Corporate insiders can earn abnormal returns by trading on private information about their firms. Because this informational advantage is especially pronounced before major releases of information—such as earnings announcements—regulators and firms impose trading bans, known in the UK as close periods, during which the executive and non-executive directors may not trade their firm’s shares. Yet, directors who hold multiple board seats face no restrictions on trading the shares in other firms on whose boards they sit. Given that these connected directors must disclose their transactions in every firm where they hold an executive or non-executive directorship, such trades are different from shadow trading. Indeed, these trades occur in broad daylight, are disclosed, and are lawful.
We examine this potential regulatory gap. If private information about one firm affects the value of other firms, trading bans may merely redirect informed trading to other firms rather than suppress it. Studying these trades promises insights for regulators and investors and sheds light on the extent to which the stock prices of connected firms are correlated. The London Stock Exchange (LSE) offers a particularly attractive setting for studying this regulatory gap, because close periods are stipulated by regulation rather than voluntarily adopted by individual firms, as is the case in the United States. Consequently, this research avoids the endogeneity concerns that affect research on U.S. blackout periods, which firms set themselves and which vary in length and enforcement.
This setting raises three questions. First, are directors more likely to trade in their connected firms when a close period prohibits them from trading in one of their firms? Second, are such transactions influenced by the information that emerges during the close period? Third, do investors exploit the information conveyed by these insider transactions to trade in firms subject to a close period?
We refer below to the firm under a close period as the “close firm” and the connected firm in which the director trades as the “traded firm.”. We expect the following. First, when connected directors are banned from trading in one of their firms, they are more likely to trade in their other firms. Second, directors are likely to purchase shares in the traded firm when the insider information about the close firm is positive. By contrast, they are likely to sell shares in the traded firm when the insider information in the close firm is negative. Third, the market reactions in the traded firm and the connected close firm should be positively correlated. Finally, unlike in the United States, it is rare for company directors in the UK to sit on the boards of competing firms. Nevertheless, directors may still sit on the boards of firms that have a friendly or neutral relationship. If the traded and close firms are in a friendly, partnership-based relationship, the positive correlation between their market reactions should be stronger.
The ethical and regulatory dimensions of the study deserve further attention. Insider trading regulation rests on the principles of market fairness and equal access to information. Investors deserve to be that better-informed counterparties do not exploit them, since such exploitation distorts prices, widens spreads, and ultimately erodes investor confidence and market liquidity.
Regulatory approaches to insider trading differ across jurisdictions. In the United States, the Securities and Exchange Commission (SEC) prohibits trading on material non-public information. However, blackout periods before earnings announcements are adopted voluntarily by firms, with better-governed firms more likely to have such restrictions in place. In the UK, by contrast, the close period has been a requirement since the LSE’s Model Code of 1977. The Code imposed close periods of 60 days before annual and semi-annual earnings announcements, while a shorter close period of 30 days applied to quarterly earnings announcements. The European Union’s Market Abuse Regulation (MAR), effective on July 3, 2016, replaced the code by imposing a uniform 30-day close period.
UK regulation also features faster reporting requirements, making insider trades more informative than in the United States. Crucially, the transactions studied in this paper comply with the letter of the law: Directors respect the trading ban in the close firm, while trading elsewhere and disclosing these trades as usual. Precisely therein lies the ethical problem. Connected directors convert privileged information that regulation intends to neutralize into personal gain, exploiting their informational advantage over uninformed outsiders, while remaining formally compliant. Such behavior violates the spirit of securities regulation, creates an unfair advantage, and threatens the integrity and trustworthiness of capital markets (even if average profits appear modest).
The empirical analysis draws on more than 86,000 disclosed insider transactions by executive and non-executive directors of UK listed firms between 1999 and 2019. The results are as follows. Of all directors’ transactions, 40.7% are made by connected directors, and 21.0% of these occur while one of a director’s firms is subject to a close period. When directors are subject to a close period, the likelihood that they trade in their other firms increases by about 6%, an effect that is strengthened by the number of board seats they hold.
In turn, whether the insider information about the close firm is positive or negative matters a lot. The insider information is deemed positive if the market reaction to the impending earnings announcement is positive. Alternatively, the insider information is deemed to be positive if the announced earnings per share exceed the forecasted earnings per share. A purchase in the traded firm is 24% more likely when the insider information in the close firm is positive, and 15% less likely when it is negative. The market reaction in the traded firm and the contemporaneous market reaction in the close firms are found to be positively correlated. Tests pairing traded firms with 15,000 randomly selected unconnected firms yield no correlation, ruling out market-wide momentum. In addition, mere membership in the same industry does not generate this positive effect. The correlation nearly doubles when the firms are in a friendly relationship. It also strengthens with large institutional ownership in both firms. The close firm’s market reaction follows shortly after the traded firm’s market reaction. This implies a synchronized lead-lag pattern rather than a synchronous market reaction. This pattern is consistent with institutional investors observing the insider trades in the connected firm. They then mimic the trades in the close firm, where they can trade freely while the insiders are banned from trading. Information leakage is rejected as an alternative explanation.
We conclude that close periods leave a consequential gap: Insiders legally monetize their private information in their connected firms; institutional investors follow suit by trading in the firms that are subject to a trading ban. Regulators should extend trading bans to all firms on whose boards a director sits.
Marc Goergen is a professor at IE University’s Business School, Luc Renneboog is a professor at Tilburg University, and Yang Zhao is a senior lecturer at the University of Liverpool’s Management School. This post is based on their recent article, “Insider Trading in Connected Firms during Trading Bans,” available here.