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E-MailAndrew T. Pierce is an Assistant Professor of Accounting at Georgia State University. This post is based on an article forthcoming in the Journal of Accounting & Economics. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation (discussed on the Forum here) by Jesse M. Fried.
One of the most distinguishing features of US securities regulation is strict enforcement of insider trading. However, because of long-run persistence in insider trading enforcement and a lack of variation in the underlying laws, we have surprisingly little well-identified empirical evidence on the market benefits conveyed by strictly regulating insider trading.
In my article, Capital-Market Effects of Tipper-Tippee Insider Trading Law: Evidence from the Newman Ruling, which is available on SSRN and forthcoming in the Journal of Accounting and Economics, I exploit the landmark December 2014 Newman ruling issued by the 2nd Circuit Appeals Court, which reduced the risk of prosecution for managers (tippers) and investors (tippees) by limiting the types of exchanges that trigger insider trading liability. The US Department of Justice sharply critiqued the Newman decision as “one of the most significant developments in insider trading law in a generation that [would] limit the Government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.”
While nearly a decade has passed since Newman, the ruling nonetheless provides a unique glimpse into how capital markets move in relation to the enforceability of insider trading restrictions. Moreover, the institutional setting provides several features that allow for plausible causal inferences to be drawn. First, the ruling represents a shock to market participants’ expectations of legal jeopardy, since by all accounts, the court’s decision came as a surprise. Second, the ruling only represented binding precedent for market participants located within the 2nd Circuit’s jurisdiction (Connecticut, New York, and Vermont), which provides credible “as if” random treatment assignment due to the arbitrary division of US circuit court boundaries. Lastly, Newman’s effect on the law held for a two-year period until it was essentially reversed via two subsequent rulings by the Supreme Court in Salman, and the 2nd Circuit Appeals Court in the Martoma decision, which provides variation in treatment over well-defined pretreatment, treatment, and posttreatment periods. In total, these features qualify Newman as a plausible natural experimental setting. I leverage these features to study (i) the potential pervasiveness of insider trading in the absence of viable enforcement, and (ii) the impact of relaxing insider trading restrictions on trade activity and stock liquidity.
In my first set of analyses, I examine the effect of Newman on plausible insider trading. For these tests, I investigate the trades of US-based hedge fund managers, who are natural candidates to examine as tippees since they likely maintain a sophisticated understanding of securities laws and possess strong incentives to outperform passive benchmarks. Hedge funds are also often defendants in insider trading cases (Ahern, 2017), which makes their trading activity post-Newman of particular interest. To measure Newman’s impact on plausible insider trading, I examine the stock-picking abilities of these investors using a measure from Baker et al. (2010), which approximates the trading skills of institutional investors based on the ability to buy and sell stocks profitably in relation to future earnings announcement returns. To the extent that a hedge fund’s stock-picking abilities are independent of the insider trading laws, then this measure should not significantly vary in relation to the Newman ruling.
Trading data from Form 13F filings show that the Newman ruling significantly altered the private information environment of the 2nd Circuit. Specifically, I observe a sharp increase in the stock-picking ability of treated (2nd Circuit-located) hedge funds in their trades of treated stocks (2nd Circuit-located firms) following Newman, as well as a significant decline in the performance of these trades after Newman’s reversal. Importantly, I observe no evidence of an improvement in stock-picking ability by any of the sample hedge funds, including the treated funds, in situations where the risk of insider trading enforcement was preserved. This inference is further supported by two additional tests, where I find that the treated hedge funds’ trades were more informative of treated firms’ earnings surprises during the Newman treatment period, and their trading advantage under Newman led to significant and economically meaningful trade-based portfolio returns.
Having documented a plausible increase in insider trading activity, in my second set of tests I examine the implications of Newman on general trading activity and liquidity. Theories of adverse selection suggest that transaction costs are expected to rise when informed traders enter the market, largely due to market makers widening spreads to reduce losses (e.g., Glosten and Milgrom, 1985; Kyle, 1985). Moreover, in markets with unchecked insider trading, uninformed investors are expected to significantly reduce their trading activity due to an inability to compete with informed traders in addition to facing higher transaction costs (e.g., Bhattacharya and Spiegel, 1991; Fishman and Hagerty, 1992; Leland, 1992). This latter theory is generally referred to as the “crowding-out hypothesis” of insider trading, though it has remained largely untested in archival settings because of long-lived restrictions and explicit enforcement in capital markets. Because Newman constrained regulators and the implications of the ruling were broadly reported by the business press, the crowding-out hypothesis is particularly relevant to this setting.
In these tests, I document a significant decrease in trading activity by investors in 2nd Circuit firms. The estimated magnitudes of the ruling’s effect on trading activity in 2nd Circuit firms relative to firms outside the 2nd Circuit are substantial – specifically, I document an approximate 8.9% to 9.8% reduction in daily trading volume, and a decline of 10.4% to 11.8% in total daily trades in the 2015-2016 period. Relatedly, I also document that hedge funds based outside the 2nd Circuit reduced their trading activity in 2nd Circuit stocks post-Newman by about 12%, consistent with the ruling placing these investors at an information disadvantage relative to 2nd Circuit-based hedge funds. I also find that Newman produced deleterious liquidity effects in the 2nd Circuit. Specifically, relative to untreated firms, daily quoted bid-ask spreads of treated firms increased 2.6% to 3.3% following Newman; the daily price impact of trading also increased by about 7.9% to 8.5%. In total, these findings are consistent with unchecked insider trading pushing investors out of the market and increasing transaction costs.
This study contributes to a broad literature stream related to insider trading regulation and enforcement. The Newman ruling is novel in that it constitutes a rare break in the US enforcement regime. Thus, I am able to provide evidence related to the consequences of relaxing insider trading restrictions, whereas prior related literature has mainly examined market-effects of insider trading in connection with actual litigated events or by studying events related to regulatory expansion. This paper is particularly relevant to the current US enforcement environment, in that my findings demonstrate that, to the extent that the contours of insider trading law remain a sole product of the courts, then variation in judicial decision-making can degrade market quality and lead to an unlevel playing field for investors. This study may thus inform current policy discussions related to a statutory definition of insider trading. Relatedly, an important insight provided by my study is that a reduction in the enforceability of insider trading law triggers a significant reduction in liquidity. Thus, when regulatory processes disrupt the equilibrium of public enforcement, my results suggest that market forces can, at least partially, self-balance or correct for insider trading activity by impairing liquidity where insider trading is suspected.
The full study is publicly available for download here.
