Legal insider trading? This is what it is and how it affects investors
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Many people presume that insider trading is always illegal. The term has been associated with scandals and names such as Enron, celebrity businesswoman Martha Stewart, and former Goldman Sachs director Rajat Gupta.

In fact, if you type “insider trading” in Google’s search box, the first hit is a definition from Google: “the illegal practice of trading on the stock exchange to one's own advantage through having access to confidential information.” This is inaccurate at best, because the term “insider trading” includes both legal and illegal conduct.

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Illegal insider trading is considered an action of security fraud. The Securities Exchange Act of 1934 makes it clear that any person who purchases or sells a security while in possession of “material, non-public information” shall be held liable. This does not only apply to “corporate insiders” such as managers, directors or employees, but also to de-facto insiders who obtain material, private information from various sources. You could overhear some important news when dining at a restaurant, but trading on such information could potentially constitute illegal insider trading.

 

You can’t even ask your friends to profit from the information because “tipping” the information violates the law as well (Gupta got two years in jail because of this). Information is material if there is a substantial likelihood that it will affect a company’s stock price once released. In practice, it is usually difficult to prove how “material” information is. As such, illegal insider trading is very difficult to detect and prosecute.

The legal conduct of insider trading refers to trading by “corporate insiders.” A long list of people fall into this category — directors, managers, employees, beneficial owners, and people affiliated with the firm in other significant ways. These people are allowed to trade securities of their firms, provided that they are not in possession of material, non-public information.

Trades by corporate insiders must be filed with the U.S. Securities and Exchange Commission within two business days. Although these trades are not supposed to contain material information, many people believe that these trades reflect information which is not material enough to be released otherwise. Academic studies also find that insider trades can predict future stock returns and earnings.

How informative are these legal insider trades? In my research, my collaborator and I analyzed all open-market insider purchases from 1991 to 2014. The cumulative abnormal return (excess return after adjusting for stock beta) over a three-day window after insider purchases is 1.359 percent. Furthermore, we observed an upward trend in the cumulative abnormal return over time (from 0.889 percent in 1991 to 1.697 percent in 2014).

Consistent to what people would expect, insider purchases seem to move stock prices more than insider sales do, and trades by managers and directors seem to move stock prices more than other trades do. Following insider trades, especially the large purchases by directors and managers, can be a lucrative trading strategy for sophisticated investors.

So, should all forms of insider trading be prohibited? While many people might feel insider trading is not “fair” to outside investors (like you and me), economists have long attempted to answer the question from the perspectives of shareholder wealth and cost of capital. Empirical evidence so far suggests that illegal insider trading may have adverse effects on the general information environment, and can thus increase a firm’s cost of capital and decrease a firm’s market value.

However, some researchers argue that legal insider trading could benefit shareholders by making stock prices more informative, which further leads to lower cost of capital and higher firm value. In my research, I did find empirical evidence supporting this view. It also shows that the intensity of legal insider trading may increase firm value, and firm-level insider trading restrictions may have adverse effects on a firm’s market value.

Furthermore, it finds that these results primarily reside in moderately profitable insider trades. When analyzing the insider trades which are extremely profitable, the findings show that the intensity of such trades is associated with higher cost of capital and lower firm value. Overall, the findings suggest that legal insider trading and illegal insider trading have very different effects on a firm’s information environment, cost of capital, and shareholder value.

While illegal insider trading hurts shareholders and should be prohibited, legal insider trading may actually reveal valuable information to investors and analysts (in practice, we see investors designing trading strategies based on legal insider trading, and analysts revising their forecasts following insider transactions), and lower a firm’s cost of capital in the long run.

However, effective monitoring, both from the SEC and from shareholders, is still necessary for legal insider trading. Extremely profitable insider trades, which are more likely to contain material information, or in the “grey area,” may cost shareholders.

David Tang is an assistant professor at the Graduate School of Management at Clark University, where he specializes in empirical corporate finance, market efficiency, and insider trading.


The views expressed by contributors are their own and are not the views of The Hill.