Literature review on Insider Trading and Insider Trading Regulation

Abstract Views on insider trading and its effects on information asymmetry have evolved over the years. In the very early days, academic research on insider trading initially focused on establishing its existence and the need for regulation. Subsequently, research focused extensively on gauging the effectiveness of insider trading regulation. In recent times, the focus has shifted to identifying factors that contribute to effective enforcement of insider trading regulation. Indeed, markets across the world are in various stages of enforcement and are actively setting up the relevant support systems in a determined bid to curb insider trading. Developed markets have been at the forefront; establishing and continuously improving the regulatory architecture. Asia, in general and India, in particular, have been playing catch up. In India, insider trading regulation has gained vigor with the inclusion of prohibition of insider trading in the revamped Companies Act of 2013; so far it had the status of only a rule. A new ordinance also empowers the regulator, Securities and Exchange Board of India (SEBI), with explicit powers to settle administrative and civil proceedings. Our survey explores the various facets of the academic research on insider trading and its regulation. We place such research in the context of Asian and Indian regulations on the subject, where in contrast to developed markets, insider trading is considered to be more prevalent and research on its effects considered being more limited. October 2013

Literature review on Insider Trading and Insider Trading Regulation

I. Introduction Corporate insider trading as a theme has resonated with researchers across domains spanning disciplines such as Accounting, Economics, Finance, Law, Management and Social Science. Various facets of Insider Trading and Insider Trading Regulation, from here on referred as IT and ITR respectively, have been explored extensively in academic literature across such disciplines. This is especially true in the context of the developed world and more so with regard to the US. In this report, we present a overview of the literature coverage on this theme with a special focus on ITR. The review is organized as follows. Section II discusses who an insider is and the philosophy behind abnormal returns. Section III elucidates the divergent views on ITR drawing support from extant literature. Section IV sheds light on the current state of ITR across the world. Section V discusses the effectiveness of ITR while section VI takes a detailed look at literature to crystallize what aspects of ITR have worked and are necessary for ITR to succeed. Section VII critically examines the various methodologies adopted by researchers to validate their findings. Section VIII examines ITR related studies from an Indian context. Section IX suggests areas for further research. Section X summarizes and concludes.

II. Insiders and abnormal returns There is no uniform definition of an insider. The definition varies across jurisdictions, across purpose and is dependent on the relevant regulatory context in which it is stated1. In general, the definition is narrower from a disclosure viewpoint but much broader in scope from a legislative perspective. The narrower definition covers directors, officers and large shareholders of a company who are close to the source of potential material, non-public information (MNPI) relating to the company by virtue of their position. Accordingly, regulatory disclosure requirements are stringent with respect to insiders as per the narrower sense. In its broader sense, insiders could encompass several others who have access to MNPI and could trade on them. Here again, the definition varies across jurisdictions. US laws require existence of a fiduciary relationship for an individual trading on MNPI to be charged under ITR while such a fiduciary relationship is not necessary in the UK. Researchers have found evidence of abnormal returns earned by both the narrower and broader groups of insiders. From an empirical standpoint, most of them have restricted themselves to the narrower scope given the richness of data availability. Finnerty (1974) notes that insiders, who during 1969-72 bought their own company shares listed on the NYSE, managed a cumulative abnormal return (CAR) of 8.61% over an 11-month holding period. Pratt and DeVere (1970), Jaffe (1973), Seyhun (1986) and Jeng et al (2002), among others have validated the earning of abnormal returns by registered insiders. A few have attempted to target the wider group too, basing their study on prosecutions by regulatory authorities. For instance, Muelbroek (1992) based her analysis on individuals charged with insider trading by the US Securities and Exchange Commission (SEC) in civil or administrative cases during 1980-892. The author estimated that CAR for an insider trading episode to be 6.85%.

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For instance, the US SEC defines a registered insider as an officer, director or a shareholder owning >10% of any equity share class of a company. From a regulation viewpoint, insiders include constructive insiders encompassing among other members, lawyers, accountants and investment bankers associated with the company 2 Frino et al looked at similar cases prosecuted by SEC over 1996-2004 October 2013

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III. Views on ITR Manne3 (1966) is clearly the most quoted on discussions of the benefits of insider trading and correspondingly, why ITR should not be adopted. Manne put forth two primary arguments in support of insider trading. He argued that insider trading helps to gradually move the price of a stock closer to its fair value since insiders’ trade on the basis of MNPI4. He asserted it prevents abrupt adjustment shocks in the share price when the news turns public, which he contended could adversely affect investors. Manne also argued that IT is the best means to reward entrepreneurship5 and promote innovation. He believed this would be an effective solution to tackle the agency problem between shareholders and managers, as it rewards producers of information and encourages them to produce more information and add to the value of the firm 6. Meanwhile, Carlton and Fischel (1983) debated that if insider trading was bad, investors would have put in place even tougher restrictions than what is observed currently. They opined that IT serves as an effective alternative to costly renegotiations of manager compensation contracts 7. In addition, they claimed that IT would promote the generally risk-averse managers to take up more risky projects8 and reduce their aversion to disclose negative news. Javier Estrada (1994), although specifically not arguing in favor of IT, highlighted that the introduction of ITR leads to reduced social welfare by decreasing the flow of information, greater price volatility, risk sharing among a fewer group of investors and diverts resources from production to regulation. While Estrada advocated against ITR, literature is arguably richer with arguments in favor of ITR. Broadly, the arguments in support of ITR can be grouped under three categories: Market participant benefits, overall market benefits and firm benefits. Primary argument in support of ITR is that it ensures fairness and equality for all market participants. Insiders could profit from both positive and negative information. This could force them to not act in the best interest of the shareholders. This moral hazard issue can be addressed with ITR (Mendelson, 1969). Leland (1993) estimated that liquidity traders would be hurt the most with IT while outside investors will have to live with lower returns9 since part of the risk gets passed through the price if IT is allowed. Investor confidence would also collapse in a market with IT, making them reluctant to trade (Bhattacharya and Spiegel, 1991). From an overall market benefit perspective, academic researchers believe that IT could facilitate insiders to manipulate information and earn profits from artificial price volatility (Masson and Madhavan, 1991). It could also encourage them to deliberately delay information release (Easterbrook, 1985; Ausubel, 1990). Further, IT would result in concentrated ownership as outsiders stay away from such market leading to lower liquidity10 (Beny, 2005) and market as a 3

