Corporate insiders’ opportunistic trading – particularly selling their firms’ stocks before bad news – erodes public trust, reduces market participation, and exacerbates the agency problem that occurs when the interests of insiders and the company conflict. Yet, regulators have been cautious about stricter regulation of insider selling for mainly two reasons. First, theories suggest that a strict insider trading policy could lower the informativeness of stock prices and reduce market efficiency. Second, many companies claim such a policy could unfairly punish innocent insiders who trade for liquidity or diversification. Both claims were hard to test in the real world until recently, when the SEC approved the amendments to Rule 10b5-1 in 2022, which introduced restrictive measures to make insider trading more difficult. In a new paper, we examine whether those amendments have had their desired effect.

Rule 10b5-1 and the Amendments in 2022

Originally enacted in 2000, the Rule 10b5-1 program is based on the assumption that disclosing trading plans in advance and trading according to those plans would make insiders’ trades  less reliant on material nonpublic information. That assumption led the SEC to offer an affirmative defense for all plan-based trades. Yet, mounting evidence shows that some participants have severely abused the program. For example, after learning of bad news, insiders can instantly initiate a plan to sell and execute the plan before the bad news becomes public, while still enjoying the SEC’s protection (opportunistic planning). In addition, even when the plan adoption is uninformed, opportunistic insiders can manage earnings before the pre-scheduled sales to maximize their selling proceeds.

To address these issues, in late 2022, the SEC amended Rule 10b5-1 in several ways. For example, it limited opportunistic planning by imposing a mandatory cooling-off period, requiring all participants to wait for at least 90 calendar days after the plan adoption (or two business days after 10-Q/10-K disclosure, whichever is later) to make the first trade. To reinforce the rule’s control over opportunistic insiders, the SEC also mandated that participants (1) explicitly state, in writing, that they are not aware of material nonpublic information at the time of plan adoption, and (2) act good faith throughout the plan’s execution.  The amendments of Rule 10b5-1 provide us with an excellent opportunity to assess whether and how a stricter insider trading regulation affects market efficiency and corporate participation.

Testing the Two Regulatory Concerns

To examine the impact of a stricter insider trading policy on market efficiency, we identify a group of firms that are directly affected by these amendments (treatment group, firms that participate in this program) and a group that are not affected (control group, firms that do not participate in this program). We then investigate how the informativeness of these firms’ stock prices changes around the amendments’ effective date (February 2023).

We find that the amendments neither reduce the stock price informativeness nor increase the mispricing of the affected firms’ stock.  We introduce five stock-price informativeness metrics that reflect different levels and aspects of market efficiency, such as whether the stock prices fluctuate randomly (weak-form efficiency) and how much firm-specific information is incorporated into the stock prices (semi-strong form efficiency) and, finally, a score related to the possible stock mispricing. We also refine our research method to ensure that there are no other ways insiders of the treatment firms can leak their private information into the stock market after the amendments. We find that the amendments’ effects on these metrics are universally insignificant and remain so after various robustness checks.

This finding is surprising because it challenges a widely accepted theory that insiders always add information to the stock markets. We argue that, although this theory is generally true, its altered form – limiting insider trading will reduce the informativeness of stock prices – is not necessarily true. We posit two explanations for the amendments’ neutral effect on market efficiency. The first is that a strict insider trading policy can increase market liquidity. To the extent that improved liquidity facilitates information transmission and stimulates arbitrage, it could partially offset the negative impact that the amendments might have.  The second explanation is related to a possible substitution effect between insiders and outsiders in the information-production process. We hypothesize that reducing informed insider selling can increase outside investors’ motivation to gather more information because it also increases those investors’ marginal gains of information collection. This substitution mechanism can also contribute to the amendments’ neutral effect on market efficiency.  Using the daily number of page requests for stocks’ non-Form 4 filings as a proxy for outside investors’ information production activities, we find evidence consistent with this conjecture: After the amendments, the searches for the affected firms’ filings in the EDGAR database increase significantly.

Our finding that restrictions on informed insider trading do not necessarily lower market efficiency challenges the existing theories on insider trading because they fail to account for the information effect of the increased liquidity and the endogenous relationship between corporate insiders and outside investors in information production.

We next examine whether stricter insider-trading regulations might unfairly punish innocent insiders. We first note that a stricter policy sometimes has benefits. What matters is whether the increased costs outweigh the benefits. Take the cooling-off period introduced in the amendments, for example. By delaying trades, this new policy imposes a significant time cost and price risk on insiders who trade for liquidity or diversification. Yet, it also increases the credibility of the Rule 10b5-1 program, which could benefit innocent participants through improved stock liquidity, lower trading costs, and reduced cost of capital. The lack of consensus on this matter derives mainly from the firm-specific and typically unobservable nature of these costs and benefits. The Rule 10b5-1 program, however, overcomes this problem and makes this assessment possible because firms and insiders can voluntarily participate in or withdraw from the program, and we can use their actions to infer how a stricter policy affects them.

We thus first focus on a set of firms that stop participating in the Rule 10b5-1 program after the amendments (the quitters). If these firms withdraw simply because the increased compliance cost outweighs the benefits, then their stock sales should not offer useful information either before or after the amendments (the “innocent quitter” hypothesis). If they withdraw because the amendments make opportunistic selling through the Rule 10b5-1 program more difficult, however, then their pre- and post-amendment Rule 10b5-1 stock sales should be informative about future stock price declines (the “opportunistic quitter” hypothesis). Our evidence strongly supports the opportunistic quitter hypothesis. Firms appear to withdraw from the amended Rule 10b5-1 program mostly because it makes opportunistic insider selling more difficult (opportunistic withdrawal). Indeed, we find that after the amendments become effective, more firms join the Rule 10b5-1 program, and more Rule 10b5-1 plans are adopted. And these newly joined firms are not opportunistic. Overall, this evidence suggests that while a stricter insider trading policy may increase the participation cost, it does not necessarily punish innocent insiders.

Implications for Insider Trading Policy

Overall, our paper provides some of the first evidence supporting stronger regulations on insider trading.  Yet, our findings do not unconditionally support any policies that make insider trading difficult, especially when the regulators disregard market participants’ interests.

This post comes to us from professors Pengfei Ye at the Pamplin College of Business at Virginia Tech and Qingsheng Zeng and Cheng Zhang at the School of Accountancy of the Shanghai University of Finance and Economics. It is based on their recent paper, “Real Concern or False Alarm: Do Stricter Insider Selling Policies Impede Market Efficiency and Hurt Innocent Players?” available here.