing date of the i th option exercise. Finally, industry (calendar year) indicator variables are included to control for industry (calendar year) fixed effects, where the industry indicator variables are based on the 18 Decile rankings of all variables used in this study are based on the distribution of the variable in the prior 12 months, and are scaled to range between zero and one. 19

22 Fama-French (1997) 48-industry classification. We include the first control variable, BHAR[-60; -1], to control for diversification needs and for risk-averse executives exercising more stock options after a stock price run-up pushes their options further into the money, thereby increasing their wealth exposure to changes in the stock price, and the second control variable, NetProceeds, to control for liquidity needs. We include the third and final control variable, ReportingLag, to control for the delay in filing option exercise transactions. This variable is not expected to be an important variable in predicting stock returns in the post-sox period, but may be an important variable in the pre-sox period. The variables of interest in Equation (7) are Forgo and the interaction term Forgo*Large. If investors react to the option value forgone information conveyed by executives early option exercise disclosures, the coefficient on the variable Forgo, β1, should be negative. Further, if investors have greater difficulty incorporating the information conveyed by exercise disclosures of small firms, β2 should be positive. Table 4 displays the results from estimating two specifications of Equation (7), Model I and Model II, for the pre- and post-sox periods separately. Model I tests for the relation between Forgo and stock returns around the filing date of option exercises, BHAR[0; +3], not allowing this relation to vary across firm size. In the pre-sox period, the results show an insignificant coefficient on Forgo (β1 = ). Conversely, in the post-sox period the coefficient on Forgo is significantly negative, β1 = (t-statistic = -2.05). These results, which are consistent with the results in Panel A of Table 3, imply that the immediate market response to early exercise disclosures considers the amount of option value forgone due to early exercises, but only in the post-sox period. The second specification of Equation (7), Model II, allows the coefficient β1 to vary across 20

23 firm size by adding an interaction term Forgo*Large. The primary finding from this specification is that the market responds to the option value forgone information in early exercise disclosures, but only for large firms and only in the post-sox period (in untabulated results, we find that the sum of β1 and β2 equals with a p-value of 0.04 from a F-test of whether the sum of these two estimated coefficients equals zero). Together, the portfolio and regression results provide evidence of an immediate stock price response to executives early stock option exercise disclosures as well as to the amount of option value forgone reflected in these exercises in the post- SOX period, and virtually no response in the pre-sox period. To assess their robustness, we supplement the tests on the stock price reaction to executives option exercises by examining the abnormal trading volume around their SEC filing dates. Table 5 reports, for the pre- and post-sox eras separately, the abnormal trading volume net of insider trading) means for each day -3 to +3, as well as for the window [0; +3], where day zero is the SEC filing date of top-level executive stock option exercises. These means are obtained by individually estimating the coefficient on the variable SECFilingi,t using Equation (6) above. Panel A displays abnormal trading volume results for the full sample, and Panel B reports abnormal trading volume results for the Low Forgo and High Forgo portfolios. Consider the results in Panel A of Table 5 first. Clearly, in the pre-sox period no unusual trading volume is observed in the seven-trading-day window around the SEC filing date, [-3; +3]. Conversely, in the post-sox period, the trading volume is markedly elevated in the three days leading to the SEC filing date, days -3, -2, and -1. Since our measure of trading volume is net of stock sales acquired from option exercises of firms top-level executives, this may indicate that in the post-sox period either executives tend to exercise options and sell the acquired stock when trading volume is temporarily high, or that the information about the insider trading activity leaked 21

24 to the market prior to the formal filing of Form 4. The results also show a significantly elevated trading volume in the post-sox period in days +2 and +3, as well as over the four-trading-day window [0; +3], which is consistent with investors considering exercises when making their investment decisions. Overall, the results in Panel A of Table 5 are consistent with the findings in Table 3 showing a significant stock price reaction to option exercise disclosures only in the post- SOX period. The primary finding in Panel B of Table 5 is that, following the SEC filing of executive stock option exercises (window [0; +3]) in the post-sox period, the abnormal trading volume is higher for the High Forgo portfolio, 1.92 percent (t-statistic = 4.49) than for the Low Forgo portfolio, 0.78 percent (t-statistic = 1.83), suggesting that the greater the amount of value forgone, the stronger the market reaction in terms of trading volume. This result is again consistent with the return results in Table 3 showing a stronger stock price reaction among firms in the High Forgo portfolio, but only in the post-sox period. Finally, Panel C of Table 5 replicates the tests of Panel B of Table 5 separately for small and large firms. The primary insight from this panel is that excess trading volume around the SEC filing date in the post-sox era, documented in Panel B of Table 5, is driven by small firms. Overall, the findings in Tables 3 to 5 suggest that investors react to executives early option exercise disclosures, especially in the post-sox period. In the next section, we examine whether investors fully incorporate into stock prices, or partially overlook, the information conveyed by these exercises when making their investment decisions at the time of the exercise disclosures Stock price drift following executives early stock option exercise disclosures If investors partially overlook valuation relevant information conveyed by option exercise disclosures, a negative stock price drift should be observed in the post-exercise-filing period, as 22