Does Common Ownership Constrain Rent Extraction by Managers?

Over the past four decades, the share of U.S. public firms held by institutional investors who concurrently invest in other firms within the same industry – common ownership – has increased fivefold. While some argue that common ownership has anticompetitive effects, others tout its economic benefits. Yet the impact of common ownership on rent seeking by managers remains relatively unexplored.

Within corporations, the divide between ownership and control creates inherent information asymmetry between insiders and public investors. Corporate insiders, motivated by self-interest, have both the incentive and means to manage firms in ways that favor their private interests, often at the expense of public investors. Opportunistic insider trading is a prominent example of managerial rent extraction and has negative consequences. For example, prior studies suggest that it can harm stock market liquidity, elevate litigation risks, tarnish corporate reputations, and precipitate stock-price declines. These consequences can disproportionately affect institutional investors, especially common owners, due to their significant holdings. Given these effects, global policymakers have introduced various regulations to curb insider trading. Recent studies suggest that  corporate governance and firms’ insider trading policies can also deter insider trading.

In a new study, we examine whether common ownership curbs opportunistic insider trading. The study posits that common ownership’s unique characteristics enable it to exert distinct effects on insider trading beyond those of other institutional investors. Common institutional owners enjoy economies of scale in information acquisition and processing. This is because their significant holdings in multiple companies within the same industry may enable them to gather and process information more efficiently, enhancing their role in monitoring and curbing insider trades. Additionally, corporate governance of one firm has externalities for the governance practices of other firms within the same industry because firms and executives are influenced by peer pressure. By holding shares of multiple same-industry firms, common owners can benefit from the positive corporate-governance spillover effects and thus internalize corporate governance externalities among their portfolio companies, and that gives them greater incentives to monitor insiders. For example, when common owners encourage firms to adopt insider trading restrictions or discipline opportunistic insiders by voting against them in shareholder-initiated proposals in a single firm, they can benefit from the reduced insider trading at that firm. But they can also benefit  from the potential reduction in the insider trades of peer firms within the portfolio because those firms are likely to adopt similar good governance practices. These discussions suggest that common institutional ownership should be negatively related to a firm’s opportunistic insider trading.

Our study used three firm-level common ownership proxies to test the relation between common ownership and insider trading, including an indicator variable of common ownership, the number of common owners, and the number of rival firms connected through the common owners. Opportunistic insider trading is measured by insider trading profitability, which is defined as the profits earned after purchasing company shares and the losses avoided from selling shares. Using a sample of U.S. public firms from 1997 through 2015, the study finds that the insider trading profitability of firms with common ownership is about 20 percent lower than that of firms without common ownership. Additional identification strategies suggest that common ownership is indeed a causal factor for the lower insider trading profitability.

A significant challenge to studies on opportunistic insider trading is that many insider transactions are not exclusively based on confidential information; they often occur because of the need for liquidity or portfolio diversification. Consequently, most insider transactions are legal, making it challenging for regulators and academic researchers to identify opportunistic insider trading based on nonpublic information. In our study, we use two ways proposed by prior studies to measure opportunistic insider trading. First, we classify insider trades into opportunistic trades and routine trades and find that common ownership is negatively related to both the proportion and abnormal returns of opportunistic trades. Second, the fact that insider transactions preceding a news event are more likely to be prompted by private information allows us to measure opportunistic insider trades in an alternative way. We find that greater common ownership is negatively related to insider trading preceding earnings announcements.

The study also tests the possible mechanisms through which common ownership reduces opportunistic insider trading. Better connected investors (i.e., central investors) possess more private information, while peripheral investors are relatively less informed. When most of a firm’s blockholders are central investors, its common owners are less likely to have significant information advantages and, consequently, their monitoring effect on opportunistic insider trading should be less evident. Consistent with this prediction, we find that the presence of central investors weakens the negative relation between common ownership and insider trading profitability, supporting the argument that information advantages enable common owners to curb opportunistic insider trading. The study also finds that this negative relation is more pronounced in industries where common institutional owners are more likely to benefit from positive corporate-governance spillover effects.

Our paper also explores whether common institutional investors can effectively constrain insider trading, both before and after it occurs. The findings reveal that firms with common ownership are more likely to adopt firm-level restrictive measures (e.g., imposition of a blackout period) to constrain opportunistic insider trading. In addition, we explore the disciplinary actions that common owners take to penalize executives who engage in opportunistic insider trading. We find that, when a firm has more insider trading, common owners are more likely to voice dissent publicly by voting against management in shareholder-initiated proposals. Overall, our findings suggest that common institutional shareholders have information advantages, governance incentives, and effective means to constrain opportunistic insider trading.

On a practical level, our research informs the debate over the economic consequences of common institutional ownership. To date, common ownership has been scrutinized by regulatory bodies in the European Union and the United States, including the Department of Justice, the Federal Trade Commission, and the SEC. To the best of our knowledge, this is the first study to show that common institutional owners deter opportunistic insider trading. The finding reveals a new, beneficial economic consequence of common ownership and suggests that common institutional investors play a valuable corporate governance role in curbing managerial rent extraction.

This post comes to us from professors Shenglan Chen at Zhejiang University of Technology, Hui Ma at Shanghai University of Finance and Economics, Qiang Wu at Hong Kong Polytechnic University, and Hao Zhang at Rochester Institute of Technology. It is based on their recent paper, “Does Common Ownership Constrain Managerial Rent Extraction? Evidence from Insider Trading Profitability,” available at here.