Does regulation deter insider trading? This has been a controversial question, with mixed empirical findings. One set of studies finds that insider trading regulations have been effective in reducing the frequency and profitability of opportunistic trades (e.g., Agrawal and Jaffe (1995) and Garfinkel (1997)), while several other studies cast doubt on the efficacy of regulations (see, e.g., Seyhun (1992), and Banerjee and Eckard (2001)). A possible reason for the disagreement is the difficulty in establishing a causal connection between regulation and insider trading. There are two main obstacles to doing so. First, most modern insider trading laws in the United States are adopted at the federal level and are designed to affect all firms at the same time. Second, a decrease in insider trading after the passage of a stricter law or an increase in enforcement may simply reflect mean-reversion after a period of rampant insider trading that led to the law. Perhaps recognizing these issues, Bhattacharya (2014) concludes his extensive review of the insider trading literature with the verdict, “We need methodologies (such as natural experiments) to evaluate the efficacy of current and future insider trading rules.”
We exploit the staggered adoption of Universal Demand (UD) laws in 23 U.S. states and the District of Columbia over 23 years to examine the effect of shareholder litigation risk on opportunistic insider trading. Our research is motivated by recent studies that find that UD laws significantly reduce shareholders’ ability to bring derivative lawsuits (DLs) against directors and officers (D&O) for breach of their fiduciary duty to the company (see, e.g., Appel (2019)). Appel estimates that the adoption of UD laws is associated with a decrease in the probability of DLs by about a third compared with its mean.
How do UD laws affect insider trading? DLs, which typically allege that D&O breached their fiduciary duty and harmed the company, often include allegations of insider trading, especially selling. Erickson (2010) finds that about 60 percent of DLs contain allegations of insider trading. While most DLs don’t target insider trading alone, evidence of insider trading makes shareholder lawsuits more likely to succeed (see, e.g., Choi, Nelson and Pritchard (2009)). Therefore, the threat of DLs should deter insiders from trading opportunistically. By making it harder to bring DLs, UD laws embolden insiders to trade more opportunistically. States’ adoption of UD laws provides an excellent opportunity to study a causal effect of regulation on insider trading for two reasons. First, UD laws are adopted by different states at different times over many years. So their adoption offers rich variation over time and across firms in the ex-ante probability of DLs. Second, although DLs encompass insider trading, they are much wider in scope, and most states seem to have adopted them for reasons largely unrelated to concerns about insider trading. This feature makes the passage of UD laws likely exogenous to pre-existing levels of insider trading. Our empirical methodology builds on recent studies that employ multiple exogenous shocks for identification to make causal inferences.
Using our full sample of trades, we analyze the effect of UD laws on the profitability of insider trades measured by their estimated buy-and-hold abnormal returns (BHARs). Our baseline regressions show that compared with control firms, insiders of treatment firms avoid losses of about 1.8 percent and 3.4 percent in BHARs over one month and three months following a sale, respectively. These returns translate into abnormal loss avoidance of about $23,000 and $60,000, over one month and three months respectively.
While the effect of UD laws on the profitability of insider purchases in terms of abnormal stock returns is mostly insignificant in the full sample, it is significant in some pertinent subsamples such as trades before quarterly earnings announcements (QEA). Moreover, we find some significant effects of UD Laws on estimated abnormal dollar profits, which considers the trade volume along with subsequent stock returns, from insider purchases.
We conduct many additional tests to understand the timing and opportunism in insider trades following UD Laws. We find that UD laws predict increases in the dollar volume of shares sold within a given period, but not the number of shares sold. This finding supports the view that the reduction in litigation risk encourages insiders to time their sales more opportunistically, i.e., they are more likely to sell when prices are inflated and large price declines are likely. In addition, we find that in treatment firms, UD laws lead to an increase in the ratio of opportunistic sales to routine sales, as defined by Cohen, Malloy, and Pomorski (2012). Moreover, we analyze insider trades before QEA, which Ali and Hirshleifer (2017) show are opportunistic trades. We find that pre-QEA insider trades – both purchases and sales – become more profitable after the adoption of UD laws. These results suggest that the risk of being sued by shareholders deters arguably more serious types of insider trades: opportunistic sales and trades before major recurring corporate events.
