The Deterrent Effect of Insider Trading Enforcement Actions

Robert H. Davidson is Associate Professor of Accounting and Information Systems at Virginia Polytechnic Institute and State University, and Christo A. Pirinsky is Associate Professor of Finance at the University of Central Florida College of Business. 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).

This study examines whether exposure to an insider trading enforcement action deters corporate insiders’ future opportunistic trading. A priori, the answer is not clear. While it is illegal for insiders to trade based on material private information, this can be difficult to establish in court. Further, many insiders continue to earn large profits from their trades, which raises questions about the effectiveness of existing regulations.

To address this question, we examine whether the enforcement of insider trading laws for illegal trades in the stock of one firm affects affiliated corporate insiders’ trading behavior in other firms unaffected by the enforcement. We then compare the trades of these ‘exposed’ insiders to the trades of their peers in these non-enforcement firms to assess whether insiders trade differently following exposure to an enforcement event. The evaluation of insider trading away from the enforcement firm alleviates concerns that our results are attributable to omitted factors related to the enforcement event or firm.

We find that the profitability of insiders’ trades decreases significantly following exposure to an enforcement event. The effect is significant when insiders buy or sell equity and is economically meaningful. For example, we estimate that after the enforcement event, treated insiders earn 7.9% lower abnormal returns over the 180 days from purchases than do control insiders in the same firm. Exposure to enforcement is also associated with smaller trade size. Our results suggest that insiders strategically assess the costs and benefits of their trades. Next, we examine whether exposure to enforcement is associated with future illegal insider trading. We find that the future conviction rate of exposed insiders is substantially lower than the conviction rate of unexposed insiders, suggesting that enforcement may deter illegal insider trading. Of the 4,544 insiders present at firms at the time of an enforcement event, only one is convicted of illegal trading in the future.

We consider two channels through which enforcement could deter informed trade—information and salience. Enforcement actions may contain information about both the probability of future enforcement and the expected penalty. For example, enforcement actions could reveal information about the resources and enforcement priorities of regulators. Enforcement could also raise individual awareness about existing laws and regulations. As a result, exposure to enforcement could prompt individuals to update their priors about both the probability and the expected costs of enforcement. We refer to this possibility as an information effect.

Witnessing an enforcement event could also prompt insiders to react to the event and change their behavior even if enforcement risk is unchanged. A growing body of research has shown that individuals tend to overweight salient information when making decisions. For example, salience has been found to bias a series of consumption, management, and judicial decisions. We refer to this possibility as a salience effect.

The information and salience channels are not mutually exclusive and could jointly affect insider trading behavior. As an example, the SEC could require that firms hire an Independent Compliance Consultant following illegal trading in the firm’s securities to ensure the firm’s improvement with internal compliance procedures. Insiders who go through mandatory compliance training could change their behavior because they learn new information related to enforcement risk or because the training made the enforcement event more salient even if there was no change in enforcement risk.

The case is analogous to studying why an airline crash reduces travel. On the one hand, airline crashes could reduce travel by legitimately altering assessments of flight risk. For example, the recent Boeing 737-MAX disasters uncovered a broad range of issues with internal Boeing processes and triggered negative public response to the events. On the other hand, airline crashes could reduce travel through salience alone without providing any information per se about the future probability of a crash. Indeed, there is evidence that individuals routinely overreact to fearsome risks.

Ex ante, it is not clear whether a deterrent effect of enforcement on insider trading occurs through the information channel or the salience channel. However, our research design and several of our tests suggest that the information channel alone is unlikely to explain the totality of our results. We compare the behavior of insiders at the same firm and the same time using a staggered difference-in-differences design with firm-year fixed effects that effectively controls for systematic regulatory factors as well as a wide range of time-varying covariates correlated with enforcement activity.

We indirectly evaluate the significance of the information channel by conditioning our analysis on whether a fellow Section 16 insider (generally executives, directors, or those owning more than 10 percent of the firm’s outstanding equity) was convicted for insider trading. 85 percent of insider trading cases are against non-Section 16 insiders. In these cases, individuals who are not officers of the firm (e.g. investment bankers, auditors, and even therapists) obtain proprietary information by a matter of chance and trade based on this information. As a result, these insider trading cases are expected to contain limited information about the degree of compliance within the firm. Our results remain significant when examining the effect of exposure to enforcement events involving non-Section 16 insiders, suggesting that the behavioral response we document is unlikely to only reflect information related to increased regulatory scrutiny in the future.

Our results provide evidence that enforcement is a salient event that can deter informed insider trading even when it provides limited information about enforcement risk.

The complete paper is available for download here.

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