1. Literature Review on Insider Trading and Insider
Trading Regulation
Dr. Tony Tan, CFA
Head, Standards and Financial Market Integrity Division – Asia Pacific
12 November 2013
2. 2
Literature Survey – Summary
Research on insider trading has evolved over the years
n Early research was focused on establishing the existence of insider trading and the need for regulation
n Subsequently, it moved toward gauging the effectiveness of insider trading regulation
n Now, the focus has shifted to identifying the factors that contribute to effective enforcement
The US has been at the forefront of regulations, while emerging markets are catching up
n Developed markets have been at the forefront; establishing and continuously improving the regulatory
architecture. Asia, in general, and India, in particular, have been playing catch up
n In India, insider trading regulation has gained momentum on the back of the inclusion of prohibition of
insider trading in the revamped Companies Act of 2013 and a new ordinance that empowers the
regulator with explicit powers to settle administrative and civil proceedings
Research of local markets necessary to improve effectiveness
n The wealth of learning from the developed markets could be used to analyze and understand the
regulatory regimes in Asia and other developing markets
n We could explore potential areas of research in the Asian and Indian context where regulators are
moving toward enacting effective insider regulations and building infrastructure for enforcing them
3. Agenda
n Insider Trading and Abnormal Returns
n Debate on Insider Trading Regulation
n Evolution of Theories on Insider Trading
n ITR Across the World
– The US
– Europe and Asia
– India
n Effectiveness of Insider Trading Regulations
n Elements of Insider Trading Regulation
n Methodologies to Study IT and ITR
n Further Research
3
4. 4
Insider Trading and Abnormal Returns
Citation
1. Jaffe (1973), Finnerty (1974), Pratt and DeVere (1970), Jaffe(1973), Seyhun(1986) andJeng et al. (2002)
2. Muelbroek (1992)
What is Insider
Trading (IT)?
n The trading of a corporation’s stock or other securities by insiders with potential access to
material, non-public information (MNPI)
– Could be legal or illegal based on when an insider makes the trade
– Illegal to trade when MNPI is non-public as it is unfair to other shareholders
Who is an Insider?
n There is no uniform definition of an insider – it varies across jurisdictions and purpose
n The definition is narrow from a disclosure viewpoint, but much broader from a legislative
perspective
– Narrower sense – covers directors, officers and large shareholders who are close to
the source of MNPI
– Broader sense – encompasses several others who have access to MNPI and could
trade on them
n The US and UK laws differ in terms of fiduciary relationship
Abnormal Returns
n Studies have found evidence of abnormal returns around periods when insiders have
transacted and time periods before dissemination of MNPI
n Most of them have restricted themselves to the narrower scope1
n Few have attempted their studies based on prosecutions2
5. 5
Debate on Insider Trading Regulation – Case for Regulating
Insider Dealing is Much Stronger than the Case Against It
Case for ITR
Market Participants3
n Ensures fairness and equality
n Without ITR, liquidity traders might be hurt
n Investor confidence could collapse without ITR
Financial Markets4
n Insiders could manipulate information and earn profits from artificial price volatility
n Deliberate delay in the release of information
n Without ITR, ownership will be concentrated
n ITR could reduce volatility and bid-ask spread
Firm Level5
n Without ITR, firms could venture into excessively risky projects
n IT could lead to an overall decline in a firm’s welfare
Case Against ITR
Agency Costs and
Market Efficiency6
n IT helps to gradually move the price of a stock closer to its fair value
n IT is the best means to reward entrepreneurship and promote innovation
n IT serves as an effective alternative to costly renegotiations of manager compensation
Citation
3. Mendelson(1969), Leland(1993)and (Bhattacharya and Spiegel, 1991)
4. Easterbrook (1985), Ausubel(1990), (Beny, 2005), Fishmanand Hagerty(1992), Glosten(1985)and Bhattacharya and
Spiegel (1991)
5. Easterbrook (1985), Ausubel (1990),Manove(1989) andLeland(1993)
6. Manne (1966), Carltonand Fischel 1983) , Javier Estrada (1994) and Bainbridge (2002)
6. 6
Evolution of Theories on Insider Trading
Source : Get serious about insider trading , BusinessLine
Equality of Access – First Approach Adopted toward ITR7
n Although directors did not have the duty to disclose all MNPI to
shareholders, they had to disclose under ‘special circumstances’
when trading with the less-informed investors
Disclose or Abstain – Emphasis on Fiduciary Duty8
n Insiders were expected to either disclose the MNPI before
trading or if the disclosure is not possible, abstain from trading
n The fiduciary requirement to shareholders proved to be a
limitation and served as a loophole for others to trade
