Insider Trading and Financing Constraints

Date01 November 2014
Published date01 November 2014
The Financial Review 49 (2014) 685–712
Insider Trading and Financing Constraints
Ali Ataullah
The School of Business & Economics, Loughborough University
Marc Goergen
Cardiff Business School, CardiffUniversity
The European Corporate Governance Institute, Brussels, Belgium
Hang Le
The Business School, University of Nottingham
Insider trading may alleviate financing constraints by conveying value-relevant infor-
mation to the market (the information effect) or may exacerbate financing constraints by
impairing market liquidity and distorting insiders’ incentives to disclose value-relevant infor-
mation (the confidence effect). We examine the significance of these two contrasting effects
by investigating the link between insider trading and financing constraints as measured by
the investment-cash flow sensitivity. We find that, overall insider trading exacerbates financ-
ing constraints; however the information effect dominates the confidence effect for insider
purchases. Only trades by executive directors are significantlyrelated to financing constraints.
Keywords: Insider trading, investment-cash flow sensitivity, financing constraints, informa-
tion hierarchy hypothesis
JEL Classifications:G1,G3
Corresponding author: The School of Business & Economics, Loughborough University,Leicestershire
LE11 3TU, UK; Phone: +44-1509-223094; Fax: +44-1509-222723; E-mail:
The authors thank the editor, Robert VanNess, two anonymous referees, Gayane Hovakimian, Amandeep
Sahota, and participants at a seminar at the University of Stirling and at the 11th Workshopon Corporate
Governance and Investment, Universitat Aut`
onoma de Barcelona (19–20 November 2010), for their
comments and suggestions. All errors remain ours.
C2014The Eastern Finance Association 685
686 A. Ataullah et al./The Financial Review 49 (2014) 685–712
1. Introduction
It is widely accepted that corporate insiders trade in the shares of their firms
on the basis of their informational advantage over outside investors (Seyhun, 1986;
Fishman and Haggerty, 1992; Piotroski and Roulstone, 2005). We examine the im-
pact of insider trading1on corporate financing constraints, which are likely to arise
when information asymmetries and/or agency problems impede firms’ ability to raise
external capital and, consequently, make their investments sensitive to the availabil-
ity of internal funds (Fazzari, Hubbard and Petersen, 1988; Hadlock, 1998; Cleary,
Povell and Raith, 2007).
Theoretically, insider trading is likely to have two contrasting effects on cor-
porate financing constraints. On the one hand, insider trading may convey insiders’
private information to outside investors (Seyhun, 1986; Lakonishok and Lee, 2001;
Fidrmuc, Goergen and Renneboog, 2006) and may act as a credible signal to the
market about the value relevance of various corporate events, such as dividend pol-
icy and investment expenditure (John and Lang, 1991; Damodaran and Liu, 1993).
This “information effect” of insider trading may improve the allocation of capital
by enabling outside investors to make more informative assessments of the value
of firms’ investment projects (Leland, 1992; Manne, 2005). Consequently, insider
trading, via the information effect, may alleviate financing constraints that arise due
to the presence of information asymmetries in the market.
On the other hand, corporate insiders’ ability to gain from insider trading may
induce them to manipulate/delay value-relevant information to maintain their in-
formational advantage over outside investors (Narayannan, 2000; Cheng and Lo,
2006) and may encourage them to undertake projects that are not compatible with the
shareholder value maximization principle (Bebchuk and Fershtman, 1994). From this
perspective, insider trading may reduce outside investors’ confidence in the firm’s
projects by making them more skeptical about insiders’ motives and about the infor-
mation that is available in the market (Manove, 1989; Ausubel, 1990; Giammarino,
Heinkel and Hollifield, 1994). This “confidence effect” of insider trading may reduce
investors’ willingness to providecapital to firms with a high incidence of insider trad-
ing and, consequently, increase these firms’ reliance on the availability of internal
funds to finance their investments.
Given the contrasting effects of insider trading on financing constraints, the
question arises as to whether just one of these effects exists or whether they both
exist. If the latter is the case, the question arises as to which one dominates. We
1Strictly speaking, insider trading refers to trading on the basis of privateinformation that is not available to
other market participants. Such information-based trading is not restricted to corporate insiders. However,
most empirical studies on insider trading focus on the trades of executiveand nonexecutive directors while
a few studies also examine trades of large shareholders. U.K. regulation on insider trading also defines
insiders as executives and nonexecutives.Hence, following the empirical literature on insider trading, we
focus on directors and use the terms directors and insiders interchangeably. Finally and in line with U.K.
regulation, we use the term “insider trading” to refer to trading by the directors.

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