by Binay K. Adhikari, Anup Agrawal, and Bina Sharma

Does insider trading regulation actually deter insider trading? This is an unsettled question, on which prior empirical findings have been mixed. One set of studies finds that insider trading regulations have been effective in reducing the frequency and profitability of opportunistic trades,[1] while several other studies cast doubt on the efficacy of regulations.[2] Why do studies disagree on this question? A possible reason is the difficulties inherent in evaluating the effects of regulation on insider trading. These difficulties fall into two main categories: First, most modern insider trading laws in the United States are adopted at the federal level[3] and are designed to affect all firms at the same time. That makes it difficult to tell whether any changes in insider trading are due to the law or some other contemporaneous event. Second, a decrease in insider trading after the passage of a stricter law or an increase in enforcement can either be an effect of such action or simply a return to a more normal level of insider trading after an elevated period that led to the law being passed. Perhaps recognizing these issues, Utpal Bhattacharya concludes his extensive review of the insider trading literature with the verdict, “[w]e need methodologies (such as natural experiments) to evaluate the efficacy of current and future insider trading rules.”[4]

This is the focus of our recent paper, “Does Litigation Risk Deter Insider Trading? Evidence from Universal Demand Laws.” We exploit the staggered adoption of Universal Demand (“UD”) laws in 23 U.S. states and the District of Columbia over 23 years to examine the effect of shareholder litigation risk on opportunistic insider trading. These laws require that in order for a shareholder to bring a derivative lawsuit against directors and officers (“D&O”) for a breach of their fiduciary duty to the company, the shareholder first needs to ask the board itself to bring such a lawsuit. Since boards are unlikely to sue either themselves or the managers who helped them get their board positions, UD laws effectively make it harder to bring derivative lawsuits. Our research is motivated by recent findings that UD laws indeed significantly reduce shareholders’ ability to bring derivative lawsuits.[5] Ian Appel estimates that the adoption of UD laws is associated with a decrease in the probability of derivative lawsuits by 0.5%, or about one-third (= 0.5/1.4), compared to the average probability of 1.4% over his 1994-2010 sample period.[6]

How do UD laws affect insider trading? Derivative lawsuits, which typically allege that D&O breached their fiduciary duty and harmed the company, often also allege that they engaged in insider trading, especially selling. Jessica Erickson finds that about 60% of derivative lawsuits contain allegations of insider trading by D&O.[7] While most derivative lawsuits don’t target D&O insider trading per se, evidence of insider trading by D&O makes shareholder lawsuits more likely to succeed.[8] Therefore, the threat of derivative lawsuits should deter insiders from trading opportunistically. By reducing the risk of facing derivative lawsuits, UD laws embolden D&O to trade more opportunistically, making their trades more profitable. States’ adoption of UD laws provides an excellent opportunity to study a causal effect of regulation on insider trading for two reasons. First, UD laws are adopted by different states at different times over many years. So, their adoption offers rich variation over time and across firms in the probability of derivative lawsuits. Second, although derivative lawsuits encompass insider trading by D&O, they are much wider in scope; and most states seem to have adopted these laws for reasons largely unrelated to concerns about insider trading. This feature makes the passage of UD laws likely exogenous to pre-existing levels of D&O insider trading.

Using our full sample of trades, we analyze the effect of UD laws on the profitability of insider trades measured by their estimated abnormal stock returns.[9] Our analysis shows that, compared to firms unaffected by UD laws,  insiders at firms subject to UD laws avoid approximately -1.8% and -3.4% in abnormal returns over one and three months following a sale, which translates to abnormal dollar loss avoidance of about $23,000 and $60,000, respectively.[10]

While the effect of UD laws on the profitability of insider purchases in terms of abnormal rates of stock returns is mostly insignificant in the full sample, it is significant in some pertinent subsamples such as trades before quarterly earnings announcements (“QEA”). Moreover, we find some significant effects of UD laws on the estimated abnormal dollar profits from insider purchases, which consider the trade volume along with subsequent stock returns.

We conduct many additional tests to understand the timing and opportunism in insider trades following the passage of UD laws. We find that the reduction in litigation risk encourages insiders to time their sales more opportunistically, i.e., they are more likely to sell when prices are inflated and large price declines are likely. In addition, we find that UD laws lead to an increase in the ratio of opportunistic sales to routine sales, as defined by Lauren Cohen, Christopher Malloy, and Lukasz Pomorski.[11] Moreover, we analyze insider trades before QEA, which Usman Ali and David Hirshleifer show are opportunistic trades.[12] We find that pre-QEA insider trades—both purchases and sales—become more profitable after the adoption of UD laws. These results suggest that the risk of being sued by shareholders deters arguably more serious types of insider trades: opportunistic sales and trades before major recurring corporate events.

