An Empirical Analysis of Illegal Insider Trading

Abstract

Whether insider trading affects stock prices is central to both the current debate over whether insider trading is harmful or pervasive, and to the broader public policy issue of how best to regulate securities markets. Using previously unexplored data on illegal insider trading from the Securities and Exchange Commission, this paper finds that the stock market detects the possibility of informed trading and impounds this information into the stock price. Specifically, the abnormal return on an insider trading day averages 3%, and almost half of the pre-announcement stock price run-up observed before takeovers occurs on insider trading days. Both the amount traded by the insider and additional trade-specific characteristics lead to the market's recognition of the informed trading. THIS PAPER INVESTIGATES THE stock price effects of insider trading, that is, the illegal trading in securities by individuals or firms possessing important non-public information. WVhether insider trading affects stock prices is central both to the current debate over whether insider trading is harmful and pervasive, and to the broader public policy issue of how best to regulate securities markets.While opponents of insider trading argue that insider trading decreases market liquidity, produces abusive managerial practices, and is unfair to uninformed investors, proponents of insider trading champion its benefits. Manne (1966) and Carlton and Fischel (1983), for example, assert that insider trading fosters efficient capital markets by improving the accuracy of stock prices.1 Specifically, insider trading promotes quick price discovery which mitigates the incentive for many individuals to collect the same information. * Meulbroek is from Harvard University. Taggart, an anonymous referee, and seminar participants at Harvard University, M.I.T., New York University, Ohio State University, University of Pennsylvania, University of Rochester, the Securities and Exchange Commission (SEC), and Stanford University contributed many helpful comments. Special thanks to former SEC Commissioner Joseph Grundfest for assistance in obtaining data. Partial financial support provided by IFSRC at M.I.T. 1 Security prices that reflect all relevant information enhance the allocative efficiency of capital markets. A firm's stock price also guides decisions made by other firms. For instance, a potential entrant may judge the incumbent firm's probability by its stock price and base its entry decision on this estimate. 1662The Journal of Finance The belief that insider trading is pervasive also rests on the assumption that insider trading creates significant stock price movements. Alleging widespread insider trading, Keown and Pinkerton (1981) note that, on average, 40 to 50% of the price gain experienced by a target firm's stock occurs before the actual takeover announcement. The view that insider trading is widespread contributed to the demand for legislation; in response, Congress substantially increased insider trading penalties in 1984, and again in 1988. T...

Can the publication of annual financial reports become an opportunity for insider trading?

“…A detailed analysis of available news releases from the period under study does not bring any excuses for observed abnormal returns and volumes. Meulbroek (1992) as well as Cornell and Sirri (1992) show that such unexplained alerts appear on days marked by insider trading. Although they cannot pose any kind of statistical proof of market abuse behavior, they give an important signal for the financial supervisory authority that should closely monitors markings of the companies.…”

“…Increased trading volume may be noted simultaneously. Meulbroek (1992) states that this can be caused by uninformed investors who follow insiders and empower the changes in trading. The so-called herd-effect on the Polish stock market is studied by Gurgul and Majdosz (2007).…”

Do Board Characteristics Matter to Insider Timing and Profitability in the US Market?

“…The SEA of 1934 and the amendment provisions from the Williams Act of 1966 were aimed at curtailing illegal insider trading and protecting minority shareholders against losses that they might incur while trading against informed insiders. These regulatory provisions state that any person who is in possession of material, non-public information is not allowed to trade, and any violation amounts to a criminal infraction [27]. Sections 10 and 14 both state that any person who is in possession of material, non-public information should abstain from trading or from disclosing such information.…”

Share repurchase regulations: Do firms play by the rules?

“…Not all insider trading is illegal, and offences are not always easily detectable. Meulbroek (1992), in a study of 183 cases listed by the SEC, shows that the abnormal price movement on an illegal insider trading day is 40 to 50% of the subsequent price reaction to the public announcement of the inside information. 2 See Bhattacharya and Daouk (2004), who argue for insider trading that it is sometimes better not to have a law than to have a law but not enforce it.…”