Insider Trading Restrictions and Insiders’ Supply of Information

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 16, 2012 at 9:11 am
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Editor’s Note: The following post comes to us from Ivy Zhang of the Department of Accounting at the University of Minnesota and Yong Zhang of the Department of Accounting at Hong Kong University of Science and Technology.

In our paper, Insider Trading Restrictions and Insiders’ Supply of Information: Evidence from Reporting Quality, which was recently made publicly available on SSRN, we exploit a natural experiment involving first-time enforcement of insider trading laws around the world in order to examine the impact of insider trading restrictions on insiders’ supply of information. Following the existing literature, we measure the quality of financial reporting along four dimensions: earnings smoothing, earnings management towards positive earnings, loss recognition, and value relevance.

Empirical analyses indicate that reporting quality improves following a country’s first-time enforcement of insider trading laws only in countries with strong macro governance infrastructure, suggesting that a country’s legal infrastructures play an important role in determining earnings quality. Consistent with the prediction that firm-level governance structures significantly affect insiders’ incentives and their responses to regulations, we also find that the improvement in earnings quality is concentrated in less closely held firms.

This study contributes to the literature in several ways. First, we add to the literature on the costs and benefits of insider trading and the need for regulation. Uncovering an important channel through which insider trading restrictions benefit the information environment, this study extends research on the informational impact of insider trading restrictions, such as Fernandes and Ferreira (2009) and Bushman et al. (2005). Specifically, insider trading law enforcement improves the quality of information supplied by corporate insiders and thus the information environment, in addition to increasing the information collection by outsiders as shown by Bushman et al. (2005). We show that the improvement in reporting quality is concentrated in developed countries and countries with strong legal infrastructures, offering an explanation for Fernandes and Ferreira’s (2009) finding of a larger increase of price informativeness in developed markets.

Second, this study sheds light on the relation between insider trading and earnings management. While the literature has shown a positive correlation between earnings manipulation and insider trading activities, it is unclear whether insider trading motivates managers to distort corporate disclosures or managers trade passively to take advantage of their knowledge of the earnings management. By exploiting the unique setting of insider trading law enforcements, we provide evidence consistent with the former interpretation and further the understanding of the impact of insider trading opportunities on reporting quality.

Finally, we add to the literature on securities legislation and accounting regulations by highlighting the importance of managerial incentives in determining the consequences of regulations. We find that both country-level legal infrastructures and firm-level structures such as ownership concentration cause variations in managerial incentives and lead to differential responses to regulations.

The full paper is available for download here.


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