Legal Insider Trading Profits Often Amount to Peanuts

How much do corporate insiders make on their trades? It has long been shown that insiders realize significant positive abnormal returns on their transactions, in percentage terms. Surprisingly, however, there has been little research examining insiders’ dollar profits, even though it is dollar profits, rather than percentage returns, that insiders themselves likely care about.

Why is it important to make this distinction? Even if insiders realize high percentage returns, they may trade small amounts or trade infrequently, so that overall profits are still small. Conversely, even small percentage returns may lead to high profits if an insider trades large amounts or trades frequently. Trade size and trade frequency may vary substantially across insiders and in turn be correlated with abnormal returns. Empirical analysis is thus required to shed light on the extent and determinants of profits.

In our paper titled “Perks or Peanuts? The Dollar Profits to Insider Trading,” we provide the first such empirical analysis. We examine all insider trades reported to the Securities and Exchange Commission during 1986-2013, working on the basis that insiders have access to valuable nonpublic information. The question we pose is: Given that information, how much money do insiders earn from it? Addressing this question matters for two key reasons. First, it helps shed light on whether corporate insider trading presents a meaningful source of private benefits and is therefore a form of compensation. Second, against the backdrop that informed trading is thought to impose costs on outside market participants, our analysis helps to quantify these costs by focusing on corporate insider trading, which represents a subset of all informed trading activity.

Our main findings are two-fold. We document that typical profits are small, and we show that percentage returns studied in prior literature do not line up with insiders’ profits. We start by documenting the magnitude and range of the economic profits that insiders make when trading their company stock. Here, we use two methods to calculate the profits. First, we calculate hypothetical profits that insiders make by multiplying one-month abnormal returns by trade value. Second, for a subset of insiders who place round-trip trades (e.g., a buy followed by a sell), we can also calculate actual profits, and compare those to the profits the insider would have made if she had traded a benchmark portfolio instead.

Profits are small for the typical corporate insider. The median insider in our sample earns annual abnormal profits of $464 per year. Focusing on round-trip transactions, which have an average holding period of 2.4 years, we find that insiders placing such trades realize average abnormal profits of $128,000 a year and median abnormal profits of $5,000 a year. However, considering that only 8.3 percent of insiders in our sample actually have round-trip transactions, the average across all insiders remains small, at $11,000. Moreover, a typical insider incurs losses in 44 percent of all years in which he trades, and 11 percent of insiders make a loss on their insider trading each year.

The average abnormal trading profit is $12,000 per year, much larger than the median value. This difference between the median and mean value is due primarily to the long right tail of the distribution, meaning there is a small number of insiders making outsized profits.  Gains from trading are a meaningful fraction of compensation for only a small percentage of insiders: At the 90th percentile, trading profits account for 4.1 percent of an insider’s total compensation, suggesting that – for at least some insiders – trading profits are a significant source of private benefits. Aggregating profits at the firm level, we estimate that a median (average) amount of $3,000 ($61,000) is redistributed each firm-year from outside investors to corporate insiders.

Why are profits small for the typical insider trade? Our analysis suggests that there are two main reasons. First, most insiders trade small amounts and trade infrequently. Second, we show that trade volume and frequency are negatively correlated with abnormal returns over certain ranges. Holding percentage returns per trade constant, the size of profits depends on two factors: trade volume and trade frequency. We document a non-monotonic relationship between trade volume and abnormal returns: Trade size initially increases with abnormal returns, but shrinks thereafter. As a result, the volume of trades with the highest abnormal returns is smaller than the volume of trades that earn medium-sized abnormal returns. Next, we show that abnormal returns also vary with trade frequency. Dollar profits to insider trading are small in part because insiders with the most informative trades (i.e., the ones who generate larger abnormal returns) are also the ones who trade smaller amounts and trade infrequently. As a result, average profits cannot be straightforwardly estimated by multiplying average trade size with average abnormal returns.

We illustrate that returns and profits do not line up using several subsample comparisons. Infrequent traders realize abnormal returns that are approximately one percentage point higher than those of infrequent traders, while their yearly abnormal dollar profits are $13,000 dollars smaller. CFOs’ abnormal returns are 0.2 percentage points higher than those of CEOs, while their yearly dollar profits are $10,000 smaller. Opportunistic traders, i.e. insiders who do not exhibit routine trading patterns in the sense that they place trades in the same calendar months each year, realize abnormal returns that are 0.5 percentage points higher, while these larger returns do not translate into larger overall profits.

Using the variation in SEC budgets over time and speedier reporting requirements on insider trading contained in the Sarbanes-Oxley Act (SOX) of 2002, we examine how profits vary with market-wide changes in litigation risk or monitoring. Here, we find that as litigation risk and monitoring increase, abnormal returns decrease, but overall profits do not. This pattern is driven by infrequent traders, i.e., insiders who typically trade on private information and are likely more sensitive to litigation risk. Surprisingly, frequent traders can actually increase their overall profits when litigation risk is higher, driven by an increase in their trade frequency.

Our results provide important insights for insider trading regulation, and for firm-level policies on insider trading. On the one hand, firms and regulators may wish to prevent insiders from trading on information and enjoying large gains at the expense of uninformed investors. We show that the magnitude of such gains on reported insider trades is moderate. On the other hand, with the increase in stock-based compensation over the past decades, it is important to permit corporate insiders to sell their shares. By showing new and comprehensive evidence on the distribution of the profits, our work provides insights for firms and regulators on the extent to which insider trading actually benefits insiders.

This preceding post comes to us from Professor Peter Cziraki at the University of Toronto and Jasmin Gider at the University of Bonn. It is based on their recent paper, “Perks or Peanuts? The Dollar Profits to Insider Trading,” available here.

 

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