Insider trading laws and stock markets around the world: an empirical contribution to the theoretical law and economics debate.

• Author: Beny, Laura Nyantung

ABSTRACT

The primary goal of this Article is to bring empirical evidence to bear on the heretofore largely theoretical law and economics debate about insider trading. The Article first summarizes various agency, market, and contractual (or "Coasian") theories of insider trading propounded over the course of this longstanding debate. The Article then proposes three testable hypotheses regarding the relationship between insider trading laws and several measures of stock market performance. Exploiting the natural variation of international data, the Article finds that more stringent insider trading laws are generally associated with more dispersed equity ownership, greater stock price accuracy and greater stock market liquidity, controlling for various economic, legal and institutional factors. These results cast doubt on pure "Coasian" theories of insider trading and suggest the appropriate locus of academic and policy inquiries about the efficiency implications of insider trading and its regulation. Further empirical research is necessary, however, to conclusively resolve the perennial insider trading debate.

1. INTRODUCTION II. THE LAW AND ECONOMICS DEBATE OVER INSIDER TRADING A. Agency Theories of Insider Trading 1. Insider Trading as an Efficient Compensation Mechanism 2. Insider Trading as an Agency Cost B. Market Theories of Insider Trading 1. Insider Trading and Stock Price Accuracy a. The Meaning and Economic Significance of Stock Price Accuracy b. The Law and Economics Debate about Insider Trading and Stock Price Accuracy 2. Insider Trading and Stock Market Liquidity a. The Meaning and Economic Significance of Stock Market Liquidity b. The Law and Economics Debate about Insider Trading and Stock Market Liquidity c. A "Coasian" Approach to Insider Trading: Private Contracting III. TESTABLE HYPOTHESES A. Insider Trading Law and Ownership Concentration B. Insider Trading Law and the Information Content of Stock Prices C. Insider Trading Law and Liquidity IV. DESCRIPTION OF THE DATA A. Data Sources 1. The Dependent Variables 2. Insider Trading Regulation and Enforcement a. Insider Trading Law Variables b. Enforcement Environment 3. Additional Economic, Legal and Institutional Variables B. Descriptive Statistics V. REGRESSION ANALYSIS OF INSIDER TRADING LAW AND THE STOCK MARKET A. Insider Trading Law and Corporate Ownership B. Insider Trading Law and Stock Price Informativeness C. Insider Trading Law and Stock Market Liquidity D. Interaction of Sanctions and Public Enforcement Power E. Summary and Discussion of Results VI. CONCLUSION AND IMPLICATIONS FOR THE THEORETICAL LAW AND ECONOMICS DEBATE I. INTRODUCTION

   The law and economics debate about the desirability of prohibiting insider trading--trading by corporate insiders on material, non-public information--is both long-standing and unresolved. The early legal debate centered on whether insider trading is unfair to public investors who are not privy to private corporate information. (1) However, the fairness inquiry was malleable, lacked a rigorous theoretical framework, and therefore did not yield coherent or practical policy prescriptions. (2) Professor Henry Manne abruptly shifted the debate to an efficiency inquiry with his now classic 1966 book, Insider Trading and the Stock Market. In Insider Trading and the Stock Market, Manne argued that, contrary to the prevailing legal and moral opinion of the time, insider trading is desirable because it is economically efficient. (3) Professor Manne's controversial thesis abruptly shifted the focus from fairness to the economics of insider trading and precipitated an intense debate in the law and economies literature about the efficiency implications of insider trading. (4) The central question in the law and economics debate is whether insider trading is economically inefficient and thus ought to be subject to government regulation or, conversely, whether it is economically efficient and thus ought not to be regulated. Law and economics scholars sit on both sides of the fence. Some even straddle the fence, for example, by arguing that even if insider trading might be inefficient (bad) for some firms, it might be efficient (good) for other firms, and therefore the law should enable corporations and shareholders to address insider trading via private contract on a case by case basis. Without question, the law and economics approach has advanced the legal policy debate about insider trading, but it has not achieved consensus on fundamental questions.

