Despite the extensive scholarship on insider trading, relatively little attention has been directed to a basic but fundamental question: Does insider trading law actually affect the amount of insider trading? In a new article, available here, I seek to empirically evaluate that question by leveraging a change in insider trading law that occurred in 2014 when the Second Circuit issued its seminal decision in United States v. Newman, which substantially limited the scope of tippee liability. The article provides strong empirical evidence that changes in insider trading law do affect the amount of insider trading, sometimes dramatically.
The article’s empirical methodology takes advantage of the fact that, while insider trading generally cannot be directly observed, there are indirect measures that can serve as good reflections of insider trading. As my measure of insider trading, I use the run-up in the stock price of merger targets before merger announcements. That run-up is formally calculated using event study methodology (it is a cumulative abnormal return) but the basic idea is intuitive: If there is insider trading in the stock of a merger target in advance of the merger’s public announcement, that trading will be reflected in upward pressure on the target’s share price and cause the price to exceed its expected level, i.e., insider trading will generate abnormal returns. While factors other than insider trading may be involved, a higher run-up represents greater insider trading, all else equal. Financial economists and legal scholars have used the run-up as a measure of insider trading, and studies have empirically demonstrated a connection between the run-up and insider trading.
My article empirically assesses Newman’s effect on insider trading by comparing the average run-up of targets of mergers announced in a period preceding Newman with the average run-up of targets of mergers announced in a period after Newman. The empirical analysis shows that, as measured by target run-ups, Newman had a statistically significant and economically meaningful effect on the extent of insider trading. The average target run-up in the post-Newman period was more than three times higher than that in the pre-Newman period. The empirical methodology accounts for rumors in news stories that preceded the mergers, as such rumors can generate run-ups apart from any effects of insider trading. The analysis finds that the substantial difference between average target run-ups after and before Newman persists after controlling for deal rumors and other variables.
The article’s empirical analysis generates a number of other valuable findings, such as that Newman had a pronounced effect on insider trading in the period immediately following its issuance but that the effect abated in subsequent periods, likely the result of additional judicial decisions concerning the scope of tippee liability. The article’s empirical findings also inform various policy debates pertinent to insider trading law and motivate additional areas of research into insider trading and insider trading law.
This post comes to us from Menesh S. Patel of the Program in the Law and Economics of Capital Markets at Columbia Law School and Columbia Business School. It is based on his recent article, “Does Insider Trading Law Change Behavior? An Empirical Analysis,” available here.