The Veracity of Insider Trading Signals in Financially Distressed Firms

Within a sample of firms undergoing financial distress, where the incentive to send false positive signals is high, we show that insider trading serves as a credible information channel about potential recovery for outside investors. We employ credit rating downgrades as confirmation of the distressed state, and we argue that the severe and non-transitory nature of the bad news faced by our sample firms is likely to undermine insiders' incentives to send a false positive signal. However, we find some evidence that a credit watch review prior to a downgrade increases the incentive to engage in false positive signalling, which we suggest is motivated by a desire to demonstrate recovery in the shorter term, in an attempt to avoid the downgrade