In our paper, The Deterrence Effect of SEC Enforcement Intensity on Illegal Insider Trading, which was recently made publicly available on SSRN, we argue that dramatic changes in insider trading enforcement since the 1980s enable us to empirically identify the effects of more aggressive enforcement on trader behavior and stock price discovery. First, the types of trades that expose individuals to legal liability has broadened in scope since the 1980s, extending far beyond the original principles of those with a fiduciary duty to the stock traded (Nagy, 2009; Bainbridge, 2012). Second, punishments for successfully prosecuted traders have become more severe, while at the same time the amount of resources devoted to enforcement has increased dramatically. For example, the SEC’s budget in real terms is over four-times larger today than it was in the 1980s. Finally, high-profile insider trading cases (e.g., Galleon) and recent developments in SEC enforcement have both received extensive press coverage, suggesting that regulators have been actively signaling their increased enforcement aggressiveness. We posit that traders are aware of these developments and test whether more aggressive SEC enforcement effort deters illegal insider trading and affects price discovery.
To measure variation in the intensity of SEC enforcement over time, we follow recent studies that use resource-based measures to test for the effects of enforcement on capital market outcomes. For example, Christensen, Hail, and Leuz (2011) show that stock market liquidity increases by 15% after European reforms to enforce insider trading and market manipulation laws, but only in the countries with the highest regulatory staff and the highest growth in staff from before to after the reforms. Similarly, Comerton-Forde and Putnins (2013) find that larger regulatory budgets deter closing price manipulation on U.S. and Canadian stock exchanges.
In the spirit of Jackson and Roe (2009), we argue that both the level of the SEC’s budget in constant 2011 dollars and the number of staff positions available in SEC annual reports are useful proxies for investors’ perceived enforcement intensity of insider trading laws. We show that SEC resources vary substantially over time, and more importantly, that annual increases and decreases are often driven by the idiosyncrasies of the federal budgeting process and are arguably exogenous to the level of illegal insider trading.
We also show that the years following the high-profile Galleon insider trading case in October 2009 represent a structural break in SEC enforcement, and an opportunity for further identification of the effect of enforcement. This date marks the beginning of a transformative restructuring of the SEC’s Enforcement Division, including the introduction of more effective detection technologies, new legal tools (e.g., cooperation agreements), and a commitment to target more sophisticated serial Wall Street offenders. Most legal experts agree that the SEC’s aggressiveness in detecting and prosecuting insider trading in the post-Galleon era is unprecedented. For example, former SEC Commissioner and current Stanford Law Professor Joseph Grundfest stated in the Wall Street Journal that the SEC has “declared war on insider trading” and is taking “a zero-tolerance approach.” We use data on a comprehensive sample of SEC prosecuted cases from fiscal years 2003 through 2007 and 2010 through 2011 to document that the typical prosecuted trader is more likely to be a sophisticated Wall Street professional in the post-Galleon era, consistent with a structural break.
Recent data on SEC prosecuted cases also allows for a comparison to Meulbroek’s (1992) results from the 1980s, a period with both fewer enforcement budget and staff resources and less effective tools for detecting and prosecuting insider trading. Under more aggressive enforcement, traders with access to inside information before its public announcement should fear detection and punishment, and thus less illegal trading will occur. As long recognized in the literature, deterrence should also manifest in the pattern of price discovery around news events. With less illegally-informed trading, the stock price reaction to news should be more concentrated at the public announcement, with less anticipatory run-up of prices in the pre-announcement period. Market makers and other liquidity providers would also view trading by insiders as a less serious threat under aggressive enforcement, suggesting that insiders’ trades would result in smaller price changes.
We find that the price impact on days with prosecuted insider trades is in fact much smaller in the last decade than in the 1980s, consistent with a deterrent effect. Meulbroek reports an average abnormal return of 3.1% on insider trading days, whereas the average from our more recent sample is 0.5%. Moreover, inflation-adjusted insider dollar volume is surprisingly similar in the two sample periods despite a roughly eight-fold increase in total trading volume, suggesting that insiders did not scale up their volume in the later period, perhaps reflective of an increased fear of prosecution. The pronounced decrease in relative insider trading volume is only partially responsible for the smaller price impacts. In a subsample representing the top quintile of insider volume, the abnormal insider trading day return is still only about 1.5%, significantly different from 3.1% at the 1% level, consistent with more muted reactions to informed trading by liquidity providers.
To tie these findings more directly to enforcement intensity, we show that variation in insider volume is significantly related to variation in SEC enforcement intensity. Specifically, we show that while illegal insiders trade more in higher-volume stocks, this sensitivity to stock volume is smaller when SEC budgets and staffing are higher and during the post-Galleon period. This is consistent with the predictions of a modified Kyle model in which insiders facing greater fear of prosecution scale up their trading less aggressively in response to increases in uninformed volume. In light of the potential lack of generalizability of results obtained from any sample of only prosecuted cases, we also test whether pre-announcement run-up is negatively related to our proxies for SEC enforcement intensity using two additional samples that are free of selection bias. Specifically, we analyze patterns of price discovery for all annual earnings announcements and all takeover bid announcements for publicly traded target firms from the early 1980s through 2011. Earnings and takeover news are especially relevant because they represent the most common type of information on which prosecuted insiders trade.
For general samples of both types of informational events, we find significant negative relations between the pre-announcement price run-ups and both resource-based measures of SEC enforcement intensity after controlling for a time trend and other factors related to the information content of the announcement. This suggests that increased SEC effort reduces insider trading in advance of these events. Even after controlling for these continuous measures, we find that pre-announcement price run-ups are significantly lower for earnings announcements during the 2010 and 2011 fiscal years, indicating that the change in SEC tools and increased severity of punishment had an additional dampening effect on insider trading, beyond what would have been expected given the level of SEC budget or staff. Our resource-based, U.S. enforcement intensity measures allow us to exploit thirty years of time-series variation to explain patterns of price discovery and pre-announcement price run-up, and improve our understanding of the deterrence effects of public enforcement.
The full paper is available for download here.