The receipt of a comment letter from the Securities and Exchange Commission induces many top executives to start selling shares in their companies before the letters are released to the public, according to a new study.

The study, which was presented at a recent annual meeting of the American Accounting Association, raises troubling questions. Researchers found that top executives frequently take advantage of a period before the letters are made public (no sooner than 20 business days from resolution) to unload large amounts of their company shares. The study noted that the stock market reacts slowly to SEC disclosures of comment letters, in part because information about them can be difficult for the average investor to discover.

The SEC is required to issue comment letters every three years at a minimum to each of the thousands of companies that file documents with it. In the words of the SEC, these reviews “involve evaluating the [filings] from a potential investor’s perspective and asking questions that an investor might ask when reading the document.”

If the SEC has questions or concerns, they are detailed in a comment letter to which companies have 10 days to respond, and correspondence goes back and forth until all of the comments have been resolved.

The new study, “SEC Comment Letters and Insider Sales,” by Patricia Dechow, Alastair Lawrence and James Ryans of the University of California, Berkeley, was among hundreds of scholarly presentations at the American Accounting Association meeting, which drew more than 3,000 scholars and practitioners to Atlanta earlier this month. The researchers found that insider sales were nearly 70 percent above normal in the five business days prior to public disclosure of SEC comment letters that involve revenue recognition, which is among the most critical of the accounting issues addressed in these letters and arguably the most likely to raise red flags for investors.

Over those five days the value of shares unloaded by insiders of the relevant firms was about $360 million above normal (that is, above what would randomly be expected), with CEOs, CFOs, board members and other higher-ups all contributing to the total.

In addition, by virtue of the slowness of market reaction, heavy insider selling continued in the two weeks after the disclosure, proceeding at 30 percent above normal from disclosure day through day five, and then rising to 108 percent above normal from day six through day 10.

The slow market reaction enables insiders “to wait until after the comment-letter release date to trade, and [thereby] fulfill their fiduciary and ethical duties,” the study’s authors wrote. However, the lack of an immediate negative stock-price response to the release of the comment letter correspondence would make it difficult for class-action lawyers to sue the insider.”

The researchers concluded that “the current practice of delaying the real-time disclosure of SEC comment-letter correspondence is problematic and support[s] concerns from the investment industry that the disclosure delay appears to best serve the interests of corporate insiders.

Moreover, the results suggest that the SEC should encourage corporate boards to implement insider-sale blackout periods during the comment-letter review process.”

The SEC could take further steps, according to one of the researchers. “Besides shortening the time lag of disclosure from the current 20 days, the Commission should improve online access to comment letters,” Dechow added. “The current set-up is quite opaque unless you check daily, and it almost certainly contributes to the slow response of the market to disclosure.”

The study found that downloads of comment letters from the SEC Web site amounted to only 1.1 percent of downloads of the corporate annual reports filed on 10-K forms on their respective release dates and a mere 1.7 percent of 10-K downloads over 50 days after the public release of the letters.

“The opaqueness of comment-letter disclosures reduces the likelihood that market participants (including analysts and the press) will read comment letters and subsequently detect insider trading,” the study’s authors wrote. They noted that “the average news coverage on comment letter disclosure dates is virtually non-existent relative to news around other events, such as earnings announcements.”

The researchers analyzed comment letters issued in response to 6,728 corporate 10-K submissions filed with the SEC from 2006, when public disclosure of comment letters was first instituted, through 2012. The research focused specifically on letters dealing with revenue recognition, which constitute 1,299 correspondence exchanges, or close to 20 percent of the total.

As they anticipated, the researchers found that letters involving revenue recognition elicited significantly more insider selling than those raising other matters. For example, simple requests for clarifications or for more information on fairly minor issues. More importantly, they found the greatest amount of insider-selling to occur among two subgroups of companies: those with large amounts of shares sold short or those with high levels of non-cash accounting items called accruals.

Among 293 companies in the former subgroup, which constituted the top quintile for short interest, insider sales in the five days before disclosure were approximately 200 percent above normal. Among 255 firms in the latter group, constituting the top quintile in accrual levels, insider sales in those five days were about 77 percent above normal.

“A high short position indicates disagreement among investors about the value of the firm,” the study explained. Such firms are “likely to have both financial-quality reporting issues and be overpriced. This combination is likely to provide stronger [selling] incentives for insiders who are worried about the information in a comment letter.” As for firms with high accruals, research has shown that they “have less sustainable earnings and greater future write-offs” and that their stocks “tend to underperform in the future.”

For all the groups—whether the 1,299 companies questioned about revenue recognition or the subgroups with high levels of short interest or accruals—cumulative stock returns for the 20 business days following disclosure of comment letters were roughly in line with those of the market. But then cumulative returns for the firms in the subgroups went south, as those of companies with high short interest fell to 5 percent below returns of the market at 50 days post-disclosure and those with high working-capital accruals fell to 2 percent below the market.

As for the revenue-recognition group as a whole, cumulative returns remained roughly at market levels for the full 50 days following comment-letter disclosures for companies where the letters did not motivate insider sales. But they fell 1 percent below market in firms where executives could be perceived as betraying shareholders by selling stock based on privileged knowledge of the letters and doing so with impunity thanks to vagaries in the corporate disclosure system.

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