Executives get advance warning when an unfavorable regulatory comment on revenue is going to be made public, and they use that lead time to dump stock, according to a recent academic study presented to the American Accounting Association.

The authors of the study out of the University of California at Berkeley say they have gathered evidence that shows an increase in insider trades before public disclosure of comment letters from the Securities and Exchange Commission related to revenue recognition. They also say they see evidence that trading is more pronounced at companies where there are legitimate financial reporting and valuation concerns. “Our finding suggest that the time delay in comment letter disclosure can be used by corporate executives to avoid small but significant stock price losses,” wrote authors Patricia Dechow, Alastair Lawrence, and James Ryans.

The study analyzes SEC comment letters issued in response to 6,728 corporate 10-Ks filed from 2006 through 2012. The research focused particularly on letters dealing with revenue recognition, which constitute nearly 20 percent of the correspondence exchanges. The study looked for trade patterns in the 20 business days before a comment letter is published. That window of time is important because the SEC allows 20 days after completing a comment letter exchange to redact any confidential information before releasing comment letters to the public. That means executives know for at least 20 business days before investors what is about to be made public.

The study identifies companies that have financial reporting quality and valuation issues as those with high interest among short sellers and those with high accruals. The results say insider sales are nearly 70 percent above normal in the five business days leading up to public disclosure of SEC comment letters that involve revenue recognition, one of the most critical accounting issues to be raised and most likely to raise red flags with investors. Over the course of those five days, the value of shares dumped by insiders was about $360 million above what might be expected to occur randomly, the study says, with CEOs, CFOs, board members and other top executives all involved.

The study also found that the market is slow to react to the release of such comment letters, and insider trading remains heavy in the two weeks following disclosure. The slow response allows insiders to wait until the comment letters are released and then trade, thus fulfilling their fiduciary and ethical duties, the authors say.

The authors concludes that while the 20-day delay in publishing comment letters is unavoidable, it creates a window of time after comment letter correspondence is complete for insiders to “sit on private information” concerning the findings. “The study provides empirical evidence suggesting that corporate insiders take advantage of this opportunity and unload shares prior to the public disclosure of SEC comment letter correspondence,” the research report says.

The results suggest the SEC should encourage corporate boards to implement insider sale black-out periods during the comment letter review process, the authors say. "Besides shortening the time lag of disclosure from the current 20 days, the commission should improve online access to comment letters,” says Dechow. “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."

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