Insider Trading via the Corporation

Jesse Fried is a Professor of Law at Harvard Law School.

My paper, Insider Trading via the Corporation, recently posted on SSRN, critically examines the regulations applicable to U.S. firms trading in their own shares and puts forward a proposal for reform.

Publicly-traded U.S. firms buy and sell a staggering amount of their own shares in the open market each year. Open-market repurchases (“OMRs”) alone total hundreds of billions of dollars per year; in 2007, they reached $1 trillion. Firms are also increasingly selling shares in the open market through so-called “at-the-market” issuances (“ATMs”).

When a U.S. firm trades in its own shares, its trade-disclosure requirements are minimal. The firm must report only aggregate trading activity, and not until well into the following quarter. Thus, the firm can secretly buy and sell its own shares in the open market for several months, and never disclose the exact details of its trades to shareholders and regulators. The lack of detailed disclosure, I explain, makes it difficult to detect illegal trading on material inside information; the lack of timely disclosure makes it difficult for investors to determine when the firm is trading on valuable but sub-material information.

The trade-disclosure requirements imposed on U.S. firms are much more lax than those imposed on many firms abroad. For example, the U.K. and Hong Kong require firms trading in their own shares to disclose the details of their trades by the morning of the next business day.  The trade-disclosure requirements imposed on U.S. firms are also much less stringent than those imposed on insiders of those firms; since the Sarbanes-Oxley Act of 2002, insiders must report details of their trades in firm shares within two business days.

What U.S. regulators have failed to grasp is that when insiders are subject to strict trade-disclosure requirements and firms are not, insiders have a strong incentive to exploit the relatively lax trade-disclosure rules applicable to the firm to engage in indirect insider trading: having the firm buy and sell its own shares at favorable prices to pump up the value of insiders’ equity.  Average insider ownership in publicly-traded firms is surprisingly high, over 20%. Thus, insiders can capture a large fraction of the insider-trading profits generated by firms. Not surprisingly, there is considerable evidence that insiders use control of the firm to engage in indirect insider trading.

Such indirect insider trading, I argue, is likely to impose considerable costs on public investors in two ways. First, just like ordinary (“direct”) insider trading, indirect insider trading secretly redistributes value from public investors to insiders. To be sure, much of the indirect insider trading profits generated by firms are shared with public investors. But on average, public investors lose, and insiders systematically profit—to the tune of several billion dollars per year.

Second, similar to direct insider trading, the use of the corporation for insider trading can lead insiders to take steps that waste social resources. For example, indirect insider trading can distort capital deployment decisions by re-allocating capital between the shareholders and the firm in a manner that destroys economic value. Thus, indirect insider trading can diminish the value flowing to investors over time by far more than the profits reaped by insiders.

The paper concludes by putting forward a simple and intuitive proposal: that regulators subject firms to the same 2-day disclosure rule applied to their insiders. Such a rule would substantially reduce insiders’ ability to engage in indirect insider trading and the resulting costs to public investors.  And it would be less burdensome than the trade-disclosure requirements already imposed on many firms abroad.

The full paper is available for download here.

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