A U.S. firm buying and selling its own shares in the open market can trade on inside information more easily than its own insiders because it is subject to less stringent trade-disclosure rules. Not surprisingly, insiders exploit these relatively lax rules to engage in indirect insider trading: they have the firm buy and sell shares at favorable prices to boost the value of their own equity. Such indirect insider trading imposes substantial costs on public investors in two ways: by systematically diverting value to insiders and by inducing insiders to take steps that destroy economic value. To reduce these costs, I put forward a simple proposal: subject firms to the same trade-disclosure rules that are imposed on their insiders.
INTRODUCTION I. DIRECT INSIDER TRADING AND ITS REGULATION A. Costs of Direct Insider Trading 1. Diversion of Value 2. Weakening and Distortion of Incentives B. Regulation 1. Rule 10b-5 and its Limits 2. Section 16(a)'s Trade-Disclosure Rule II. INSIDER BUYING VIA THE CORPORATION A Open Market Repurchases B. Regulation of OMRs 1. Announcement Requirement 2. Rule 10b-5 3. Repurchase-Disclosure Rules C. Insiders' Incentive to Engage in Bargain Repurchases D. Evidence of Bargain Repurchases 1. Executives' Own Statements and Behavior 2. Post-Repurchase Stock Returns III. INSIDER SELLING VIA THE CORPORATION A. At-the-Market Issuances B. Regulation of ATMs 1. Filing Requirements 2. No Trading on Material Inside Information 3. Trade-Disclosure Rules for ATMs C. Insiders' Incentive to Engage in Inflated-Price ATMs IV. COSTS TO PUBLIC INVESTORS A. Value Diversion 1. The Amount of Value Diversion 2. Are Indirect Insider-Trading Profits Different? 3. Why Bother with Indirect Insider Trading? B. Destruction of Value 1. Costly Stock-Price Manipulation 2. Capital Misdeployment V. TOWARD REDUCING INDIRECT INSIDER TRADING A. The Proposed Two-Day Rule B. Benefits of the Two-Day Rule 1. Reduced Diversion of Value to Insiders a. Reduced Illegal Insider- Trading Profits b. Reduced Legal Insider-Trading Profits i. Reduced Profits Per Trade ii. Reduced Trade Volume 2. Less Value Destruction 3. A Step in the Right Direction CONCLUSION INTRODUCTION
Publicly traded U.S. firms buy and sell a staggering amount of their own shares in the open market each year. Open-market repurchases (OMRs) alone total hundreds of billions of dollars per year; in 2007, they reached $1 trillion. (1) Firms are also increasingly selling shares in the open market through so-called "at-the-market" issuances (ATMs). (2)
For a U.S. firm trading in its own shares, trade-disclosure requirements are minimal. The firm needs to report, at most, aggregate monthly trading activity, and may wait until well into the next quarter before doing so. (3) Thus, the firm is permitted to buy and sell its own shares secretly in the open market for months and withhold the exact details of its trades from shareholders and regulators.
The trade-disclosure requirements imposed on U.S. firms are quite lax relative to those imposed on firms listed on some of the largest overseas stock markets. For example, the United Kingdom and Hong Kong require firms trading in their own shares to disclose the details of their trades by the morning of the next business day, while Japan requires same-day disclosure. (4) In Switzerland, firms commonly repurchase shares through a second, dedicated trading line, thereby making trade disclosure instantaneous. (5)
More important, the trade-disclosure requirements imposed on U.S. firms are substantially less stringent than those imposed on insiders of those firms. Since the 1930s, insiders of a U.S. firm have been required to report the specific details of each trade in the firm's shares. (6) Before the Sarbanes-Oxley Act of 2002, (7) insiders typically had until the tenth day of the following month to disclose such trades. (8) Today, an insider's trades in firm shares must be reported within two business days. (9)
The strict trade-disclosure rules for insiders reflect a strong, longstanding consensus in the United States that a corporation's insiders--its officers, directors, and controlling shareholder (if any)--should not be permitted to profit freely from their access to inside information about the firm. These rules are part of an elaborate set of regulations designed to reduce insiders' ability to engage in insider trading: buying and selling a firm's shares on inside information. (10)
Unfortunately, U.S. policymakers have failed to grasp that when insiders are subject to strict trade-disclosure requirements and firms are not, insiders have a strong incentive to exploit the relatively lax trade-disclosure rules that apply to firms in order to engage in indirect insider trading: having the firm buy and sell its own shares at favorable prices to increase the value of the insiders' equity. Such indirect insider trading--made possible by insiders' control over the firm's assets--can generate substantial profits for insiders. If, for example, insiders own 10% of a firm's equity, they will capture approximately $1 out of every $10 in insider-trading profits generated by the firm when it buys and sells its own shares on inside information.
