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Federal securities law defines a ‘corporate insider’ to be an officer, director, or major shareholder of a corporation. The first definition of ‘insider trading’ refers to any purchase or sale of public-corporation stock by an insider of that corporation. The second definition does not require the trader to be a corporate insider, but does require that the trader possess material non-public information. Within this article, all uses of the generic term ‘insider trading’ encompass both of these definitions. When necessary, the two definitions are referred distinctly as ‘trading by insiders’ (any transaction that is made by a corporate insider) and ‘trading on inside information’ (a transaction that requires material non-public information but need not be made by a corporate insider).

In the United States, prior to 1934 insider trading was regulated by state-level corporate law. In the first few decades of the 20th century, states used a variety of criteria to adjudicate cases, with a substantial minority of states holding that corporate directors had a duty to disclose material information before buying (but not selling) stock. Federal regulation of insider trading did not begin until the Securities and Exchange Act (SEA) of 1934. Rule 10b of the SEA made it unlawful for any person ‘to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative device or contrivance in contravention of such rules and regulations as the Commission may prescribe (Bainbridge, 2001). This sweeping language does not directly mention either corporate insiders or material non-public information, but later judicial interpretations expanded its scope to these cases. Corporate insiders do appear in Section 16a of the SEA, which requires that open- market trades by insiders be reported to the Securities and Exchange Commission (SEC) within ten days after the end of month in which they took place. These reports, filed on the SEC’s ‘Form 4’, are the source of data for almost all of the empirical studies of trading by insiders.

It was not until 1961 that the SEC took its first administrative action on an insider-trading case (Cady, Roberts, & Co.), and it would be another seven years before the first federal insider-trading case was decided by the courts (SEC v. Texas Gulf Sulphur Co. (1968)). In the decades since these seminal cases, the courts have reaffirmed and expanded the SEC’s role in the regulation of trading on inside information. Despite the long judicial record, there is still considerable confusion and a continuing evolution about the scope of regulation, with debates about the type of information that is considered to be ‘non-public’ or ‘material’, and about the necessity of the trader having some fiduciary relationship to the company. A discussion of these issues is beyond the scope of this survey; readers are referred to Bainbridge (2001) for a summary.

The United States was the first country to use securities regulation to prohibit trading on inside information. Other countries were slow to adopt similar regulations: Bhattacharya and Daouk (2002) report that, as of 1990, of 103 countries with stock markets, only 34 had any prohibitions on insider trading, and only 9 had enforced their prohibitions with a prosecution. The same paper, however, reports that, by 1998, 87 countries had prohibitions and 38 had made at least one prosecution.

The remainder of this article reviews the two main strands of economic literature on insider trading. First, scholars on the intersection of law and economics analyse the social-welfare implications of insider-trading regulation. Second, financial economists use empirical evidence of trading by insiders to analyse the efficiency of stock markets. Each of these two topics has developed an extensive literature since the 1960s.

Social Welfare

Prior to the 1960s, scholars gave little thought to the social-welfare implications of insider-trading regulation. With the Cady case of 1961, the first federal regulation in the United States stimulated a large literature on the topic, beginning with Manne (1966). The economic debate revolves around six main issues: market liquidity, informational efficiency, market manipulation, efficient managerial compensation, the costs of regulation, and the necessity of federal law.

Market liquidity. The pro-regulation side argues that, if trading on inside information were pervasive, then non-insiders would be discouraged from trading, thus reducing market liquidity and all of the other good things that come from having well-functioning capital markets. The logic here is straightforward: if non-insiders perceive that counterparties are likely to possess inside information, then they face an adverse-selection problem, and will demand a discount (if buying) or premium (if selling). The resultant spread between bid and ask prices would then act effectively as a tax on every transaction, which lowers the amount of trade.

In response to this argument, the anti-regulation side argues that the total amount of insider trading is very small, and is thus unlikely to create much of an adverse-selection problem for most stocks. Under the current regulatory regime in the United States, these adverse-selection costs do indeed seem to be low. Jeng et al. (2003) examine all reported trading by insiders in the United States from 1975 to 1996. After estimating the profits earned by insiders on these trades, the authors estimate that non-insiders have expected trading losses of about ten cents per $10,000 trade for non-insider sales and less than one cent per $10,000 trade for non-insider purchases. These results require two caveats. First, the study considers only the trades that were reported to the SEC. If the most profitable trades by insiders go unreported, then non-insiders may face larger expected losses. Second, these costs reflect the regulatory regime in place during the relevant period in the United States. If insider-trading restrictions were significantly loosened, then the frequency and profitability of insider trades might be quite different.

