Newswise — Nejat Seyhun, Jerome B. and Eileen M. York Professor of Business Administration and professor of finance, and Cindy Schipani, Merwin H. Waterman Collegiate Professor of Business Administration and professor of business law, are among the most knowledgeable scholars on insider trading. They have individually or collectively contributed to more than two dozen studies on the topic and their research has the ear of Wall Street’s watchdogs.
Yet, the professors are still mining and finding new information about the practice of executives and directors trading their companies public stock and other securities based on important information about that business. Their latest study, in fact, notes they “discovered a massively popular strategy for insider trading."
"Insider Trading by Other Means," which is forthcoming in the Harvard Business Law Review, was co-authored by Sureyya Burcu Avci of the Sabanci University School of Business and Andrew Verstein of the University of California, Los Angeles, School of Law. The paper uncovers techniques by which those insiders sell overvalued stock worth more than $100 billion annually, shifting losses to ordinary investors. Essentially, insiders conceal their suspicious trades by publicly reporting them—as required—in ways that confuse or discourage investigators.
The “subterfuge,” based on analysis of a database of all stock trades since 1992, appears to work: These leaders outperform the market by roughly 20% and nobody has ever been prosecuted for any of these trades.
The researchers say the reporting system was not built to maximize oversight and has weakened in some respects in the last thirty years. Seyhun and Schipani discuss their study and the reasons insider trading persists and evolved over the decades in the following Q&A.
How did you make this discovery?
Seyhun — While I worked as an expert witness for the government, I noticed that during the Enron Corp. trial, even though insiders had dumped shares using both S (open-market sale) and J (other) reporting codes right up to the declaration of bankruptcy, only those transactions reported as S-codes became suspicious while transactions with J-codes were totally ignored. Years later, I decided to take a closer look at why this distinction was made, which led to the findings in our current paper.
Insider trading seems like a whack-a-mole situation, where one aspect can be regulated only to have another pop up. What do you recommend to regulate it? Is it even possible?
Seyhun — I agree with the whack-a-mole characterization. However, this is true for most white-collar crimes. Once a loophole is closed, the criminally minded go to their next game, the next loophole until they get caught and penalized again. This does not mean, however, that closing loopholes and holding those who violate them responsible and subject to sanctions, are fruitless efforts. In the absence of such government intervention, the criminally minded will simply continue and enlarge their efforts, and similar to deadly parasites, continue until they destroy their host—which in this case is the system of trust in capital markets.
Schipani — Yes, insider trading and white-collar crime in general has been very much a whack-a-mole situation. It seems that where there is money on the table, and if no one is looking (little or no likelihood of getting caught), the temptation is strong to take the money and run. We see this with insider trading, with bribery of foreign officials, misleading financial statements—Enron being a prime example—with off-the-books special purpose entities. The list goes on and on, unfortunately.
What intrigues you the most about insider trading, and what keeps you coming back to it as an avenue of research? And what might be next in terms of studying it?
Seyhun — Insider trading is at the intersection of corporate finance, investments, law, and economics. It is important for pricing securities, understanding corporate finance decisions, corporate governance, executive malfeasance, and economic incentive structures. In investments, it would be silly to make a stock buy-or-sell decision without knowing what insiders are doing. If the investors buy shares while insiders are selling shares, the investors need to be highly confident of their buying decisions.
In corporate finance, suppose a firm wants to issue new shares. If insiders sell shares personally versus buying shares personally right before the equity issue, that could change the interpretation of why the firm is issuing shares. In corporate governance, if top executives engage in blatant, profitable insider trading right before earnings or dividend announcement, our confidence in corporate governance of that firm would be weakened. Our confidence also would be undermined if executives awarded themselves in-the-money backdated options—stock options that cheat the taxpayers and the shareholders, and are highly valuable to the recipient. As such, insider trading continually offers new, multi-disciplinary lessons, which is fascinating from an academic perspective.
As a result, I found research on insider trading similar to Hotel California: I checked in 45 years ago, but after all these years of research, I still find myself unable to leave.
Schipani — The focus of my work in corporate governance is the fiduciary duty of corporate directors and officers. Fulfillment of fiduciary duties to the firm and the shareholders requires integrity—working with the utmost loyalty and good faith. Executives that personally benefit from trading on insider information are violating those duties, in addition to committing crimes. Good corporate governance demands integrity and those who trade on inside information are clearly lacking in integrity.
When I first started researching fiduciary duty issues back in 1986, I had no idea that I would still be working in this area in 2024. But I’ve found there is always a new game being played, when the criminally minded think no one is looking. It’s important to keep playing whack-a-mole to try to curb the behavior. The rules aren’t that hard—don’t lie, cheat or steal—but we continue to see violations of all of the above. I’m intrigued with the creative ways insiders find to lie, cheat and steal, and hope my work helps to rein in some of these behaviors. At the very least I hope it helps discourage good people from starting down the slippery slope of unethical, and then illegal, behavior.
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