Information Networks: Evidence from Illegal Insider Trading Tips

Illegal insider trading has become front-page news in recent years. High profile court cases have brought to light the extensive networks of insiders surrounding well-known hedge funds, such as the Galleon Group and SAC Capital. Yet, we have little systematic knowledge about these networks. Who are inside traders? How do they know each other? What type of information do they share, and how much money do they make? Answering these questions is important. Augustin, Brenner, and Subrahmanyam (2014) suggest that 25% of M&A announcements are preceded by illegal insider trading. Similarly, the U.S. Attorney for the Southern District of New York believes that insider trading is “rampant.”

In my paper, Information Network: Evidence from Illegal Insider Trading Tips, which was recently made publicly available on SSRN, I analyze 183 insider trading networks to provide answers to these basic questions. I identify networks using hand-collected data from all of the insider trading cases filed by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) between 2009 and 2013. The case documents include biographical information on the insiders, descriptions of their social relationships, data on the information that is shared, and the amount and timing of insider trades. The data cover 1,139 insider tips shared by 622 insiders who made an aggregated $928 million in illegal profits. In sum, the data assembled for this paper provide an unprecedented view of how investors share material, nonpublic information through word-of-mouth communication.

First, the data show that insiders earn substantial returns by trading in advance of specific corporate events. Merger-related events account for 51% of the sample, followed by earnings-related events, accounting for 26%. Across all types of events, the average stock return from the date of the original leak to the official announcement of the event is 34.9% over an average holding period of 21 trading days. M&As generate average returns of 43% in 31 trading days. Earnings generate relatively smaller returns of 14% in 11 days.

Insider trading networks involve a wide array of people. The average inside trader is 43 years old and about 10% of insiders in the sample are women. The most common occupation among insiders is top executive, including CEOs and directors. There are a significant number of buy side investment managers and analysts, as well as sell side professionals, such as lawyers, accountants, and consultants. The sample also includes non-“Wall Street” types, such as small business owners, doctors, engineers, and teachers. The median inside trader invests about $200,000 and earns about $72,000 per tip at the median. Using home prices as a proxy for wealth, insiders are among the wealthiest people in the nation, with median home values three times the national median. Compared to next-door-neighbors, insiders have fewer family members, and are much more likely to have prior criminal records.

The second set of results documents that inside traders share strong social connections. Of the 461 pairs of tippers and tippees in the sample, 23% are family members, 35% are friends, and 35% are business associates, including pairs that are both family members and business associates. Sibling and parental relations are the most common type of family connections. Of business associates, about half of the relationships are between a boss and a subordinate or client and agent.

Inside traders are connected in other ways, too. First, insiders live close to each other. The median distance between a tipper and his tippee is 26 miles. Second, women are more likely to tip and be tipped by other women. Third, insiders are more likely to share tips with people who share a common surname ancestry. Finally, information tends to flow from subordinates to bosses, from younger tippers to older tippees, and from children to parents. These patterns suggest that social hierarchies may influence how information flows among market participants.

The third set of results in this paper exposes how information flows across a network of traders. I find that as information diffuses away from the source, top executives and mid-level managers are less likely to send or receive tips. Instead, after three degrees of separation from the original source, buy side managers and analysts account for the majority of information sharing. The first links in a tip chain are more likely to be friends and family, but as the information diffuses further from the source, business links become more prevalent. People further from the source invest larger amounts, make smaller percentage returns, and earn larger dollar gains. The speed of information also increases as it moves further from the source.

Finally, the last set of facts documents the structure of the networks of inside traders. Of 183 insider networks in the sample, 59 contain only one person. These are original sources who trade on inside information, but do not tip anyone else. On the other end of the spectrum, the network surrounding SAC Capital has 63 members. In the cross-section of networks, larger networks are less dense with fewer clusters of links. Information networks sprawl outward, like a tree, rather than through one central node, as in a star network.

Because the sample only includes traders who were caught by regulators, the sample might not be representative of the average inside trader. I directly test for selection bias and find that the sample tends to omit infrequent, opportunistic traders who make smaller investments, share information with family and friends, and are older and more likely female. These results highlight that the sample comprises traders that are more likely to actually impact stock prices: wealthy CEOs and fund managers who are likely to be in larger networks and invest larger sums.

The results in this paper inform the ongoing debate about the definition of illegal insider trading. In December 2014, the a U.S. Court of Appeals overturned the convictions of Todd Newman and Anthony Chiasson, based in part on the fact that they were several steps removed from the original source. As I show in this paper, many of the insiders named in court documents are many steps removed from the original source. Moreover, those that are many steps removed tend to be buy side portfolio managers who make large investments based on inside information. Based on my evidence and the December 2014 ruling, many of the convictions of high profile serial inside traders could soon be subject to appeal.

The full paper is available for download here.