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Literature review on Insider Trading and Insider Trading Regulation
Abstract Views on insider trading and its effects on information asymmetry have evolved over the years. In the very early days, academic research on insider trading initially focused on establishing its existence and the need for regulation. Subsequently, research focused extensively on gauging the effectiveness of insider trading regulation. In recent times, the focus has shifted to identifying factors that contribute to effective enforcement of insider trading regulation. Indeed, markets across the world are in various stages of enforcement and are actively setting up the relevant support systems in a determined bid to curb insider trading. Developed markets have been at the forefront; establishing and continuously improving the regulatory architecture. Asia, in general and India, in particular, have been playing catch up. In India, insider trading regulation has gained vigor with the inclusion of prohibition of insider trading in the revamped Companies Act of 2013; so far it had the status of only a rule. A new ordinance also empowers the regulator, Securities and Exchange Board of India (SEBI), with explicit powers to settle administrative and civil proceedings. Our survey explores the various facets of the academic research on insider trading and its regulation. We place such research in the context of Asian and Indian regulations on the subject, where in contrast to developed markets, insider trading is considered to be more prevalent and research on its effects considered being more limited.
October 2013
Literature review on Insider Trading and Insider Trading Regulation
October 2013 Page 2
I. Introduction Corporate insider trading as a theme has resonated with researchers across domains spanning disciplines such as Accounting, Economics, Finance, Law, Management and Social Science. Various facets of Insider Trading and Insider Trading Regulation, from here on referred as IT and ITR respectively, have been explored extensively in academic literature across such disciplines. This is especially true in the context of the developed world and more so with regard to the US. In this report, we present a overview of the literature coverage on this theme with a special focus on ITR.
The review is organized as follows. Section II discusses who an insider is and the philosophy behind abnormal returns. Section III elucidates the divergent views on ITR drawing support from extant literature. Section IV sheds light on the current state of ITR across the world. Section V discusses the effectiveness of ITR while section VI takes a detailed look at literature to crystallize what aspects of ITR have worked and are necessary for ITR to succeed. Section VII critically examines the various methodologies adopted by researchers to validate their findings. Section VIII examines ITR related studies from an Indian context. Section IX suggests areas for further research. Section X summarizes and concludes.
II. Insiders and abnormal returns There is no uniform definition of an insider. The definition varies across jurisdictions, across purpose and is dependent on the relevant regulatory context in which it is stated1. In general, the definition is narrower from a disclosure viewpoint but much broader in scope from a legislative perspective. The narrower definition covers directors, officers and large shareholders of a company who are close to the source of potential material, non-public information (MNPI) relating to the company by virtue of their position. Accordingly, regulatory disclosure requirements are stringent with respect to insiders as per the narrower sense. In its broader sense, insiders could encompass several others who have access to MNPI and could trade on them. Here again, the definition varies across jurisdictions. US laws require existence of a fiduciary relationship for an individual trading on MNPI to be charged under ITR while such a fiduciary relationship is not necessary in the UK.
Researchers have found evidence of abnormal returns earned by both the narrower and broader groups of insiders. From an empirical standpoint, most of them have restricted themselves to the narrower scope given the richness of data availability. Finnerty (1974) notes that insiders, who during 1969-72 bought their own company shares listed on the NYSE, managed a cumulative abnormal return (CAR) of 8.61% over an 11-month holding period. Pratt and DeVere (1970), Jaffe (1973), Seyhun (1986) and Jeng et al (2002), among others have validated the earning of abnormal returns by registered insiders.
A few have attempted to target the wider group too, basing their study on prosecutions by regulatory authorities. For instance, Muelbroek (1992) based her analysis on individuals charged with insider trading by the US Securities and Exchange Commission (SEC) in civil or administrative cases during 1980-892. The author estimated that CAR for an insider trading episode to be 6.85%.
1 For instance, the US SEC defines a registered insider as an officer, director or a shareholder owning >10% of any equity share class of a company. From a regulation viewpoint, insiders include constructive insiders encompassing among other members, lawyers, accountants and investment bankers associated with the company 2 Frino et al looked at similar cases prosecuted by SEC over 1996-2004
Literature review on Insider Trading and Insider Trading Regulation
October 2013 Page 3
III. Views on ITR Manne3 (1966) is clearly the most quoted on discussions of the benefits of insider trading and correspondingly, why ITR should not be adopted. Manne put forth two primary arguments in support of insider trading. He argued that insider trading helps to gradually move the price of a stock closer to its fair value since insiders trade on the basis of MNPI4. He asserted it prevents abrupt adjustment shocks in the share price when the news turns public, which he contended could adversely affect investors. Manne also argued that IT is the best means to reward entrepreneurship5 and promote innovation. He believed this would be an effective solution to tackle the agency problem between shareholders and managers, as it rewards producers of information and encourages them to produce more information and add to the value of the firm6.
Meanwhile, Carlton and Fischel (1983) debated that if insider trading was bad, investors would have put in place even tougher restrictions than what is observed currently. They opined that IT serves as an effective alternative to costly renegotiations of manager compensation contracts7. In addition, they claimed that IT would promote the generally risk-averse managers to take up more risky projects8 and reduce their aversion to disclose negative news.
Javier Estrada (1994), although specifically not arguing in favor of IT, highlighted that the introduction of ITR leads to reduced social welfare by decreasing the flow of information, greater price volatility, risk sharing among a fewer group of investors and diverts resources from production to regulation.
While Estrada advocated against ITR, literature is arguably richer with arguments in favor of ITR. Broadly, the arguments in support of ITR can be grouped under three categories: Market participant benefits, overall market benefits and firm benefits.
Primary argument in support of ITR is that it ensures fairness and equality for all market participants. Insiders could profit from both positive and negative information. This could force them to not act in the best interest of the shareholders. This moral hazard issue can be addressed with ITR (Mendelson, 1969). Leland (1993) estimated that liquidity traders would be hurt the most with IT while outside investors will have to live with lower returns9 since part of the risk gets passed through the price if IT is allowed. Investor confidence would also collapse in a market with IT, making them reluctant to trade (Bhattacharya and Spiegel, 1991).
From an overall market benefit perspective, academic researchers believe that IT could facilitate insiders to manipulate information and earn profits from artificial price volatility (Masson and Madhavan, 1991). It could also encourage them to deliberately delay information release (Easterbrook, 1985; Ausubel, 1990). Further, IT would result in concentrated ownership as outsiders stay away from such market leading to lower liquidity10 (Beny, 2005) and market as a
3 Manne, Henry G., 1966, 'Insider trading and the stock market', New York Free Press, 1966. 4 Bainbridge (2002) refutes Manne argument on the premise that insider trading volumes are insignificant and cannot move prices significantly. He also contends that others can pick on insider activity only if they know of insider identity. With most trades occurring over the exchange, trades are impersonal in nature 5 Bainbridge (2002) contends that is practically tough to distinguish insider trades of entrepreneurs versus the other insiders 6 Value addition argument also supported by Jensen and Meckliing (1976), Meulbroek (1992) and Leland (1993) 7 Bainbridge (2002) felt that compensation argument for insider trading is not valid as it is driven by how many shares an insider can purchase which becomes a question of wealth. 8 Carlton and Fischel (1983)also were supportive of the price efficiency argument and felt insider trading helps identify prospective good managers as only good managers would be open to have insider trading included in their compensation contracts 9 Bainbridge (2002) felt arguments of injury to investors is invalid as investors make a trading decision independently and they would have traded at a given level irres
