The Governance Effect of the Media’s News Dissemination Role

The following post comes to us from Lili Dai of the College of Business and Economics at Australian National University; Jerry Parwada and Bohui Zhang, both of the Finance Area at UNSW Australia.

That the media plays a role in corporate governance is well known. What is less clear is how the governance effect of the media works. Existing evidence supports the notion that the media disciplines managers by creating content that exposes governance problems. In our paper, The Governance Effect of the Media’s News Dissemination Role: Evidence from Insider Trading, forthcoming in the Journal of Accounting Research, we use evidence from a large sample of insider trading filings to investigate whether the media’s news dissemination role directly affects governance.

The SEC requires insiders to report their trading activities on Form 4 filings, which are typically disseminated through the media. This setting provides us with a useful opportunity to examine the effect of the media’s dissemination role on corporate governance, and specifically in restricting insiders’ trading profits. Since news dissemination increases the breadth of coverage and the attention of investors through repetition, we conjecture that the media reduces the profitability of insiders’ future transactions by disseminating regulatory releases of prior insider trading activities. We call this view, which forms our main hypothesis, disciplining via dissemination.

Our main hypothesis is based on three mechanisms. First, by disseminating news on prior insider trades, insiders’ information advantage is reduced and prices adjust more quickly to the news, directly reducing the profitability of future insiders’ trades. We refer to this attenuation effect of the media on insiders’ profits as the information asymmetry channel. Second, recent studies show that litigation can restrict and punish insiders’ opportunistic behavior, especially their selling activities. Therefore, because of concerns regarding litigation risk, insiders in firms in the media spotlight avoid opportunistic trading strategies and thereby earn reduced profits. We refer to this effect of news coverage as the litigation risk channel. Third, since the dissemination of insider trading news can adversely affect executives’ personal wealth and reputation, we expect that the disciplining effect of news is more pronounced when executives have a greater amount of personal capital tied to firms. We refer to this mechanism as the capital-at-risk channel.

We examine our hypotheses using more than 1.375 million trades by U.S. corporate insiders. We investigate whether insiders consistently earn future abnormal profits when they face news coverage on their prior trades. Our examination is similar to recent studies of corporate activities conditional on prior media coverage. Consistent with our disciplining via dissemination hypothesis, we find a negative association between insiders’ future trading profits and news coverage of regulatory releases of insiders’ prior trading activities.

Next, we find evidence suggesting that our disciplining via dissemination hypothesis operates through three economic channels, namely, information asymmetry, litigation risk, and capital-at-risk. First, we show that news coverage is more effective in attenuating insiders’ profits in firms with higher analyst forecast dispersion and in firms that are not audited by Big N auditors. Second, we find that the effect of news coverage is more pronounced in firms that face higher litigation risk. Finally, we find that the relation between insiders’ trading profits and news coverage is magnified when insiders’ personal capital is more closely tied to firms.

In additional tests, we provide evidence in support of our main findings. First, the negative effect of news coverage on insiders’ trading profits operates by reducing trading profits instead of increasing trading losses. Second, to rule out the possibility that the media engages in information creation rather than mere news dissemination, we show that initial news coverage alone does not have a significant influence on insiders’ trading profits. Third, news coverage significantly reduces the incidence of abnormal insider trading activities and transactions executed around earnings announcements. Finally, using both instrumental variable and natural experiment approaches, our endogeneity analysis suggests that news dissemination has a causal disciplining effect on insiders’ trading profits.

We believe that our work provides avenues for further research on the real effects of news dissemination. In particular, one promising direction for future research is to further investigate the economic implications of this effect on other important corporate decisions that are made by insiders and managers, as well as the associated outcomes. Such work would contribute to the question of the fundamental benefits of the media’s role in financial markets.

The full paper is available for download here.

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