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Insider Trading, News Releases, and Ownership Concentration

Fidrmuc, Jana P., Goergen, Marc and Renneboog, Luc 2006. Insider Trading, News Releases, and Ownership Concentration. The Journal of Finance 61 (6) , pp. 2931-2973. 10.1111/j.1540-6261.2006.01008.x

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This paper investigates the market's reaction to U.K. insider transactions and analyzes whether the reaction depends on the firm's ownership. We present three major findings. First, differences in regulation between the U.K. and United States, in particular the speedier reporting of trades in the U.K., may explain the observed larger abnormal returns in the U.K. Second, ownership by directors and outside shareholders has an impact on the abnormal returns. Third, it is important to adjust for news released before directors' trades. In particular, trades preceded by news on mergers and acquisitions and CEO replacements contain significantly less information. Insiders, that is, managers and members of the board of directors of publicly traded corporations, usually possess more information about their company than do (small) outside shareholders. The main argument in favor of insider trading is that it communicates this superior information to outsiders. For instance, Leland (1992) shows that when insider trading is allowed, share prices incorporate more information, and are higher. However, while an insider purchase conveys positive information about the firm's prospects, it is less clear what information an insider sale conveys. On the one hand, an insider sale may convey unfavorable information about the firm's prospects. On the other hand, an insider sale may be less informative if it is made to meet the liquidity needs of the seller. Seyhun (1986), Lin and Howe (1990), and Chang and Suk (1998) report positive abnormal returns on insider purchases for the United States. Similarly, several studies, such as Gregory, Matatko, and Tonks (1997), find positive abnormal returns for the U.K. over horizons of 6 to 12 months following directors' purchases.1 A more recent U.K. study by Friederich et al. (2002) on daily share prices corroborates these findings for short-term horizons. In this paper we analyze the immediate market reaction to directors' transactions (excluding sales after the exercise of options) for companies listed on the London Stock Exchange during the 1990s. Consistent with the findings from previous studies, our results suggest that directors' trades convey new information on the firm's prospects. An interesting aspect of the paper is that we give a detailed account of both the U.K. and U.S. regulations on insider trading and directors' share dealings. There are marked differences between the two sets of regulations, for example, the regulations with respect to the definition of insiders and (illegal) insider trading, the main aspects of the regulation (e.g., the frequency of information releases and trading bans), the length of the period within which insiders must report their trades, and the level of the enforcement of the regulation. We conclude in our discussion on the regulatory differences between the two countries that directors' trades in the U.K. are likely to be more informative and hence trigger larger market reactions. Our paper makes two major contributions to the existing literature. First, the paper is innovative in terms of the event study methodology we use in the context of insider trading. Specifically, we adjust the abnormal returns on insider trades for the release of news during the period preceding the trade and we examine whether the share price reactions to directors' trades remain significant if the trades follow news releases that relate to the firm's prospects, corporate restructuring, changes in capital structure, board restructuring, and other business events. We find that, in general, directors' transactions communicate new information to the market even if they are preceded by news releases. However, the informational content of trades is smaller when news on mergers and acquisitions (and to a lesser extent CEO replacement) precedes the trades. Indeed, in these cases, purchase transactions do not contain new information. Second, when measuring the market reaction to directors' purchases and sales, we differentiate between the ownership of the directors who trade as well as the ownership held by outsiders. To the best of our knowledge, no other study explores the impact of the presence of different types of blockholders on the announcement effect of directors' transactions. We argue that the market takes into account all available public information—including director and outsider ownership—when reacting to insider transactions. As a result, directors' trades in firms with outside blockholders who monitor the firm may have relatively less informational value than directors' trades in widely held firms that may suffer from higher informational asymmetry. Our analysis therefore provides new evidence on the market's perception of ownership and control. Our results confirm that the market takes into account the firm's ownership structure when reacting to directors' trades. The market reaction differs significantly depending on the degree of outsider ownership, director ownership, and the type of outsider ownership. In particular, firms controlled by other companies or by individuals or families unrelated to the directors experience significantly lower cumulative abnormal returns (CARs) in absolute value. This suggests that monitoring by these blockholders reduces informational asymmetry and ensures that the management focuses on value maximization, in which case directors' trades convey less information. In contrast, firms whose dominant shareholders are institutional investors have higher CARs on average. This suggests the higher information content of directors' transactions and confirms the findings of Franks, Mayer, and Renneboog (2001) and Faccio and Lasfer (2002), who argue that institutional shareholders in the U.K. do not monitor the firms in which they invest and do not mitigate problems of asymmetric information. Further, our evidence is consistent with institutional investors trading on the information signal conveyed by directors' trades. Interviews with fund managers in the City of London confirm that this is indeed the case. Our results also demonstrate that the market takes into account director ownership when reacting to directors' trades. For firms with little director ownership, the CARs of directors' purchases are strongly positive, which is in line with the precommitment explanation. In contrast, for firms whose directors hold large stakes, the positive news that directors' purchases contain is mitigated by the danger of increased entrenchment. Similarly, the market reacts less negatively when directors with significant stakes sell, as this reduces their dominant position. For poorly performing firms and those close to financial distress, we find stronger market reactions, with the reaction to directors' purchases (sales) significantly positive (negative) irrespective of the shareholder structure. We fail to find support for the information hierarchy hypothesis (Seyhun (1986)). Although CEOs are assumed to have superior knowledge about their company's prospects, the information content of their trades is lower than that of other directors' trades. It is possible that CEOs, who may be subject to greater market scrutiny, trade more cautiously and at less informative moments. The remainder of the paper is organized as follows. The next section summarizes the U.K. regulation on directors' dealings and compares it to the U.S. regulation. Section II develops the hypotheses based on the existing literature. Section III describes the data and discusses the methodology. Section IV analyses the results and Section V concludes.

Item Type: Article
Date Type: Publication
Status: Published
Schools: Business (Including Economics)
Subjects: H Social Sciences > H Social Sciences (General)
H Social Sciences > HF Commerce
H Social Sciences > HG Finance
Publisher: Wiley-Blackwell
ISSN: 0022-1082
Last Modified: 04 Jun 2017 04:30

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