Insider Trading and Innovation

Ross Levine is Professor of Finance at the University of California, Berkeley. This post is based on an article authored by Professor Levine; Chen Lin, Professor of Finance at the University of Hong Kong; and Lai Wei of the School of Economics and Finance at the University of Hong Kong.

In our paper, Insider Trading and Innovation, which was recently made publicly available on SSRN, we investigate the impact of restricting insider trading on the rate of technological innovation. Our research is motivated by two literatures: the finance and growth literature stresses that financial markets shape economic growth and the rate of technological innovation, and the law and finance literature emphasizes that legal systems that protect minority shareholders enhance financial markets. What these literatures have not yet addressed is whether legal systems that protect outside investors from corporate insiders influence a crucial source of economic growth—technological innovation. In our research, we bridge this gap. We examine whether restrictions on insider trading—trading by corporate officials, major shareholders, or others based on material non-public information—influences technological innovation.

Theory provides differing views on whether restricting insider trading accelerates or slows innovation. One view builds from the premise that technological innovation is difficult for outside investors to evaluate, so that improving incentives for acquiring information will enhance valuations, lower the cost of capital, and improve investment in innovative activities. One way that restricting insider trading can increase incentives for acquiring information is by reducing the ability of corporate insiders to exploit other investors, thereby encouraging those other investors to devote more resources to valuing firms. Another way that restricting insider trading can improve valuations is by boosting market liquidity, which can make it less costly for investors who have acquired information to profit by trading in public markets. And, a third mechanism operates through managerial incentives. If restricting insider trading enhances the efficiency of stock prices, this can encourage managers to invest more in long-run, value-maximizing activities. From these perspectives, restricting insider trading enhances the valuation of and hence improves the quality of investments in technological innovation.

Other theories, however, suggest that restricting insider trading can deter effective price discovery, with adverse effects on innovation. For example, if insider trading quickly reveals information in public markets, restricting insider trading will hurt the informativeness of prices. And, if restricting insider trading boosts liquidity, this can both (a) attract myopic investors who induce managers to forgo long-run, profit-maximizing to satisfy short-term performance targets and (b) facilitate takeovers that can encourage managerial myopia.

To provide the first assessment of whether legal systems that protect outside investors from corporate insiders increase or decrease the rate of innovation, we exploit the quasi-natural experiment of the staggered enforcement of insider trading laws across countries. We use the date when a country first prosecutes a violator of its insider trading laws. We have data for over 100 countries covering the period since 1976. This setting is appealing for three reasons. First, countries started enforcing their insider trading laws for a variety of reasons, such as increased competition between stock exchanges for trading volume, and differences in political ideologies. Fortunately, there is no indication that technological innovation or the desire to influence innovation affected the timing of when countries started enforcing their laws. Thus, the potential effects of enforcement on innovation are likely unintended consequences of these legal actions. Second, the cross-country heterogeneity in the timing of the enforcement of insider trading laws allows us to employ a difference-in-differences strategy to identify their impact on innovation. Third, this setting allows us to test whether the cross-industry response of innovation and equity issuances to restrictions on insider trading are consistent with particular theoretical perspectives of how insider trading affects innovation. For example, models stressing that insider trading discourages outside investors from researching firms predict that restricting insider trading will have a particularly positive impact on investment in informationally opaque activities, including innovation.

We use patent-based measures of innovation. Specifically, we obtain information on patenting activities for industries in 94 countries from 1976 through 2006 from the EPO Worldwide Patent Statistical Database (PATSTAT) and compile a sample of 76,321 country-industry-year observations. We construct and examine five patent-based proxies for technological innovation: (a) the number of patents, (b) the number of patent citations to patents, (c) the number of patenting entities, (d) the degree to which technology classes other than the one of the patent cite the patent, and (e) the degree to which the patent cites innovations in other technology classes.

We find that the enforcement of insider trading laws exerts a large, positive impact on innovation. For example, we find that, on average, patent counts increase by 26% and citations by 37% after a country starts enforcing its laws.

We build on these initial analyses by differentiating between industries within the same country to better identify the impact of restricting insider trading on innovation. First, we distinguish among industries by their natural rate of innovation. If insider trading slows innovation, limiting insider trading should spur innovation more in industries that would otherwise experience rapid rates of innovation. Second, we differentiate by opacity. If insider trading laws encourage innovation by enhancing valuations, then the impact of such laws is likely to be greatest in industries with a high degree of informational asymmetries. We use the U.S. to benchmark industries. We include country-year and industry-year fixed effects to control for all time-varying country and industry characteristics.

Consistent with the view that insider trading impedes valuations and boosts the costs of raising capital for innovation, we find that (1) innovation increases much more in industries that are naturally more innovative or opaque after countries enforce their insider trading laws and (2) initial public offerings and seasoned equity offerings rise much more in naturally innovative industries after a country enforces its insider trading laws.

The full paper is available for download here.

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