Misappropriation – Emphasis also on Duty of Confidentiality9
n The person misappropriating confidential MNPI has the duty to
disclose the information before trading or abstain from trading
n The definition of an insider expanded to include ‘constructive
insiders’
n The scope has widened to cover misappropriation of confidential
information arising out of a breach of duty
Citation
7. Stong vs. Repide(1909)
8. SEC vs. Texas Gulf Sulphur Co. (1966)
9. Chiarella vs. United States(1980
7. 7
ITR from Across the World – the US
Dennis Levine on the July 28, 1986 issue of New York
magazine. Source: www.nymag.com
Ivan Boeksy on the cover of the Dec. 1, 1986 issue of TIME
magazine. Source: www.LIFE.com
Front page of the Brooklyn Daily Eagle newspaper on Oct. 24,
1929 (also known as Black Thursday) reads "Wall St. in Panic
as Stocks Crash." Source: abcnews.go.com
http://www.sec.gov/spotlight/insidertr ading.shtm l
The US has the Toughest ITR Laws Among Developed Markets
n Section 16(b) of the SEC Act (1934)
– Widespread securities fraud blamed for the collapse
– Law enacted to prevent insiders from profiting based on MNPI
– Restrictions on short-swing transactions and insider sales
n Insider Trading Sanctions Act (ITSA, 1984) and Insider Trading
and Securities Enforcement Act (ITSFA, 1988)
– Enhanced monetary penalties and intensity of criminal
charges
n SEC Rule 10b-5, Sections (1) or (3) (2000)
– Proof of ‘use’ of information not necessary
– Insider is considered to have violated a duty of trust and
confidence
8. 8
ITR from Across the World – Europe and Asia
EU Insider Trading Enforcement has Intensified 10
n In the UK, ITR is governed by Criminal JusticeAct (1983) and Financial Services and Markets Act
(2000)
– The UK has a broader definition of ‘market abuse’ and grounded on ‘possession theory’
– ‘Criminal’ offense if an insider violates deliberately; ‘Civil’ offense if it involves inadvertent violations
n Europe has generally lagged behind the US with regard to the enactment of ITR and only recently it
intensified both standardization and enforcement
– In late 2013, the EU approved the Market Abuse Regulation (MAR), which is expected to replace the
Market Abusive Directive (MAD) introduced in 2005
Regulators in Asia are Beginning to Focus on Stricter Enforcement10
n ITR laws across Asia and the emerging markets have lagged the developed markets in terms of
regulations and enforcements
– Japan’s ITR is considered to be lenient in comparison with the US and the UK
– China has adopted the codification method to regulate ITR based on ‘equal access theory’
– HK has been active in the recent years in combating market misconduct to protect the investors
Citation
10. Zekos (2008), Montagano (2012), Thompson (2013) and Kylie (2013)
9. 9
ITR from Across the World – India
Prohibition of Insider Trading Regulations (1992 and 2002) are the key ITR regulations
in India enforced by the Securities and Exchange Board of India (SEBI)
Gradually Moving toward
Global Standards
n ITR laws became
applicable to all listed
companies only in 1992 and
amendments were made in
2002
n Significant changes were
made to the ITR laws in
2008
n Consent plea a deterrent
Greater Action, but Limited
Conviction
2013 – A Dynamic
Environment
n Enforcement has gathered
pace
n Conviction rates remain low
n Committee set up in 2013
to review the laws
n A new Act, the Companies
Bill, 2013, was enacted
n The ordinance empowers
SEBI with explicit powers to
settle administrative and
civil proceedings
10. 10
Effectiveness of Insider Trading Regulation
ITR has Improved Market Efficiency11
n ITR led to a more diffused ownership, more efficient stock prices and higher market liquidity
n The cost borne by uninformed traders due to insider activity has declined
n The cost of equity has declined with the implementation of ITR
Insider Trading Prevails12
n ITR has only led to a change in the trading pattern of insiders
– Smaller volumes traded over a prolonged period and less around corporate events
– Registered insiders have reduced their insider trading activities, while ‘outside-insiders’ continue
n Instances of IT and profitability have increased
n Insiders make a trade-off between potential benefits and costs
Citation
11. Bhattacharya andDaouk(2002) , Jeng et al (2003) and Beny (2005)
12. William Schwert (1996), Arshadi andEyssell (1993) , Seyhun(1992), Jagolinzer et al (2007) , Frino et al (2013) , Bris
(2003) and Padilla (2002)
11. 11
Elements of Insider Trading Regulation (1/2)
Enactment and
Enforcement of
ITR13
n Enactment leads to a decline in insider trading but is not enough
n Stricter enforcement of ITR is critical
n Toughness necessary to reap the benefits of ITR
n Insiders such as the chairman/directors should be strictly regulated
n Disclosure requirements need to be extended to nominal insiders
n Insiders to be defined in such a way that it delays inside information
reaching the public but does not constrain it completely
n Criminal sanctions and monetary fines influence effectiveness the most
