Insider Trading and Stock Splits

The following post comes to us from Vinh Nguyen and Anh Tran both of the School of Public and Environmental Affairs at Indiana University Bloomington, and Richard Zeckhauser, Professor of Political Economy at Harvard University.

In our paper, Insider Trading and Stock Splits, which was recently made publicly available on SSRN, we examine whether stock splits create value to shareholders. Inside traders capitalize on their edge in information. Typically, they buy before good news is released or sell before bad. Insiders have an even greater advantage if they can create news that moves a stock, even when no real news is available. There is strong evidence that this is precisely the strategy that inside traders in Vietnam have employed in recent years. They have purchased stock, and then announced stock splits. As is common in stock markets, these stock splits led to price rises, likely with help from manipulation. Quite suspiciously, all excess returns from split announcements had vanished in 240 trading days. This provides strong evidence that the splits were employed to create a bubble, rather than serving as value-creating corporate events.

Some special features of the Vietnam market, presumably found in markets of other countries that have weak enforcement practices, help to explain its vulnerability to such manipulation. First, in Vietnam, the State Securities Commission (SSC), the government’s agency enforcing the securities laws and regulating the securities industry, imposes strict restrictions and reporting requirements on the trading activity. However, these requirements are not followed and violations are punished, if at all, rarely and lightly. During the eleven-year history of Vietnam’s stock market, only one illegal insider trading case has been criminally prosecuted. Violators in other cases have paid a minimal fine, usually less than 10% of the illegal trading profits. Clearly, inside trading is a profitable activity. Second, Vietnam has many companies that are vulnerable to manipulation because they have substantial state ownership and low capitalizations, and thus few outside shareholders to arbitrage prices into line. (Limited participation by major investment firms in these types of companies and prohibitions on short sales inhibit arbitrage by others.) Management in state-owned firms often represents the state ownership in board of director and investor meetings. However, the government has no effective mechanism to supervise its representatives. Thus management in such firms has significant control power but a small share interest. Managements thus often elect to reward themselves through share trading rather than through creating value for the firms.

It is important to distinguish the insider trading explanation for stock splits from the two major explanations for splits from the existing literature, which is predominantly focused on the United States. One explanation argues that stock splits help improving the trading liquidity of stocks by lowering the price of shares. The other explanation argues that stock splits signal firms’ promising prospects. However, empirical evidence for these two explanations remains inconclusive. Thus, stock splits remain a puzzle in finance. This study investigates the possibility that inside traders may generate and trade on stock splits to secure profits. It examines the 718 stock splits executed by firms traded in Vietnam’s stock markets in the period 2007-April 2011. The patterns of price movements created by such splits, particularly in firms that are identified as being vulnerable to manipulation, are exceedingly suspicious. Because the decision to split stock cannot be predicted by the market, stock prices should only react to stock split decisions when the information becomes public. However, stocks in Vietnam often experience significant price run-ups before split announcements. While the average 30 day pre-split abnormal return is 9.27%, the average 30 day post-split abnormal return is only 3.1%. Moreover, the pre-split price run-up is positively correlated with factors that make the firm vulnerable to insider trading.

The study starts by asking whether stock splits create value to shareholders. The event-study method is employed to track the abnormal return of stocks around stock split announcements. Stocks enjoy excess returns when stock splits are announced. However, the excess returns disappear 240 trading days after the split announcements. The inference is that stock splits trigger stock bubbles rather than value-creating corporate events. The next logical question is why firms split their shares if shareholders do not benefit. An agency problem provides the answer. Managers are serving themselves, not their shareholders. This is shown in the relationship between firms’ vulnerability to illegal insider trading and their propensity to split stocks. A 50% state-owned firm is 12.5% more likely to split its stock over the study period than is a 100% private firm.

Vulnerable firms also reap higher abnormal return from a stock split. For example, switching from private to state ownership increases the cumulative abnormal return by 37.5 percentage points in 30 trading days after split announcements. Vulnerable firms also show greater tracings of insider trading, as revealed in the difference between the pre- and post-split abnormal returns. The greater this difference, the more the run up must be due to inside trading. Switching from 100% private to 50% state ownership increases this difference by 20.0% in the period from 30 trading days prior to splits to 30 trading days post splits.

These findings reinforce the need for effective law enforcement against inside trading. Absent effective enforcements, apparently strict regulations only help deceitful traders take advantage of law-abiding traders. This analysis also provides a new explanation of the stock-split puzzle. Insider trading will always be with us, particularly in emerging markets, and is sure to be difficult to detect. But understanding the stratagems likely to be used by insiders – in this instance splitting stocks – can help to expose their activities.

The full paper is available for download here.

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