These effects are larger among firms with greater information asymmetry, such as firms with higher R&D and lower stock liquidity, which offer more opportunities for profitable insider trading. Moreover, after the adoption of UD laws, insider sales become more profitable in treatment firms which 1) are smaller and so likely to have fewer alternate governance mechanisms such as company rules against opportunistic insider trading, and 2) have less monitoring by institutional blockholders.
Our finding that insider trading becomes more profitable following UD laws is stronger for sales than for purchases. What explains this asymmetry? By decreasing the threat of shareholder lawsuits against officers and directors for wrongdoing, UD laws embolden managers to misbehave in ways that can harm the firm, e.g., by manipulating earnings, self-dealing, or negligence. Knowledge of this harm also provides insiders an opportunity to sell stock based on their private information. Of course, insider trading is also at issue in many shareholder lawsuits, which explains why we also find some evidence of an increase in the profitability of insider purchases.
Our evidence suggests that with a decrease in litigation risk, insiders engage in otherwise riskier and more litigation-prone and profitable trades. Thus, our results support the idea that an ex-ante litigation threat caused by shareholder lawsuits plays a vital role in deterring opportunistic insider trading. Our evidence also supports Agrawal and Nasser’s (2012) conjecture that private enforcement can sometimes be more effective than public enforcement in deterring opportunistic insider trading. Finally, our findings that, on average, insider sales are more profitable after UD laws, while most insider purchases are not, stand in sharp contrast to a large literature on insider trading in general that finds that insider purchases are more profitable than insider sales (see, e.g., Lakonishok and Lee (2001)).
 For example, SEC rule 10b-5, Section 16b of the Securities Exchange Act of 1934, Insider Trading Sanctions Act of 1984 (ITSA), and Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)
 Our conclusions remain similar when we use alternate measures of abnormal returns.
 Our conclusions using 6-month BHARs are similar.
Agrawal, Anup, and Jeffrey F. Jaffe. Does Section 16b Deter Insider Trading by Target Managers? Journal of Financial Economics 39, no. 2-3 (1995): 295-319.
Ali, Usman, and David Hirshleifer. Opportunism as a Firm and Managerial Trait: Predicting Insider Trading Profits and Misconduct. Journal of Financial Economics 126 (2017): 490-515.
Appel, Ian. Governance by Litigation. Working paper, SSRN (2019).
Banerjee, Ajeyo, and E Woodrow Eckard. Why Regulate Insider Trading? Evidence from the First Great Merger Wave (1897-1903). American Economic Review 91, no. 5 (2001): 1329-49.
Bhattacharya, Utpal. Insider Trading Controversies: A Literature Review. Annual Review of Financial Economics 6, no. 1 (2014): 385-403.
Choi, Stephen J., Karen K. Nelson and Adam C. Pritchard, 2009, The screening effect of the Private Securities Litigation Reform Act, Journal of Empirical Legal Studies 6, 35-68.
Cohen, Lauren, Christopher Malloy, and Lukasz Pomorski. Decoding Inside Information. The Journal of Finance 67, no. 3 (2012): 1009-43.
Erickson, Jessica. Corporate Governance in the Courtroom: An Empirical Analysis. William & Mary Law Review 51 (2010): 1749-1831.
Garfinkel, Jon A. New Evidence on the Effects of Federal Regulations on Insider Trading: The Insider Trading and Securities Fraud Enforcement Act (ITSFEA). Journal of Corporate Finance 3, no. 2 (1997): 89-111.
Lakonishok, Josef and Inmoo Lee. Are Insider Trades Informative? Review of Financial Studies 14, no. 1 (2001): 79–111.
Seyhun, H Nejat. The Effectiveness of the Insider-Trading Sanctions. Journal of Law and Economics 35, no. 1 (1992): 149-82.
This post comes to us from professors Binay K. Adhikari at the Vackar College of Business and Entrepreneurship at the University of Texas Rio Grande Valley, Anup Agrawal at the Culverhouse College of Business at the University of Alabama, and Bina Sharma at the College of Business at Bellevue University. It is based on their recent article, “Does Litigation Risk Deter Insider Trading? Evidence from Universal Demand Laws,” available here.