Chen Chen, Xiumin Martin, Sugata Roychowdhury, and Xin Wang have posted a paper to SSRN that attempts to identify firms that suffer from poor internal information flow by comparing the relative insider trading profits of high level managers and low level managers.  They find that when lower level managers make higher profits – suggesting that they have better information than higher level officers – the firm’s external financial reporting suffers.

[More under the cut]

The study is based on an earlier paper that sought to assess the quality of internal information flow by comparing the internal-trading profits of higher level managers and lower level managers.  The theory is that if information flow is poor – so that lower level managers do not, for whatever reason, communicate their knowledge to higher level officers – lower level managers will have greater information about firm operations than higher level managers, and this disparity will manifest in higher insider trading profits for lower level managers.  The study found that firms that exhibit better information flow according to this metric have higher valuations, and more efficient internal capital allocation.

In the new study, Clarity Begins at Home: Internal Information Asymmetry and External Communication Quality, Chen et al. compare the quality of a firm’s external financial reporting to disparities in insider trading profits.  They find that where lower-level managers have greater informational advantages relative to top managers (as evidenced by their insider trading profits) the firms issue fewer, less specific, and less accurate, earnings forecasts.  The firms are also more likely to issue a restatement due to errors (rather than due to fraud), and their financial statements are less readable.  In other words, poor information flow within the firm interferes with top management’s ability to issue accurate public disclosures, and relative insider trading profits of high and low level managers are a good proxy for the quality of information flow.

The study immediately made me think of Section 10(b) litigation (um, as most things do).  In the typical Section 10(b) case, the plaintiff alleges that managers issued rosy descriptions of the business that were later revealed to be false when the managers disclosed ongoing internal problems.  Very often, the critical question is whether the plaintiffs can show that managers knew of the problems when they issued the statements.  At the motion to dismiss stage in particular – when the PSLRA denies the plaintiffs access to discovery – plaintiffs typically argue that management must have known of the problems because they were known to lower level employees.  In such cases, the court must decide whether plaintiffs have raised an inference that information available at the lower levels was reported up the chain.

Chen et al’s study offers an interesting, new way of thinking about the problem, by demonstrating that firms where lower level managers do not communicate with higher level managers can be identified by insider trading profits– and this lack of communication may very well result in false reporting.

Chen et al. also reach the intriguing conclusion that top managers are aware when they are not receiving good internal information.  Managers know, essentially, what they don’t know.  This is demonstrated by the fact that when internal information flow is poor, top managers issue fewer forecasts, less specific forecasts, and use more obscure, hard-to-parse language in their financial reporting – all indicators that they are more uncertain about the accuracy of their statements.  Yet presumably these same managers sign SOX certifications attesting that they have implemented effective internal controls to ensure that material information is brought to their attention.  Which means that one ultimate takeaway may be that managers are not as diligent about SOX compliance as we might hope.