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E-MailFelix Meschke is Associate Professor of Finance at the University of Kansas. This post is based on an article authored by Professor Meschke; Ferhat Akbas, Assistant Professor of Finance at the University of Kansas; and Jide Wintoki, Associate Professor of Finance at the University of Kansas.
Sophisticated traders can profit from material information by trading on it ahead of public releases. This makes corporate directors, who frequently have access to this kind of knowledge, a potential information source for professional traders. And though federal law forbids directors’ sharing of insider information with traders, that information can and does leak out. In our article, Director Networks and Informed Traders, forthcoming in the Journal of Accounting and Economics, we document that these traders generate greater profits when trading stocks of firms with more connected boards.
How does sensitive information reach traders? In our paper we discuss inadvertent information leakage, deliberate sharing of sensitive information, and ‘mosaic’ information gathering as possible transmission channels.
The risk of inadvertent information leakage increases with the size of the network of people who are privy to material non-public information. Since more connections increase the difficulty of guarding against the unintended disclosure of private information, we expect more inadvertent information leakage in companies with more connected boards.
More connected directors may increase the amount of publicly available information in ways that favor ‘mosaic’ information gathering by sophisticated investors. These investors obtain publicly available information from a vast array of different sources, which, when combined, can reveal material, non-public information. Jarrell (2011) argues that traders are free to act on these ‘bits and pieces’ of information without risking legal liability under insider trading laws.
Directors also face incentives to share sensitive information deliberately. After all, an important competitive advantage of broadly connected directors stems from their ability to obtain and share insights that would otherwise be inaccessible to less connected colleagues. Some directors have even tipped traders in violation of securities law, as SEC enforcement actions show. Reciprocal sharing of sensitive material by connected directors does not necessarily harm shareholders since the benefits of connectedness may outweigh the costs, and our study does not assess the legality of directors’ actions. Incentives related to reciprocal sharing simply suggest that highly connected directors are more likely to divulge some sensitive information.
In our study, we focus on informed trading by three groups of traders: short sellers, option traders, and institutional investors. We measure their magnitude of informed trading as the monthly level of short interest, the ratio of monthly option volume to stock volume, and weekly order imbalances of institutional traders. To measure board connectedness, we aggregate the first-degree connections of all board members available in the BoardEx database. These connections include links through educational institutions attended, current and previous employers, military service and civic institutions. We then ensure that our measure of board connectedness is not driven by firm size, board size, firm age, the number of analysts and institutional ownership.
To gauge the profitability of sophisticated traders we examine portfolios sorted by board connectedness and by each of the three measures of informed trading. The results show that the annualized return difference between the highest and lowest quintile of informed trading in highly connected boards is significantly more pronounced compared to the same return difference in firms with less connected boards. The economic magnitude ranges from 4% for option volume and 5.4% for short interest, to 7.2% for institutional order imbalance.
We also show that more negative earnings news is embedded in prices of highly connected firms ahead of their earnings announcements. Sophisticated traders better anticipate earnings surprises and firm-specific news content in firms with highly connected boards. Changes in board connectedness are positively correlated with the probability of informed trading (PIN), bid-ask spreads and Amihud’s price impact measure. Neither family ownership, corporate governance quality, nor asset tangibility drive our findings. By directly linking corporate governance structure to the information environment in which sophisticated traders operate, we contribute to the emerging literature on director networks, and to research into the sources of traders’ information.
The full article is available for download here.