Informational efficiency. A second argument in favour of regulation is that, in the absence of regulation, insiders might be induced to hoard information until such time as it could be exploited in the most profitable way. For example, suppose that the managers of company XYZ have just learned of a major problem at one of their production facilities, which they expect to reduce company value by ten per cent. At the same time, managers also learn that a major research breakthrough has been made on another project, which would have an offsetting effect on firm value. Under these assumptions, if both pieces of information were immediately released, there would be no stock-price reaction. However, if insider trading were always permitted, managers would have an incentive to delay one of these announcements. For example, managers could release the bad news first, decreasing the stock price, and then buy stock in advance of releasing the good news.

The anti-regulation side provides a direct counterargument, claiming that insider trading is likely to speed up the flow of information to the market. As a counter to the example presented above, imagine that managers learn only the bad news about the production facility, with no good news about research. In this case, one can imagine these managers trying to contain this information for as long as possible, perhaps in the hope that the problem can be fixed before it is made public. In a regime without any insider trading, this strategy might be possible. With no restrictions on insider trading, however, managers would have a strong incentive to sell shares. In an extreme case, they could even sell shares they do not own (‘short selling’), thus providing a virtually unlimited amount of selling, and driving the price to its ‘correct’ level. Opponents of regulation argue that this kind of scenario is common, and that insider trading would allow stock prices to adjust more quickly to new information. Unfortunately, there is no empirical evidence to give us more insight into this debate, nor is it easy to imagine a plausible data-set that could provide such evidence.

Market manipulation. Once again, consider the situation of company XYZ, with problems at its production facility and the potential of research breakthroughs. For managers who live through these events, it is only a short leap to imagine the possibilities of market manipulation. For example, a well-placed rumour – coming from an insider – could move the stock price and allow for profitable trading. Opponents of regulation could counter that market manipulation can be illegal, even if trading on inside information is not. The game can grow more complex, however, if managers engage in real activities that allow for higher volatility and increased trading opportunities. For example, a CEO can increase expenditure on research and development well beyond optimal levels, safe in the knowledge that this combination of projects will increase the real underlying volatility of corporate value. In this case, the manager is manipulating the economic activities of the firm in an economically wasteful manner.

Efficient managerial compensation. Opponents of regulation argue that profitable insider trading is mostly a transfer of wealth from shareholders to managers, and thus can be treated the same as any other form of managerial compensation. For example, if shareholders believe that the CEO of their company can earn about $5 million per year from trading on inside information, then the company can reduce the CEO’s other compensation by that same amount. In this scenario, the shareholders are not injured at all by the insider trading. Of course, this argument rests on the absence of the other costs discussed above: market liquidity, informational efficiency, and market manipulation.

The costs of regulation. Opponents of regulation argue that effective enforcement would be prohibitively costly. Insiders have many vehicles to exploit their superior information. In addition to stock trading in their own account, they can tip other traders, sometimes using complex ‘tipping chains’ that are difficult to detect. Furthermore, insiders may be able to exploit superior information by not trading at all. For example, if a manager of XYZ was planning to buy stock, but then learns bad news about a production problem, he could then decide not to buy. Since the manager has taken no action, there is no conceivable way that this exploitation of inside information could be detected. Of course, these opportunities for insider ‘nontrading’ are limited, since they presuppose a standing (but reversible) decision to trade.

The importance of this argument is ultimately an empirical question. In the absence of more complete information, it is impossible to know the frequency of different kinds of trading opportunities and the costs of detecting each type. Proponents of regulation can also argue that, even when detection probabilities are low, sufficiently high penalties can still provide effective deterrence.

Necessity of federal law. Prior to the Cady case of 1961, insider trading in the United States was governed by state law. Opponents of regulation argue that these state laws are sufficient, and the regulation of insider trading under federal securities laws is illogical and inefficient. There is much legal scholarship to support this view (Bainbridge, 2001), as the legal theories of insider trading are still struggling for a solid foundation, having adopted and discarded several models in the decades since Cady. The economic justification for leaving insider-trading regulation to the states rests on the identification of insider trading as a private issue between a company and its shareholders, with no externalities to security markets. If it is indeed a private issue, then opponents of regulation are correct that insider trading is the purview of other corporate law, which is left to individual states. If externalities exist – for example due to effects on market liquidity or informational efficiency – then federal regulation can be justified.

Overall, these six issues comprise the main topics of debate between the proregulation and anti-regulation sides. As seen by this survey, the empirical evidence on each of these issues is limited. For the debate as a whole, the best evidence comes from the aforementioned paper of Bhattacharya and Daouk (2002). After surveying the 103 countries with stock markets to assess the existence and enforcement of insider-trading laws, the authors used a variety of methods to estimate the cost of capital in each country. They find significant evidence that the cost of capital falls after the first enforcement of insider-trading laws. In contrast, the establishment of laws (prior to the first enforcement) has no effect on the cost of capital. Thus, for some combination of reasons – liquidity, informational efficiency, and so on – it is cheaper for firms to raise capital in markets that enforce prohibitions against trading on inside information.

