Insider trading takes place every day. Whether it’s legal comes down to the time the trade is executed and whether the trade is based on confidential information. Illegal insider trading happens when a company insider takes advantage of private information that can affect the company’s future stock price to make more profit or prevent loss.
By Mehrzad Azmi
Federal regulations and voluntary corporate restrictions on insider trading aim to prevent this type of unethical trading, but research suggests it’s happening regularly nonetheless.
After the Securities Exchange Act of 1934 made companies responsible for violations of insider trading by their officers, many firms adopted voluntary regulations to conform to the law. The most common voluntarily adopted policy bans insider trading during the entire financial quarter (referred to as a “black window”) except for a 10-day time period (referred to as a “white window”) that starts three days after an earnings announcement.
These restrictions are based on the presumption that during the period leading up to an earnings announcement, insiders know or have access to more information than the public. However, after an earnings announcement, the public has access to the previously private information.
Yet more than 60 percent of all insider trading in the U.S. takes place in black windows related to earnings announcements, despite being banned by many corporate policies.
Furthermore, research shows that even when trading takes place in a white window, insiders still have an advantage. Insiders trading during white windows are more likely to do so when company profits are high and the market price fails to convey all of the information. The option of choosing to or refraining from trade allows insiders to generate abnormal returns that are comparable to the black windows.
So why is this happening? It’s hard to tell. Part of the problem is that federal insider trading policies and regulations are broad and vague. Also, it’s not clear how regulations and voluntary policies are being enforced.
Tracking and observing insider trading gives us a better perspective on the way traders schedule some of their activities to maximize return. Although letting insiders trade freely at any time makes the other investors lose faith in the market and results in liquidity issues, extensive regulations on insider trading do not seem to be the answer either. It is keeping the balance between these two that results in a more efficient market.
Mehrzad Azmi is an assistant professor in the Department of Accounting. Her research interests include insider trading and mandatory and voluntary disclosures.