Internal Control Effectiveness and Insider Trading

Abstract

We predict a negative relationship between internal control effectiveness and opportunistic insider trading based on agency theories. Empirical evidence on the profitability, intensity and timing of insider trades supports the prediction. Insider trading profitability is higher for firms with internal control deficiencies than those without. Insider trading profitability decreases sharply after internal control deficiencies are exposed and decreases further when those deficiencies are remediated. Insider trading intensity is higher for firms with internal control deficiencies, but it drops significantly when such deficiencies are exposed. After internal control problems are exposed, insider trades become more concentrated in short windows immediately following earnings announcements, consistent with firms adopting blackout policies to specifically restrict insider trading as a part of their effort to improve internal control. Lastly, the increase in the likelihood of blackout policies is more pronounced for firms that have more serious insider trading problems based on ex ante classification.