Market Efficiency

While law-and-economics scholars focused on social welfare, financial economists saw a good opportunity to use insider-trading data to test market efficiency. This literature began in earnest with the definitions of the efficient markets hypothesis (EMH) (Roberts, 1967), which comes in three versions: weak, semi-strong, and strong. Weak-form efficiency means that current asset prices incorporate all information contained in past prices; semi-strong efficiency means that current asset prices incorporate all public information; strong-form efficiency means that current asset prices incorporate all relevant information, both public and non-public.

Data on trading by insiders can be used to test both the strong and semi-strong versions of the EMH. If the strong form of the EMH holds, then insiders should not be able to make excess profits on their trades, since any information possessed by insiders would already be incorporated in market prices. One can test this implication of the EMH by analysing the risk-adjusted returns earned by insiders, where the main complication is the definition of ‘risk-adjusted returns’. The capital asset pricing model (CAPM) was the first model of risk-adjusted returns to be widely adopted by economists. Finnerty (1976) uses the CAPM to evaluate the equally weighted returns to all insider trades in NYSE stocks from 1969 to 1972. He finds that insider buys overperform and insider sales underperform their CAPM benchmarks, thus providing the first direct evidence against the strong form of the EMH.

In the decades that followed Finnerty’s study, researchers developed several other methods of computing risk-adjusted returns. Jeng et al. (2003) test the strong form of EMH using these more modern methods on 25 years of disclosed insider trading: they conclude that insiders earn positive risk-adjusted returns on their purchases but not on their sales. Since both the Finnerty and Jeng, Metrick and Zeckhauser studies focus on transactions reported to the SEC, they may both be underestimating insider profits if the most profitable transactions are unreported. While comprehensive data on unreported transactions is, by definition, unavailable, a unique study by Meulbroek (1992) does provide some evidence. Using proprietary data from SEC investigations of insider trading, then-SEC employee Meulbroek concluded that these transactions earned substantial risk- adjusted profits. Overall, the Finnerty, Jeng, Metrick and Zeckhauser, and Meulbroek studies provide significant evidence against the strong form of the EMH.

While the strong form of the EMH is of interest to regulators and academics, the semi-strong version commands far greater attention from investors; if the semi-strong version is false, then there exist profitable trading strategies based on public information. Economists have focused on insider-trading data as one possible source of such information. The first study of this data is Smith (1941), who finds no trading advantage for insiders, a result that discouraged other researchers until the work of Lorie and Niederhoffer (1968). These authors point out the severe problems of the SEC data, with trade dates often off by several weeks. These data problems invalidated the Smith study and opened the door to a new generation of analyses.

To handle these problems, Lorie and Niederhoffer devised a strategy that has dominated the insider-trading literature to this day: analyse the risk-adjusted returns to firms in relation to the ‘intensity’ of insiders’ purchases and sales over well- defined periods. For example, a stock may be labelled an ‘insider buy’ for a month if at least three insiders bought the stock and no insiders sold it. In the decades that followed, many authors adopted this methodology, with the most important examples being Jaffe (1974) and Seyhun (1986). These many studies use a variety of intensive-trading criteria for many different sample periods, and are nearly unanimous in concluding that stocks that are intensely bought tend to outperform relevant benchmarks over a subsequent period, and that those that are intensely sold tend to underperform. They provide mixed evidence on whether other investors can profit, after transactions costs, by using this information. Seyhun (1998) summarizes this evidence and concludes that several different trading rules lead to profits. Overall, this literature provides strong evidence against the semi-strong version of the EMH. As in all tests of the EMH, this conclusion is specific to the time period studied and the models used to estimate risk-adjusted returns. Defenders of the EMH can always propose that the effect will go away once investors learn about it, or that researchers will discover some additional risk factor to explain the results.

Conclusion

After 40 years of intense study, research in insider-trading has made substantial progress. Scholars of law and economics have identified the main arguments for and against the regulation of insider trading, and the limited empirical evidence on these arguments has sharpened the debate for future researchers. Further progress is most likely using data-sets from the many countries that have recently begun to regulate insider trading. For financial economists, the evidence on market efficiency is more straightforward. There is significant evidence that insiders profit on their own trades, and that outsiders can profit by gleaning information from the trades of insiders. Under the assumption that there is no missing risk factor that can explain these results, this evidence argues against both the strong and the semi-strong versions of the efficient markets hypothesis.

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