Insider trading laws and stock price informativeness


Create account Login Subscribe. Economic theory offers conflicting perspectives on the relationship between insider trading and innovation. To date, the empirical evidence is similarly inconclusive.

This column exploits the staggered enforcement of inside trading laws across countries to explore the effect on patenting behaviour. The findings point to a robust positive effect of enforcement on various measures of patenting behaviour. Legal systems that protect outside investors from corporate insiders thus help to foster insider trading laws and stock price informativeness. The strong connection between technological innovation and long-run economic growth has spurred researchers to explore which factors drive technological innovation.

The finance and growth literature has discovered that insider trading laws and stock price informativeness developed financial markets foster economic growth primarily by boosting productivity growth and technological innovation. An open question, however, is whether legal systems that protect outside investors from corporate insiders by restricting insider trading — trading by corporate official or major shareholders on material non-public information — accelerate or slow technological innovation.

Theory offers differing perspectives. Leland stresses that trading by corporate insiders quickly reveals their information insider trading laws and stock price informativeness public markets, improving stock price informativeness. Thus, restricting insider trading can hinder price discovery and reduce the efficiency of resource allocation, especially among opaque activities such as innovation.

Demsetz argues that for some firms, insider trading is an efficient way to compensate large owners for exerting sound corporate control over management. Thus, restricting insider trading can impede effective governance and investment. Stein and Shleifer and Summers explain how highly liquid markets can attract myopic investors and facilitate hostile takeovers, which can in turn incentivise managers to forgo long-run, profit-maximising investments to satisfy short-term performance targets.

From these perspectives, restricting insider trading slows innovation. Other theories, however, highlight mechanisms through which restricting insider trading accelerates innovation.

Fishman and Hagerty and DeMarzo et al. This can improve the valuation of difficult to assess activities, such as technological innovation, and enhances the quality of investment. Insider trading laws and stock price informativeness addition, if restricting insider trading boosts market liquidity, this can make it less costly for investors who have acquired information to profit insider trading laws and stock price informativeness trading in public markets, which can in turn encourage investors to acquire information on firms.

Existing evidence has not yet resolved these conflicting views. For example, two sets of empirical findings suggest that restricting insider trading slows innovation. First, Bhattacharya and Daouk find that restricting insider trading boosts stock market liquidity, and Fang et al.

Second, Bushman et al. In contrast, other work suggests that restricting insider trading will accelerate innovation. Specifically, researchers find that restricting insider trading lowers the cost of capital Bhattacharya and Daouk and enhances insider trading laws and stock price informativeness price informativeness Fernandes and Ferreiraboth of which can stimulate innovation. In a recent paper, we provide the first assessment of the impact of insider trading restrictions on innovation Levine et al.

To conduct our study, we use the staggered enforcement of insider trading laws across countries. For countries starting in USBhattacharya and Daouk provide the date when a country first prosecutes a violator of its insider trading laws. Thus, for each country, we create insider trading laws and stock price informativeness enforcement indicator that equals one after a country first enforces its insider trading laws and zero otherwise.

We use the date on which a country first enforces it insider trading laws, rather than the date on which a country enacts those laws, because Bhattacharya and Daouk show that it is enforcement, not enactment, that matters for the functioning of financial markets.

Insider trading laws and stock price informativeness measure innovation, we construct six patent-based indicators. We compile a sample of 76, country-industry-year observations and calculate the following proxies for technological innovation:. In our baseline analyses, we find that the enforcement of insider trading laws is associated with a material and statistically significant increase in each of the six proxies of innovation.

Figure 1 illustrates the dynamic relationship between the citation-based measure of innovation and the first time that a country enforces its insider trading laws. For each country, we calculate the average citation counts received by patents filed by its residents in each year.

We then trace out what happens to this innovation measure in the years before and after an average country enforces the insider trading laws. As shown, there is a significant increase in innovation after a country starts enforcing its insider trading laws. Figure 1 indicates that there is not a trend in innovation prior to the year in which a country first enforces its insider trading laws.

The overall pattern suggests that enforcing insider trading has an immediate and enduring simulative effect on innovation. The figure plots the dynamic impact of the enforcement of insider trading laws on country-level innovative activities. Citation equals the natural logarithm of one plus the total number of truncation-adjusted citations to ultimately granted patents in country c, and in year t, where t is the application year.