These effects are larger among firms with greater information asymmetry, such as firms with higher intensity of research and development and lower stock liquidity, which offer more opportunities for profitable insider trading. Moreover, after the adoption of UD laws, insider sales become more profitable in firms that: (1) are smaller, and therefore likely to have fewer alternate governance mechanisms such as company rules against opportunistic insider trading, and (2) have less monitoring by institutional shareholders.

Our finding that insider trading becomes more profitable following the passage of UD laws is stronger for sales than for purchases. What explains this asymmetry? By decreasing the threat of shareholder lawsuits against D&O for wrongdoing, UD laws embolden D&O to misbehave in ways that can harm the firm, for example, by manipulating earnings or engaging in self-dealing transactions. Knowledge of this harm, which would hurt the stock price when the harm is revealed, also provides D&O with an opportunity to sell their stock in the company based on their private information. Since this is the type of conduct that derivative lawsuits typically target, the effect is larger for insider sales than insider purchases.

Our evidence suggests that with a decrease in litigation risk, insiders engage in otherwise riskier and more litigation-prone and profitable trades. Thus, our results support the idea that ex-ante litigation threat caused by shareholder lawsuits plays an important role in deterring opportunistic insider trading. Our evidence also supports the idea that private enforcement can sometimes be more effective than public enforcement in deterring opportunistic insider trading.[13]

Footnotes

[1] See, e.g., Anup Agrawal & Jeffrey F. Jaffe, Does Section 16b Deter Insider Trading by Target Managers?, 39 J. Fin. Econ. 295 (1995); Jon A. Garfinkel, New Evidence on the Effects of Federal Regulations on Insider Trading: The Insider Trading and Securities Fraud Enforcement Act (ITSFEA), 3 J. Corp. Fin. 89 (1997).

[2] See, e.g., H. Nejat Seyhun, The Effectiveness of the Insider-Trading Sanctions, 35 J.L. & Econ. 149 (1992); Ajeyo Banerjee & E. Woodrow Eckard, Why Regulate Insider Trading? Evidence from the First Great Merger Wave (1897–1903), 91 Am. Econ. Rev. 1329 (2001).

[3] E.g., SEC Rule 10b-5, 17 C.F.R. § 240.10b-5 (2015); Securities Exchange Act of 1934 § 16(b), 15 U.S.C. § 78p(b) (2012); Insider Trading Sanctions Act of 1984 (“ITSA”), 15 U.S.C. § 78u-1 (2012); Insider Trading and Securities Fraud Enforcement Act of 1988 (“ITSFEA”), 15 U.S.C. § 78u-1 (2012).

[4] Utpal Bhattacharya, Insider Trading Controversies: A Literature Review, 6 Ann. Rev. Fin. Econ. 385 (2014).

[5] See, e.g., Ian Appel, Governance by Litigation (Bos. Coll. Carroll Sch. Mgmt. Working Paper, 2019).

[6] Id.

[7] Jessica Erickson, Corporate Governance in the Courtroom: An Empirical Analysis, 51 Wm. & Mary L. Rev. 1749 (2010).

[8] See, e.g., Stephen J. Choi, Karen K. Nelson & Adam C. Pritchard, The Screening Effect of the Private Securities Litigation Reform Act, 6 J. Empirical Legal Stud. 35 (2009).

[9] Abnormal returns are stock returns above normal rates of returns predicted by, for example, the Carhart (1997) four-factor model. Our conclusions are not affected by which particular measure of abnormal returns we use. See Mark M. Carhart, On Persistence in Mutual Fund Performance, 52 J. Fin. 57 (1997).

[10] Our conclusions are qualitatively similar over six months following a sale.

[11] Lauren Cohen, Christopher Malloy & Lukasz Pomorski, Decoding Inside Information, 67 J. Fin. 1009 (2012).

[12] Usman Ali & David Hirshleifer, Opportunism as a Firm and Managerial Trait: Predicting Insider Trading Profits and Misconduct, 126 J. Fin. Econ. 490 (2017).

[13] See, e.g., Anup Agrawal & Tareque Nasser, Insider Trading in Takeover Targets, 18 J. Corp. Fin. 598 (2012).

Binay K. Adhikari is an assistant professor at Vackar College of Business and Entrepreneurship, University of Texas Rio Grande Valley. Anup Agrawal is a professor at Culverhouse College of Business, University of Alabama.  Bina Sharma is an assistant professor at College of Business, Bellevue University. This post is based on their recent paper, “Does Litigation Risk Deter Insider Trading? Evidence from Universal Demand Laws,” available here.

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