Legal Expertise and Insider Trading

How does legal knowledge affect corporate insiders’ trading behavior? Do corporate insiders with law degrees trade differently from others? On the one hand, with a better understanding of regulations, legal insiders are more aware of the effects and risk of litigation associated with their behavior, and they may be more hesitant to make use of their private information. Also, reputation risk may make legal insiders more conservative in using non-public information for personal benefits. In this case, legal insiders would make less profit when they make inside transactions. On the other hand, legal training might help legal insiders to obtain higher returns by enabling them to come as close as possible to the line between legal and illegal use of information without crossing that line.

In my working paper, “Legal Expertise and Insider Trading,” I study the impact of legal expertise on insider trading behavior in the context of complex laws by comparing the performance of trades from corporate directors and executives with legal education and those without. The results indicate that purchases made by legal insiders are less informed, on average. That is, compared to purchases by non-legal insiders, purchases made by lawyer insiders are followed by lower future stock returns. The differential performance of insider purchases made by legal insiders versus non-legal insiders ranges from 0.48% to 1.01% in the month following the trades. I do not find any differential trading performance between legal insiders vs. non-legal insiders when they sell because sales by both types of insiders are not informed.

This study also finds direct evidence that legal insiders are less likely to take advantage of their access to private information by relating insider trading to future earnings surprises and firm profitability. Analyses show that legal insider purchases have lower predictive power for future earnings surprises and future profitability. Furthermore, compared with non-legal insiders, legal insiders make fewer purchases following SEC investigations against illegal insider trading. This is in line with the idea that legal expertise results in a better understanding of litigation risk, leading to fewer purchases when litigation risk is high.

Like insider trading laws, corporate governance imposes additional constraints on the behavior of insiders. Legal training might also enable lawyer insiders to have a better understanding of firm level corporate governance rules; therefore, one may expect legal insiders to trade even more conservatively in firms with good corporate governance. In line with this prediction, in firms with strong corporate governance, purchases made by legal insiders are followed by even lower returns than those made by non-legal insiders. The difference is more than 2% in the month following the trade. In firms with weak corporate governance, the difference between purchase profitability of these two types of insiders is insignificant.

Overall, in this study I provide evidence that corporate insiders with law degrees make less profit when they make inside purchases and are less likely to trade on non-public information. One should be cautious in inferring any potential regulation polices because this study does not rule out the possibility that the finding arises from personal inborn characteristics rather than legal education, though it provides the first-step in this analysis. The evidence suggests that it is possible to reduce misconduct in insider trading by increasing the understanding of law and imposing stronger corporate governance. Traditional regulation of insider trading generally focuses on calling for stricter rules. This study suggests an alternative direction. That is, it is possible to restrain misconduct in insider trading by improving comprehension of laws among corporate insiders. In fact, application of strict laws, requirement for strong corporate governance, and improvement in insiders’ legal astuteness may work together to regulate insider trading.

The preceding post comes to us from Chao Jiang, PhD candidate at The University of Kansas School of Business. The post is based on his article, which is entitled “Legal Expertise and Insider Trading” and available here.