   The law and economics literature on insider trading is plagued by a few significant shortcomings. Like the fairness inquiry, the efficiency inquiry is rather elusive, as no single locus of efficiency focuses the scholarly debate. Rather, the investigations vary from examinations of the narrow effects of insider trading on efficiency at the firm level (agency theories of insider trading) to work studying the broader effects of insider trading on stock market efficiency (market theories of insider trading). (5) It is possible, for example, that insider trading may enhance efficiency within the firm, but that markets in which insider trading is permitted are thereby less efficient in the aggregate. Researchers who focus their studies at different levels and report different results could be talking past each other. A second, major deficiency of the law and economics literature on insider trading is that it is insufficiently grounded in empirical evidence, although, as Professors Carlton and Fischel note, the "desirability of [regulating] insider trading is ultimately an empirical question." (6) Rather, beginning with Professor Manne's seminal argument, law and economics scholarship on insider trading has been largely speculative and theoretical. Finally, until recently, the existing empirical literature on insider trading has been American-centered. (7) Few scholars have sought to examine the impact of insider trading rules in a comparative context. This is important because, without variation in insider trading rules, one cannot test causal hypotheses.

   This Article, unlike most of the existing legal scholarship on insider trading, is empirical and comparative. (8) The main aim is to determine whether insider trading laws are systematically related to stock market performance across countries. To that end, the Article formulates three testable hypotheses regarding the relationship between insider trading laws and equity ownership, the informativeness of stock prices, and stock market liquidity, respectively. These hypotheses are that countries with more stringent insider trading laws will have: (a) more widespread equity ownership; (b) more informative stock prices; and (c) more liquid stock markets, other things equal. To test these hypotheses, I constructed a unique index of the stringency of insider trading laws for thirty-three countries as of the mid-1990s. Using multivariable regression analysis, (9) I find that countries with more stringent insider trading laws have more dispersed equity ownership; more liquid stock markets; and more informative stock prices, consistent with the formulated hypotheses. Because of the small number of available cases and the impossibility of controlling for all potentially relevant variables, these conclusions must be regarded as tentative, but they are nonetheless significant. If insider trading laws are detrimental, as Professor Manne and others have posited, the pattern I find would have been unlikely.

   The Article is organized as follows: Part II reviews the theoretical law and economics debate about the desirability of regulating insider trading, categorizing the theories of insider trading into two broad groups, agency theories and market theories; Part HI formulates three testable hypotheses that emerge from the theoretical literature; Part IV describes the data and presents summary statistics; Part V presents and discusses the results of multivariable regression analysis; and finally, Part VI concludes by addressing some of the implications of this Article's findings for the theoretical law and economics debate about insider trading. In particular, I argue that this Article's findings tend to support the arguments of legal scholars who argue that insider trading regulation has a beneficial impact on stock markets. However, more empirical work is necessary to conclusively resolve the theoretical debate.

2. THE LAW AND ECONOMICS DEBATE OVER INSIDER TRADING

   Law and economics theories about insider trading fall into two main categories: agency theories and market theories of insider trading. (10) Agency theories of insider trading analyze its effect on the classic corporate agency problem, the manager-shareholder conflict of interest. (11) These theories consider whether insider trading ameliorates or worsens this conflict, and therefore whether it increases or reduces firm-level efficiency. (12) In contrast, market theories of insider trading address its broader ramifications for market efficiency. (13) In this Part, I summarize common agency and market theories for and against insider trading regulation, and I briefly discuss the private contracting approach that some opponents of insider trading regulation advocate.

   1. Agency Theories of Insider Trading

   Agency theories of insider trading analyze the effects of insider trading on agency costs. (14) If insider trading reduces the divergence between shareholders' and managers' interests, then it reduces agency costs. Conversely, if insider trading increases this divergence, then it increases agency costs. Proponents of unregulated insider trading argue the former is true, while proponents of insider trading regulation opt for the latter.

   1. Insider Trading as an Efficient Compensation Mechanism

      In Insider Trading and the Stock Market, Professor Manne argues that insider trading is economically efficient because it motivates entrepreneurial innovation. (15) According...