The Unintended Consequences of Forcing Insider Trading Transparency

Policies can unexpectedly backfire. It’s so common it’s sometimes even referred to as the “law” of unintended consequences.

Take insider trading. A 2002 rule meant to increase transparency regarding insiders buying or selling their company’s stock may have enabled them to make more money on their trades, according to research from Xu Jiang, an associate professor of accounting at Duke University’s Fuqua School of Business.

In a talk on Fuqua’s LinkedIn page, Jiang examined the “unintended consequences” of the 2002 Sarbanes-Oxley (SOX) Act, a U.S. law that accelerated insiders' disclosures of their trades to within two days, down from 10 business days under the previous rule.

Jiang and co-researchers (Xiumin Martin of Washington University in Saint Louis and Benda Yin, a Fuqua Ph.D. candidate, soon to join Hong Kong University of Science and Technology) studied data on insiders’ transactions before and after the 2002 regulatory change and found that company executives and other insiders made more profits on their trades, exceeding commonly used market return benchmarks.

They also found a possible explanation: adding transparency helps insiders better coordinate their trades.

A bipartisan law meant to reduce insiders’ advantage

The U.S. law prohibits insiders of a public company — executives, officers, directors, as well as “the beneficial owners of more than 10% of any class of equity securities of the issuer” — from buying or selling the company’s stock based on “nonpublic, material information” they possess about its business. 

“Imagine you are an executive at a pharmaceutical firm, and you know the details of some clinical trials of your new drugs,” Jiang said. “You have an incentive to trade on your company’s stock before the market learns about the trials, so you can make profits.”

To prevent this, regulators have long attempted to prevent insiders from trading on nonpublic information, a rule intended to level the playing field with regular investors, who lack the same access as insiders, Jiang said.

“However, proving that an insider has intentionally traded based on ‘material’ information is hard,” he said. “It’s very rare to find direct evidence, like an email stating the insider’s intent.”

To address this limitation, the U.S. Congress introduced the bipartisan SOX Act in 2002, which reduced the window for insider disclosures from 10 to two days.

The rationale behind SOX was that faster reporting might reduce insider profits by allowing regular investors to react more quickly, Jiang said.

“The regulator hoped this would lower insiders’ profits because their information advantage is reduced,” Jiang said.

A rise in insider trading profits

However, the researchers found empirical evidence that timelier reporting increased insider profits. 

Jiang and colleagues looked at insider trades between 1997 and 2006. They used 2002 — when the SOX Act was enacted — as the cutoff year to examine the changes in trading profits before and after the rule.

They obtained trading data from the Thomson Reuters Insider database, sourced from the mandatory Form 4 filings for U.S. public companies.

The researchers found that post-SOX, insider profits rose by 0.07% per day, accounting for about 27% of the extra profits insiders made in that period.

“This means that for insiders making an average number of trades, their individual trading profits increased by about $111,000 per year,” Jiang said.

He added that these are “abnormal” returns, exceeding some commonly used market return benchmarks.

How more transparency enables collusion

But how did the SOX Act backfire?

The researchers hypothesized that the accelerated reporting may have allowed better coordination among insiders, a mechanism that is key to understanding how “cartels” work, Jiang said.

He cited the Organization of Petroleum Exporting Countries (OPEC), which is a group of a dozen countries that work together to set the amount and price of the crude oil they produce. 

Similar to an oligopoly, Jiang said, OPEC keeps prices higher than in a competitive market and maximizes profits for each member.

“The key issue with this arrangement is that if the individual member deviates and produces a bit more to make more profits, then the other members will also produce more and erase that expected gain in the future. This is a penalty mechanism that, crucially, depends on the cartel being able to observe each member's output. In other words, transparency facilitates coordination and thus collusion. We use this analogy to the insider trading setting,” Jiang explained. 

The increased transparency of the SOX Act may have improved insiders’ ability to observe one another's trades, allowing the “penalty mechanism” of cartels to play out in the insider setting.

“They're more likely to coordinate and collude,” Jiang said. “Of course, they'll coordinate implicitly, because any explicit coordination is prohibited by law.”

How socially connected insiders profit more

The researchers predicted that this coordination would be more likely to succeed if insiders have tighter social connections, such as insiders attending the same school or having worked for the same company before, as stronger connections would likely facilitate better communication among insiders.

Using biographical information on businesspeople from the BoardEx database and matching it with the insider trading data, they found a larger increase in profits among socially connected insiders after the SOX Act took effect.

“Insiders with social connections see abnormal trading profit increases by 0.05% per day, which translates into about $80,000 more profits per year,” Jiang said.

Delayed reporting of trading activity hurts insider profits

The researchers also noted that after the SOX Act, not all insiders complied with the accelerated reporting (data showed that 8% of all transactions violated the reporting deadline in the post-SOX period).  This allowed them to test whether among insiders, those who submitted their reports late earned lower profits — a further indication of the unintended effects of the rule change.

Their findings confirmed that insiders who reported late had still positive but lower trading profits by about 0.018% per day, which decreased their average yearly earnings of about $28,000 per year.

“A magnitude seemingly not particularly large,” Jiang said. “But remember, we were looking at a large sample of firms, including small firms. For larger firms, this effect would be much bigger.” 

The unintended consequences of mandating transparency

The research shows how the increased transparency introduced by the SOX Act has facilitated insiders' coordination, enabling them to shift from a competitive trading strategy to a collusive one that “may have hurt uninformed market participants,” the researchers concluded.

This should warn policymakers about the potential unintended consequences of mandating more transparency, professor Jiang said.

“We need to think twice about how to implement insider trading regulations,” he said.