The figure provides a year window spanning from 10 years before to 15 years after the year of initial enforcement of insider trading laws. The year of initial enforcement, year zero in the figure, is excluded and serves as the benchmark year. We augment the baseline analyses to test whether the cross-industry changes in innovation after the enforcement of insider trading laws are consistent with two theoretical perspectives of how insider trading shapes innovation.

First, if insider trading curtails innovation by dissuading potential investors from expending resources valuing innovative activities, then enforcement of insider trading laws should have a particularly pronounced effect on innovation in naturally innovative industries—industries that would have experienced rapid innovation if insider trading had not impeded accurate valuations.

Second, if insider trading laws and stock price informativeness trading discourages innovation by impeding market valuations, then the enforcement of insider trading laws is likely to exert an especially large positive impact on innovation in industries with a high degree of informational asymmetries between insiders and potential outside investors.

Put differently, there is less of role for greater enforcement of insider trading limits to influence innovation through the valuation channel if the pre-reform information gap is small.

We use several proxies of the natural opacity and innovativeness of industries to test whether more naturally opaque insider trading laws and stock price informativeness innovative industries experience a bigger jump in innovation after a country starts enforcing its insider trading laws. We find that all six of the insider trading laws and stock price informativeness measures of innovation rise much more in naturally innovative and naturally insider trading laws and stock price informativeness industries after a country starts enforcing its insider trading laws.

This is illustrated in Figure 2. The same is true when splitting the sample by the natural opacity of industries. Thus, insider trading restrictions are associated with a material increase in patent-based measures of innovation and the cross-industry pattern of this increase is consistent with theories in which restricting insider trading improves the informational content of stock prices.

Figure 2 Dynamics of insider trading laws and innovation: The figure plots the dynamic impact of the enforcement of insider trading laws on innovative activities in high-tech intensive and non-high-tech intensive industries, respectively. Citation equals the natural logarithm of one plus the total number of truncation-adjusted citations to ultimately granted patents in industry i, in country c, and in year t, where t is the application year.

The lines indicated by circles represent the estimated effect of enforcement on innovation in high-tech intensive industries. The lines indicated by triangles represent the estimated effects of enforcement on innovation in low-tech industries.

We extend these analyses by examining equity issuances. One mechanism through which enhanced valuations can spur innovation is by lowering the cost of capital for investment in innovation. Consistent with this view, we find that equity issuances rise much more in naturally innovative industries than they do in other industries after a country first enforces its insider trading laws.

These findings further support the view that legal systems that protect outside investors from corporate insiders facilitate investment in technological innovation. Figure 3 Dynamics of insider trading laws and equity issuance: The figure plots the dynamic impact of the enforcement of insider trading laws on equity issuances in high-tech intensive and non-high-tech intensive industries, respectively. Total Proceeds equals the natural logarithm of one plus the total value of equity issuances in industry i of country c in year t.

The lines indicated by circles represent the estimated effect of enforcement on equity issuances in high-tech intensive industries. The lines indicated by triangles represent the estimated effects of enforcement on equity issuances in low-tech industries. Should it be prohibited? Causes and consequences, University of Chicago Press, On the connections between finance and innovation, see Amore et alChava et alFang et alHsu et alAcharya and Xuand Laeven et al Financial markets Frontiers of economic research Productivity and Innovation.

Innovation and restrictions on insider trading Ross Levine, Chen Lin, Lai Wei 27 May Insider trading laws and stock price informativeness theory offers conflicting perspectives on the relationship between insider trading and innovation. Patent thickets and first-time patenting: Patent rights and innovation by small and large firms.

Alberto Galasso, Mark Schankerman. Information asymmetry raises the cost of capital for corporations. James Choi, Hongjun Yan. More Insiders, More Insider Trading. Viral Acharya, Tim Johnson.

We compile a sample of 76, country-industry-year observations and calculate the following proxies for technological innovation: Figure 1 Dynamics of insider trading law enforcement and innovation Citation The figure plots the dynamic impact of the enforcement of insider trading laws on country-level innovative activities.

Endnote [1] On the impact of finance on productivity growth, see King and LevineLevine and ZervosBeck et al A trade war will increase average tariffs by 32 percentage points.

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