Carolyn B. Levine

Public Disclosure and Dissimulation of Insider Trades

Regulation requiring insiders to publicly disclose their stock trades after the fact complicates the trading decisions of informed, rent-seeking insiders. Given this requirement, we present an insider’s equilibrium trading strategy in a multiperiod rational expectations framework. Relative to Kyle (1985), price discovery is accelerated and insider profits are lower. The strategy balances immediate profits from informed trades against the reduction in future profits following trade disclosure and, hence, revelation of some of the insider’s information. Our results offer a novel rationale for contrarian trading: dissimulation, a phenomenom distinct from manipulation, may underlie insiders’ trading decisions. JEL Classification: G28 K22 M41

Discipline with Common Agency: The Case of Audit and Non-audit Services

Using a common agency model, we investigate the strategies of self-interested auditors (the agent) hired by both managers (for non-audit services) and shareholders (conducting an audit) of the same firm. In a single period model, managerial discretion over consulting fees can influence auditors to issue reports that are more favorable than warranted. Shareholders, represented by an audit committee cannot recover truth-telling. Removing the current restriction on contingent audit fees allows audit committees to offset the incentives provided by management and instead provide the auditor incentives to report truthfully. Extending the model to a multiperiod framework, the audit committee can motivate truth-telling by making retention decisions which are contingent on outcome. Auditors will consider the impact of overreporting on their ability to generate future audit fees from the same client.

Public Disclosure of Trades by Corporate Insiders in Financial Markets and Tacit Coordination

We consider the consequences of public disclosure of insider trades on trading costs and price discovery in financial markets. Similar to Cournot competition in product markets, corporate insiders with common private information have incentive to trade more aggressively than a monopolist with the same information. Since, given periodic financial corporate reporting, insiders routinely have access to information in advance of the market, it is reasonable to expect them to seek ways to limit trades and, thereby, increase profits. Public reporting of insider trades may have the unintended effect of furthering tacit coordination by allowing insiders to monitor each others’ trades. Moreover, even without such reporting, we show how insiders may be able to sustain coordinated behavior depending on the distribution characterizing liquidity trading. Thus, competition among corporate insiders may be less influential in price discovery than previously thought.

Using MD&A to Improve Earnings Forecasts

In this paper, we develop techniques that combine text with financial variables to generate explicit firm-level forecasts. We find that text-enhanced models are more accurate than models using quantitative financial variables alone, providing evidence on the predictive value of the MD&A section. Firms with smaller changes in current performance, larger changes in future performance, negative changes in future performance, higher accruals, greater market capitalization, lower Z-scores, higher audit quality, shorter and more readable MD&A text, and higher incentive-based compensation have more informative MD&As. MD&A is more informative in the period following regulatory reforms but less informative in the period covering the recent financial crisis. Finally, we show that analysts lose their forecasting superiority over text-enhanced statistical models for smaller firms and those with lower analyst following.

Ex Post Voluntary Disclosure Strategies for Insiders

Asymmetric information between corporate insiders and other market participants can lead to large bid-ask spreads or even a collapse of trade in financial markets. In this paper, we discuss how voluntary disclosure by insiders can remedy this problem. When insiders make disclosure decisions after they become informed, other market participants update their prior beliefs on the basis of both the information disclosed and the information not disclosed. Insiders then give up some or all of their information advantage to weakly increase their profits. These results do not rely on ex ante commitments on the part of the insiders.

The Relative Efficiency of Clawback Provisions in Compensation Contracts

Clawbacks are retractions of previously-awarded bonuses. In our model, the manager takes a first-period effort that stochastically determines a first-period signal and a second-period cash flow. Both the cash flow and the signal are noisy indicators of effort. The agent can manipulate the signal, i.e., manage earnings. The no-clawback contract pays the agent in the first period for a good signal. The clawback contract also rewards the good signal, but the payment is in the second period and may be lower if the cash realization is low. The agent is impatient and prefers a first-period payment. We find that the no-clawback contract dominates the clawback contract if the cash realization is relatively noisy, earnings management is difficult, or the agent is very impatient. Earnings management may be optimal even though the actual cash realization is contractible. A contract involving restricted stock is always dominated by the clawback contract. The results demonstrate that the optimal ex ante alignment of manager and shareholder interests does not imply perfect ex post alignment of manager and shareholder payoffs.

Usefulness Lost: Aggregating Information with Differing Levels of Verifiability

In this paper, we study information asymmetries about verifiability between a principal and an agent. Our main result is that an information asymmetry about verifiability not only reduces the usefulness of a given performance measure for stewardship purposes, it can completely destroy that performance measures usefulness.

Information dissemination by insiders in equilibrium

This paper generates an equilibrium explanation for partial disclosure of information by an insider to privileged associates. In our model, prices are set by competitive market makers in anticipation of trading volume, but are not affected by the actual number of trades realized. Liquidity demand is not perfectly inelastic, but rather liquidity traders are sensitive to trading costs through a reservation price. Because the profits from liquidity traders are bounded, the feasibility of an equilibrium depends on the balance between the number of associates, the precision of their information and the number of liquidity traders. Partially, rather than fully, disclosing information alters this balance by limiting the informational advantage of individual associates. If the number of associates is exogenous, this partial disclosure prevents market failure. If the insider chooses the number of associates, partial disclosure allows him to serve more associates and (potentially) increase total associate profits.

Information Externalities, Underinvestment, and Organizational Remedies

We examine the interaction between inter- and intradivisional learning and organizational design. In both periods of the model, managers make investment decisions. Innovation is costly because the expected cashflows associated with innovation are lower than expected cashflows of the status quo. However, first-period innovation produces valuable information about the probability of success of second-period innovation. Interdivisional learning, or the utilization by one division of information from another divisions innovation, may lead to underinvestment, suggesting an often overlooked cost associated with decentralization in horizontally integrated firms. We explore ways for the principal to alter information flows to increase the investment efficiency through accounting systems, organizational structure, and horizontal disintegration.