Legal Risk and Insider Trading

The debate on whether and under what circumstances insider trading should be illegal has a long tradition. The dominant view that promotes enforcement actions against trading based on material, nonpublic information highlights their potential to reduce firms’ cost of capital and increase investment and welfare. However, society can only achieve such desirable goals if insider trading regulations provide meaningful criminal deterrence. While some evidence exists on aggregate consequences of enforcement mechanisms, less is known about ex-ante incentives driving the behavior of individual insiders. Specifically, do illegally informed traders rationally internalize legal risks? If so, is this process reflected in their trades and prices? While addressing these issues is vital to assess insider trading regulations’ effectiveness, one faces a formidable empirical challenge: neither private information nor legal risks are readily observable.

To enhance our understanding, we contribute in three ways:

1. We manually collect data on individual trades and the resulting legal outcomes from 530 illegal trading investigations prosecuted by the SEC. We characterize over 6,500 trades in 975 firms from 1995 to 2018, representing many assets and market conditions. We examine the information sets, timing, quantity traded, and penalties of illegal insiders.
2. To benchmark the impact of legal risks on trading, we develop a stylized equilibrium framework of informed trading featuring an insider who internalizes his own trades’ effect on prices, the probability of being prosecuted by a regulator, and the conditional value of a legal fine.
3. We exploit two plausibly exogenous sources of variation in legal risk exposure to test the model’s predictions.

Controlling for various behavioral predictors, we provide consistent evidence that legal risk deters insider trading.

We highlight a few robust trends in the sample of inside trading investigations that later inform our modeling choices: 1) Insider tips contain economically powerful information connected to specific corporate announcements. For example, the average stock price change between receiving a tip and its public announcement is 48.64% for mergers and acquisitions and 17.64% for earnings. 2) Insiders trade more than once but do not trade continuously: the median insider trader places two trades over a median horizon of two weeks. 3) Consistent with the prevailing legal framework, we observe a strong association between dollar trading profits and pecuniary penalties. The average and median profit values per trader are $1,271,755 and $95,109, respectively. For pecuniary penalties, the corresponding values are $1.67 million and $160,000.

The model considers the interactions of a privately informed trader, a competitive market maker, and a regulator. The most significant contrast with conventional analyses, such as that in the Kyle 85 model, is that the insider is concerned with the regulator’s screening of abnormal order flow and penalties. We analyze the impact of legal risk on the insider’s behavior by considering changes in the severity of the penalties and the probability of successful prosecution. The equilibrium yields two predictions regarding informed trading: following an increase in the expected legal punishment, the insider trades smaller quantities and trades relatively earlier. The intuition for the first prediction is that the legal threat increases with the amount of trading, which incentivizes more cautious trading. The intuition for the second prediction is that the legal threat induces a smoother trade pattern across periods to mitigate the probability of prosecution. Absent legal risk, the insider trades more intensely as the information deadline nears.

To test these predictions, we consider two quasi-natural experiments that exploit plausibly exogenous variation in legal risk specific to insider trading. The first involves the 2014 U.S. Court of Appeals for the Second Circuit ruling on United States v. Newman and Chiasson (13-1837-cr(L)), which significantly narrowed the application of insider trading laws and was subsequently used as a precedent to clear several allegedly guilty individuals. The ruling likely affected insiders differently, depending on whether they acquired their private information directly (least affected group) or through social connections (most affected group). We regard this ruling as a negative shock to legal risk. The second experiment considers the impact of Preet Bharara’s tenure as the U.S. Attorney for the Southern District of New York (SDNY). Bharara became known for his aggressive and flawless track record against illegal insider trader suspects. We regard his tenure as a positive shock to legal risk for insiders subject to SDNY jurisdiction.

Our results indicate that volume and timing measures display economically significant abnormal values in response to the legal shocks. Following the Newman shock, traders acting on second-hand information behave less cautiously: informed dollar volume increases by 30.8% relative to its standard deviation. Conversely, traders within the SDNY jurisdiction reduced their trade aggressiveness during Bharara’s tenure, as reflected by a 66.9% decrease in the normalized proportion of informed trading. In turn, the timing of trades shows a negative relation with the legal-risk shock sign in both tests, although only Newman’s test results are statistically significant.

We further assess the impact of legal risk from the perspective of engagement in criminal activity. A rogue but rational insider should be less willing to act on a private signal of a given economic value when the probability of enforcement or the anticipated penalty increases. Put differently, as a result of a positive (negative) risk shock, insiders should act on private signals of higher (lower) expected returns. The evidence suggests that, compared to insiders in other jurisdictions, SDNY insiders’ private signal values increased by 20.3% relative to its standard deviation after Bharara’s appointment.

We further assess the robustness of our results from the perspective of the potential selection bias due to a non-random pool of investigated cases. First, we exploit the built-in volume-based detection rule in the model to isolate how changes in legal risk affect trading strategies for prosecuted cases. The outcomes show how volume-based screening could lead us to underestimate the impact of legal risk changes. Next, we recognize that traders who neglect legal risks will likely be overrepresented if the regulator actively screens for abnormal trade patterns. The outcomes of a model with a boundedly rational agent suggest that such overrepresentation would also lead us to underestimate the degree to which insiders internalize legal consequences. In sum, these model-based analyses indicate that our empirical estimates are best viewed as a lower bound on the actual effect of legal risk.

To empirically assess the lower bound on legal risk sensitivity, we identify investigations referred to the SEC by sources likely to indicate unusual trading patterns. These include stock and options exchanges, brokers, and industry regulating agencies, such as the Financial Industry Regulatory Authority (FINRA) and the Options Regulatory Surveillance Authority (ORSA). We hypothesize that the individuals in these specific investigations are less likely to internalize legal risks than those detected through other, more direct means and those who went undetected. We find that this group of insiders responds to both legal risk shocks and displays similar strategic responses, suggesting illegal insiders’ legal-risk sensitivity is bound away from zero.

Although our paper focuses on trading strategies—over which insiders have direct control—asset prices could also reflect their actions. First, we establish that illegal insider trades affect prices at daily frequencies, both in the case of negative and positive private information. Second, we show that illegal insiders impound a significant amount of their private information, but not near the entirety. At the end of the trading period, the average cumulative return is no more than 40% of the information’s initial value. We also find less information aggregation for cases associated with high legal risk, which is more evident in the case of the Newman ruling. These results suggest that legal efforts to deter insider trading could reduce price informativeness (e.g., Manne, 1967). A policy implication is that regulators must factor in the social costs resulting from reduced informational efficiency of securities prices against potential benefits such as enhanced liquidity and capital formation.

Our findings support the effectiveness of U.S. insider trading regulations’ deterrence. This is encouraging for domestic and foreign regulators since, absent deterring effects, the burden of investigative and enforcement efforts would amount to a net social loss. While encouraging, we cannot yet assert whether the associated social benefits outweigh the social costs concerning the negative impact on the government’s budget and asset prices’ informativeness. We hope that the results and methods in this paper inform future studies further addressing the net benefits of insider trading enforcement in financial markets.