Do an Insider’s Wealth and Income Matter in the Decision to Engage in Insider Trading?

Juha-Pekka Kallunki is Professor at the Oulu Business School at the University of Oulu and Visiting Professor at Stockholm School of Economics and the Aalto University School of Business. This post is based on an article recently published in the Journal of Financial Economics, authored by Professor Kallunki; Jenni Kallunki, Oulu Business School at the University of Oulu; Henrik Nilsson, Professor at Stockholm School of Economics; and Mikko Puhakka, Professor at the Oulu Business School at the University of Oulu. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

A body of literature shows that corporate insiders’ trades predict future abnormal returns, suggesting that insiders generally exploit their information advantage about firm prospects to make trading decisions (e.g., Seyhun, 1986; Lakonishok and Lee, 2001; and Cohen et al., 2012). However, the abnormal returns that insiders have been reported to earn are, on average, surprisingly small to justify them engaging in informed trading, given the potential costs involved. In particular, the general public and regulatory authorities monitor insiders’ trading and impose costs on insiders when trading is perceived to be opportunistic and self-serving. These costs comprise both the potential reputational losses imposed by outside investors and the media and the potential legal sanctions taken by the regulator.

In our article, Do an Insider’s Wealth and Income Matter in the Decision to Engage in Insider Trading? (Journal of Financial Economics, 2018, 130(1), pp. 135-165), we argue that less wealthy insiders are more likely to trade on private information, because their returns to such trading are large enough to compensate for the potential costs involved, compared to wealthier insiders. We moreover argue that even the less wealthy insiders refrain from informed trading, if the costs associated with being detected are large enough and do not compensate for the returns that could be earned by trading. We propose a model of a risk-averse insider’s decision to engage in informed insider trading and show that an increase in the insider’s wealth and income level decreases her willingness to trade on private information, as long as the trading is subject to a relatively low risk of legal enforcement and therefore not likely to incur large fixed costs such as criminal fines or jail time for the insider. We further show that this effect is greater in magnitude when the variable costs of trading on private information such as personal reputational damages and other costs related to the volume of insider trading are larger and the insider has lower risk aversion.

We empirically test our model’s predictions using data from Sweden, where archival data on individual wealth, income, and many other demographic variables are available for all insiders of listed firms. Corporate insider trading does not typically fall under the definition of legally material information and is consequently associated with low risk of legal enforcement actions taken by the regulator, including criminal fines, disgorgement of profits, or even jail sentences. However, insider trades, especially insider sales, considered to generate excessive personal gains can attract negative investor and media attention, thereby damaging insiders’ reputational capital and also increasing the likelihood of scrutiny by the regulator.

We find that the level of wealth and income varies substantially across the insiders in our sample. When we divide insiders into three categories based on the level of their wealth and income, we find that, on average, insiders in the low wealth and income category (“less wealthy insiders”) are considerably less wealthy than insiders in the medium and high wealth and income categories (“wealthy insiders”). In particular, insiders with a low level of wealth and income have, on average, 26 (46) times less wealth than the insiders in the medium (high) wealth and income category. Similarly, insiders with a low level of wealth and income earn, on average, 2.5 (7) times less compared to insiders with a medium (high) level of wealth and income.

Consistent with our model, the empirical results of analyzing reported insider trades show that insiders’ willingness to engage in informed insider selling significantly decreases with the level of their wealth and income. Specifically, we find that less wealthy insiders are more likely to time their selling prior to abnormal stock price declines than wealthy insiders. The size of less wealthy insiders’ sales moreover increases with the magnitude of the future stock price decline. The mean (median) buy-and-hold abnormal (market-adjusted) stock return over a one-month period following a single sale transaction by less wealthy insiders is –1.70% (–2.44%), which translates into an economically significant annualized return of –18.6% (–25.3%). In contrast, the mean and median abnormal returns following the sales by wealthy insiders are not significantly negative.

We also find that, conditional on being less wealthy, insiders who are more risk-prone as measured by their criminal convictions are more likely to time their selling to avoid stock price declines, compared to non-convicted insiders. We do not observe similar selling behavior for wealthy risk-prone insiders. These results continue to hold after controlling for other likely motives for insiders to sell their stocks besides exploitation of private information, including insiders’ portfolio diversification objectives, liquidity needs, capital gain taxation considerations, contrarian trading behavior, information asymmetry and other firm characteristics, and year and firm fixed effects. These findings are consistent with less wealthy insiders valuing the financial gain from informed insider selling more than the associated reputational and legal costs. The results also suggest that wealthy insiders’ concerns with these potential costs outweigh their benefit from selling on private information, and they therefore decide to time their selling more carefully.

Interestingly, we do not find the same contrasting patterns for insiders’ purchases, which they time prior to stock price increases regardless of the level of their wealth and income or attitude towards risk. The asymmetry of this finding is consistent with the argument in prior research that the reputational and legal risk associated with being detected for trading on private information is significantly higher for insider sales compared to purchases.

The complete article is available here.

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