There is a long standing debate in the finance, economics and law literatures about the need for insider trading regulation. Its critics argue that insider trading is an efficient form of compensating insiders. Moreover, it allowsprivate information to be quickly incorporated into stock prices, thereby
leading to more informationally efficient stock prices (Carlton and Fischel (1983), Dye (1984)). Proponents of insider trading regulation contend that insider trading subjects uninformed outsiders to an adverse selection problem, discourages investment, and damages corporate value (Manove (1989), Ausubel (1990), Fischer (1992)). Moreover, allowing insiders to trade at the expense of uninformed outsiders diminishes investor confidence and hurts the integrity of capital markets (Brudney (1979), Easterbrook (1985), Glosten (1989), Maug (1995, 1999)).
In keeping with this view, many countries have adopted insider trading regulations. A survey by Bhattacharya and Daouk (2002) finds that out of 103 countries that have stock markets, 87 have introduced insider trading rules. A principal goal of introducing insider trading restriction appears to be to prevent informationally advantaged insiders from trading at the expense of the uninformed public. In this paper, we ask whether insider trading restrictions reduce the incidence of private information based trading.
In doing so, we recognize that in theory the effect of insider trading regulation on private information trading can be ambiguous. Microstructure literature suggests that while insider trading regulation reduces trading by insiders, it increases private information acquisitions by market professionals. Insider trading regulation reduces the competition market professionals face from better informed insiders and thereby increases their return to information acquisition. Market professionals, who can acquire private information at a cost, are not subject to insider trading restrictions but also trade at the expense of the uninformed investors (Fishman and Hagerty (1992), Shin (1996) and DeMarzo, Fishman and Hagerty (1998)). Thus, whether insider trading restrictions reduce the adverse selection problem facing the uninformed investor remains an open question.
In this paper, we first examine which effect dominates in aggregate. Does insider trading regulation reduce private information trading on average? Using a sample of 2,827 firms from 21 countries we find that it does. Firms in countries with stricter insider trading restrictions are less subject to private information trading. Thus, on average any increase in informed trading by market professionals is not high enough to offset reduced trading by insiders. Next we examine whether this result varies across firms due to the differential effect of insider trading restriction on the trading behavior of informed outsiders. We use concentration of control rights in a firm as a distinguishing factor. Market professionals are likely to avoid firms with concentrated control rights because outsiders are at a severe informational disadvantage relative to controlling shareholders who have free access to information and often trade profitably on this private information. Thus, the marginal effect of insider trading restrictions on increasing the trading activity of outsiders is likely to be higher in stocks that suffer from concentrated control rights.
This factor is important for the question we want to answer. If insider trading restrictions are more likely to spur information acquisition and trading by market professionals in firms with concentrated control rights, this private information trading by outsiders may well offset the reduced activity by insiders. For this reason, we examine the effect of insider trading restrictions on private information trading conditional on the control rights of the largest shareholder. We find high control rights mitigate the negative relation between insider trading restrictions and private information trading. That is, insider trading restrictions reduce private information trading but are significantly less successful in doing so when control rights are concentrated. When control rights are very high, insider trading restrictions may lead to higher private information trading. Any reduction in insider trading caused by strict insider trading restrictions is more than offset by greater informed trading by market professionals. This result is consistent with the idea that although insider trading regulation reduces trading by insiders, it spurs trading by informed outsiders in firms with concentrated control rights, presumably because outsiders face significantly lower trading competition from better informed controlling shareholders.
However, market professionals can become more active in the face of strict insider trading restrictions not only because of lower trading competition from insiders but also, according to microstructure theory, because the return to private information acquisition is higher when there is greater information asymmetry in the market. Thus, another central theme of our paper is to argue that the positive association between insider trading restrictions and private information trading in stocks with concentrated control may exist because insider trading restrictions foster greater information asymmetry in stocks with concentrated control. The reason is as follows. It has been suggested that insider trading is an important source of compensation for controlling shareholders which, if taken away, can discourage controlling shareholders from monitoring the firm appropriately (Bhide (1993)). Moreover, insider trading is just one of many different ways in which controlling shareholders can obtain private benefits. It is not unusual for controlling shareholders to expropriate resources from a firm through various means like elaborate transfer pricing schemes, special dividends, perquisites and outright stealing (Shleifer and Vishny (1997), Johnson et al. (2000a)). We argue that restricting insider trading without closing other channels of expropriation may simply drive controlling shareholders to obtain more compensation from one or more of these other objectionable means. When controlling shareholders engage in activities that are not in the best interests of the firm, they attempt to mask the resulting poor performance of the firm (Leuz, Nanda and Wysocki (2003)). This opacity about the firm’s operations increases the return to private information acquisition and trading. Thus, when insider trading restrictions are imposed on firms with concentrated control rights, informed trading by outsiders rises not just because they face less competition from insider trading but also because opacity about the firms operations increasesthe returns to trading. This is another explanation for our finding that insider trading restrictions are less effective in reducing private information trading in firms with concentrated control rights.
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The Effectiveness of Insider Trading Regulation Around the Globe