n Existence of financial liabilities is an overriding factor over criminal liabilities
n Civil suits for insider trading render ITR ineffective
n Penalties suggested for companies whose insiders trade illegally
Right Insiders to
Target 14
Civil Versus
Criminal Penalties 15
Citation
13. Bhattacharya andDaouk(2002), Ackermanand Maug(2008) ,Beny (2005)and (Frijns et al., 2007)
14. Seyhun(1986),Bettis et al.(1998) andGeorgakopoulos (1993)
15. Beny (2005), Frijns et al.(2007),Bris(2003), Bettis et al. (1998)
12. 12
Elements of Insider Trading Regulation (2/2)
Disclosure and
Holding Period
Requirements16
n MNPI disclosure by insiders before trading important than a complete ban
n Disclosure needs to be extended to a bigger group
n Deters ownership – weakens governance
Monitoring and
Support
Mechanisms17
n Insiders play the system and manage to stay out of the radar
n Enhance monitoring to gather hard evidences or ‘smoking guns’
n Investor protection laws and financial reporting – a significant precursor
n Law enforcement capabilities and judicial effectiveness critical
n Enforcement without governance and investor protection laws to be
counter-productive
Public Versus
Private Regulation
of IT18
n Need for a private negotiation between shareholders and managers
n Shareholders lack adequate enforcement mechanisms – they favor
government regulating insider trading
n Government has scientific knowledge but lacks experiential knowledge
Citation
16. Fishman et al.(1992),Bettis et al.(1998) andPadilla(2011)
17. Spiegel and Subhramanyam (1995), Ackerman andMaug(2008),Ferriera et al. (2006),Durnev et al.(2007)
18. Carlton and Fischel(1983) and Padilla(2011)
13. 13
Methodologies to Study IT and ITR
IT and ITR Studies
n Most analysis revolve around the existence of IT and the effectiveness of ITR
n Most studies have focused on the US market
n Recent studies done in an international context, to understand what works and what does not
Effectiveness of ITR
n Multiple regression has generally been utilized for testing the effectiveness of ITR
– Dependent variable metrics – cost of equity, variations in firm-specific returns, post-event
earnings level, probability of informed trades (using imbalances in the daily order flow)
– Independent variable metrics – legislation enactment, legislation enforcement,
liberalization, disclosure, governance, size, industry concentration, legal system,
ownership, spreads coverage
n Some studies have utilized aggregate demand and supply functions, scorecards and
distribution functions for modeling trades
Existence of IT
n Initial studies were based on the Cumulative Abnormal Return (CAR) approach for a portfolio
– Involves computing excess returns over a benchmark model
– The CAPM model is the most commonly chosen benchmark, followed by the market model
– Every researcher has adopted a unique holding period/event window of study
14. 14
ITR Studies in the Indian Context
Merger Announcements and Insider Trading Activity in India: An Empirical Investigation (2006) by
Manish Agarwal and Harminder Singh
n Investigated insider trading activities prior to M&A announcements in India
n Based on a sample of 42 companies during 1996-99, it examined the trends in the pattern of stock price
movement and trading volume. The abnormal returns were measured using a modified market model
n Found evidence for the presence of insider trading activities in companies belonging to the same
business group. It recommended investigation on six companies for the existence of insider trading
Market Imperfections and Regulatory Intervention: The Case of Insider Trading Regulation in the Indian
Stock Market (2012) by Yogesh Chauhan, Kiran Kumar Kotha and Vijaya B. Marisetty
n Ascertained the impact of regulatory action (a) on insider trading profits and information content of
disclosures and (b) its variability across firms with different organizational structure
n The study analyzed nearly 22,571 insider trades that occurred during 2007-11. The abnormal returns
were measured using the Fama-French Model
n It concluded that regulatory intervention (a) reduced profiteering activities (b) significantly improved the
production of information and (c) was predominantly felt among standalone firms
15. 15
Further Research
ITR Management in India – A Case-study Approach
n Detailed examination of cases of insider trading and regulatory action in India
n Compare and contrast the Indian experience with other countries and suggest potential takeaways for
Indian regulators
ITR Policy Effectiveness Across Asian Countries – What Works and What Does Not?
n CAR-based analysis for India, Singapore and a few other countries across time
n Learning for regulators and market participants from the relatively successful countries
Definition and Disclosure Framework of Insider Trading and ITR
n Critical analysis of the way ITR is defined and interpreted across countries
n Quantitative analysis of the impact of the regulatory definition on the effectiveness of ITR
