Insider Trading and Financing Constraints

• Author: Hang Le,Ali Ataullah,Marc Goergen
• Date: 01 November 2014
• Published date: 01 November 2014
• DOI: http://doi.org/10.1111/fire.12053

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

Abstract

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: a.ataullah@lboro.ac.uk.

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.

C2014The 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.