The paper provides evidence that the threat of litigation influences managers' accounting and insider trading choices in firms experiencing deteriorating financial performance. We analyze the two-year period preceding technical default for 462 firms during 1983-1997. Our sample firms have deteriorating performance during this period (abnormal returns of -27.5%) and, as in DeFond and Jiambalvo (1994), we find upwards earnings management in the year preceding default (Year -1), but not in the year of default (Year 0). We find that debt contracts and insider selling incentives independently contribute to the Year -1 earnings management. Our tests that examine the timing of the measurement of insider selling relative to earnings management reveal that: (1) managers manage Year -1 earnings upwards when they engage in abnormal levels of selling in Year -1, consistent with earnings management distancing the sale of stock from the revelation of bad news, and (2) managers refrain from managing Year -1 earnings when they trade closer to the event of default (in Year 0). These two distinct patterns suggest that the threat of litigation matters to managers of firms with deteriorating performance. Our finding that contemporaneous insider selling is associated with upwards earnings management should be of interest to researchers who study, and professionals who oversee (e.g., directors, auditors, and regulators) management in firms with deteriorating performance.