Although U.S. firms are commonly thought to have relatively diffuse ownership, average insider ownership in publicly-traded firms is, in fact, surprisingly high. For example, one study of 375 randomly selected publicly traded firms found that directors and officers own an average of 24%-32% of a firm's equity (depending on the measurement methodology). (11)
To be sure, larger firms tend to have a lower percentage of insider ownership. (12) Thus, average insider ownership on a value-weighted basis may be less than 25%. Nevertheless, insiders' percentage ownership is likely to be substantial in many cases.
Not surprisingly, insiders use their control of the firm to engage in indirect insider trading. (13) Insiders acknowledge using repurchases to buy stock that they believe is underpriced and equity issuances to sell stock that they believe is overpriced. (14) There is also a substantial body of empirical work in the finance literature documenting that repurchases and equity issuances are frequently driven by insiders' desire to indirectly buy stock at a low price or sell stock at a high price. (15)
Such indirect insider trading likely imposes considerable costs on public investors in two ways. First, just like ordinary "direct" insider trading, indirect insider trading secretly redistributes value from public investors to insiders. (16) To be sure, much of the indirect insider-trading profits generated by firms are shared with some public investors. But on average, public investors lose and insiders profit to the tune of several billion dollars per year. (17)
Second, the use of the corporation as a vehicle for insider trading can lead insiders to waste economic resources. For example, indirect insider trading can distort capital deployment decisions by reallocating capital between the shareholders and the firm in a way that destroys economic value. (18) Thus, indirect insider trading can diminish the value flowing to investors over time by far more than the profits reaped by insiders.
The purpose of this Article is threefold: (1) to demonstrate that insiders have an incentive to (and do in fact) exploit the relatively lax trade-disclosure rules applicable to firms to enrich themselves via indirect insider trading; (2) to describe the costs of such indirect insider trading to public shareholders; and (3) to put forward a proposal that, I show, would substantially diminish insiders' ability to engage in indirect insider trading and reduce the resulting costs to public investors: subject firms to the same two-day disclosure rule applied to their insiders.
The remainder of the Article is structured as follows: Part I briefly describes the insider-trading regulations applicable to insiders, the means by which firms trade in their own shares on the open market, and the relatively lax insider-trading regulations imposed on these firms. Part II examines how insiders use share repurchases to engage in indirect insider trading; Part III explains how insiders use equity issuances to engage in indirect insider trading. Part IV identifies the cost to public investors of indirect insider trading. Finally, Part V describes my proposal that firms be subjected to the same trade-disclosure rules as insiders.
DIRECT INSIDER TRADING AND ITS REGULATION
This Part briefly reviews the economics and regulation of direct insider trading by persons controlling a firm. Section A discusses the costs imposed by direct insider trading on public investors. Section B describes the main insider-trading regulations applicable to insiders trading personally in their firms' shares.
Costs of Direct Insider Trading
Direct insider trading by those individuals controlling the firm imposes costs on public investors by (1) systematically diverting value from public shareholders to insiders, and (2) undermining and distorting insiders' incentives to generate economic value, thereby reducing the size of the pie. As we will see in Part IV, these two types of costs also arise from indirect insider trading.
Diversion of Value
When insiders use private information to time their personal trades, they directly reduce public shareholders' returns. Each dollar reaped by insiders comes at public investors' expense. (19) In an earlier article, I calculated that such trading puts at least several billions of dollars into the pockets of insiders each year. (20) This diversion of value reduces public investors' expected returns and increases firms' cost of capital. (21)
One might argue that insider-trading profits are just another form of compensation. In principle, for example, firms could reduce other components of executives' and directors' compensation arrangements to offset expected insider-trading profits. (22) But...