Shadow Trading

Mihir N. Mehta is Assistant Professor of Accounting at the University of Michigan Stephen M. Ross School of Business; David Reeb is Professor of Finance at the National University of Singapore; and Wanli Zhao is Professor of Finance at the Renmin University of China. This post is based on their recent paper, forthcoming in The Accounting Review. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

We examine whether corporate insiders attempt to circumvent insider trading restrictions by facilitating trading in competitors and supply chain partners, an activity we label Shadow Trading.

To identify situations in which insiders could use their private information to facilitate shadow trading, we use corporate announcements. We focus on announcements that are likely to represent the release of private information held by a firm’s insiders such as earnings announcements, M&A transaction announcements, and announcements about new products. Using multiple proxies of informed trading from the literature to measure shadow trading, we document that immediately before one of these corporate news announcements by a focal firm, competitors and supply chain partners display increased informed trading levels in their stocks. In particular, the magnitude of informed trading is linked to the magnitude of the information shocks. Each news event appears to represent a significant opportunity for profitable trading—a back-of-the-envelope calculation suggests that the average profit from a single shadow trading event ranges from about $140,000 to over $650,000.

We also consider that there are alternate and less-nefarious explanations for their findings. For instance, shadow trading may reflect trading activity by sophisticated investors, who use proprietary and legal methods to acquire private information, or reflect unobserved market structure characteristics. To examine these possibilities, we conduct analyses using two distinct events that change insiders’ incentives to engage in shadow trading but are unlikely to affect alternative explanations.

The first event is unanticipated, high-profile, SEC enforcement events against conventional insider trading. Following perceived increases in regulatory scrutiny, source firm insiders have incentives to switch from traditional insider trading to shadow trading to reduce concerns about detection and enforcement. The second event is state-level staggered adoptions or rejections of a legal doctrine known as the inevitable disclosure doctrine (IDD). The IDD affects in-state firms’ ability to legally prevent employees that are privy to trade secrets from obtaining employment with competitor firms. A shift in state-level interpretations of the IDD is likely to affect source firm employee incentives to engage in shadow trading because of the change in insiders’ ability to monetize their private information by obtaining lucrative employment with competitors. The evidence from tests using both of these events support the notion that our findings reflect shadow trading activity.

Finally, we also examine whether firms can directly influence shadow trading activity. Firms have incentives to prohibit their employees from engaging in shadow trading because the public revelation of such actions could adversely affect their business relationships. Using a subsample of firms for which we can obtain corporate policy handbooks, we show that shadow trading activity is relatively lower when firms explicitly mandate prohibitions against it in their employee handbooks.

Overall, our evidence shows that employees facilitate trading in their firms’ business partners and competitors to circumvent insider trading regulations designed to limit their ability to exploit private information. The findings are likely to be of interest to lawmakers and regulators interested in ensuring integrity in capital markets. At a minimum, our study suggests a need for further evaluation of the completeness of insider trading regulations.

The complete paper is available for download here.

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