The veracity of insider trading signals in financially distressed firms

Abstract

We show that insider trading behaviour provides a credible signal of future share return performance within a sample of firms undergoing financial distress. We argue that when firms are in distress the incentive for insiders to employ their trading to send a false positive signal is high, however we find that distressed firms with insider buying have significantly better future share returns than firms with no insider trading or insider selling. We employ credit rating downgrades as confirmation of the distressed state, and we investigate the reasons why the positive signal associated with insider buying deviates from the negative downgrade signal of the rating agencies. Our analysis shows that this is not due to a lack of rating agency information; there are very few rating downgrade reversals. We conclude that insider purchases are partly driven by an over-reaction to bad news in the period of distress, which subsequently reverses; such mispricing would not be expected to be related to informed credit rating actions. We also find that the share return recovery is partial, and this leaves open the possibility that it is inadequate to reach the rating upgrade hurdle. While on average outside investors would benefit from retaining their shares in distressed firms with insider buying, we highlight a subset of firms where this is not the case.