Manne, Henry G., 1966, 'Insider trading and the stock market', New York Free Press, 1966. Bainbridge (2002) refutes Manne argument on the premise that insider trading volumes are insignificant and cannot move prices significantly. He also contends that others can pick on insider activity only if they know of insider identity. With most trades occurring over the exchange, trades are impersonal in nature 5 Bainbridge (2002) contends that is practically tough to distinguish insider trades of entrepreneurs versus the other insiders 6 Value addition argument also supported by Jensen and Meckliing (1976), Meulbroek (1992) and Leland (1993) 7 Bainbridge (2002) felt that compensation argument for insider trading is not valid as it is driven by how many shares an insider can purchase which becomes a question of wealth. 8 Carlton and Fischel (1983)also were supportive of the price efficiency argument and felt insider trading helps identify prospective good managers as only good managers would be open to have insider trading included in their compensation contracts 9 Bainbridge (2002) felt arguments of injury to investors is invalid as investors make a trading decision independently and they would have traded at a given level irrespective of whether they trade with an insider or an uninformed trader 10 Also supported by Ausubel (1990) and Bhattacharya and Spiegel (1991) 4

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medium of communication would be lost (Bhattacharya and Spiegel11, 1991). The incentive for traders to research for more information would cease to exist if they suspect their counterparty could be an informed trader, leading to less informed trades and overall market inefficiency (Fishman and Hagerty, 1992). Glosten (1985) showed how IT could result in higher bid-ask spreads as specialists quote wider levels to discount and compensate for the presence of informed insiders. Even at the firm level, academic researchers see a negative impact with IT. Easterbrook (1985) believes that it could force firms to venture into excessively risky projects. He further notes that investors could react by lowering managerial compensation significantly to ensure they do not over-incentivise dishonest managers. This in turn, could lead to good managers leaving the firm. Firms would have to manage with lesser levels of capital with IT as outsiders may turn less willing to part with their money (Ausubel, 1990). It could also lead to corporate underinvestment, as existing investors might approve lesser number of projects as outsiders see lower value in their investments (Manove, 1989). Leland (1993) argues that in an environment where share issuance is less sensitive to current prices, insider trading could lead to an overall decline in firm welfare.

IV. ITR from across the world Inarguably, the US has witnessed the longest history of ITR and correspondingly, where most of the ITR studies are based on. Bainbridge (2002) traced the development of the US legislation relating to IT. Being a common law country, like any other legislation, ITR has evolved in the US over time based on case laws and judicial decisions. Equality of access to information was the first approach adopted towards ITR, where it was highlighted that although directors did not have the duty to disclose all material information to shareholders, under ‘special circumstances’ such as trading with the less-informed investors, they have a duty to disclose the material facts12. With widespread securities fraud being blamed for the collapse of the market in 1929, the US passed the Securities Act, 1933 and Securities Exchange Act, 1934 to govern the securities market. With the latter Act, the SEC was constituted and empowered to handle all aspects of the securities industry. The Acts do not discuss ITR explicitly. Sec 10(b) and Rule 10b-5 of the 1934 Securities Exchange Act deals with securities fraud and insider trading is interpreted within this rule. The first enforcement of ITR happened in 1961. Argument on fiduciary duty of insiders towards the shareholders strengthened over the years and became well known as the ‘disclose or abstain’ rule, where insiders were expected to either disclose the material information before trading or if the disclosure is not possible, abstain from trading13. However, the fiduciary requirement to shareholders proved to be a limitation and served as a loophole for others to trade on insider information14. This apart, from 1981, the SEC started moving away from fiduciary duty based argument to misappropriation theory15, where it argued that any person misappropriating confidential non11

As a result, Bhattacharya and Spiegel (1991) felt it could result in higher risk premiums Stong vs. Repide, 1909 SEC vs. Texas Gulf Sulphur Co. (1966) – several insiders bought shares and option of Texas Gulf after initial results indicated that the firm has identified a major ore discovery. The Second Circuit Court of Appeals ruled that insiders with the knowledge on material insider information should either disclose such information or abstain from trading on the information. 14 In Chiarella vs. United States(1980), a financial printer, who became aware of a pending merger through documents that came for printing and traded on its basis, was ruled to have committed no fraud as he held no duty to target company shareholders 15 Misappropriation theory essentially developed from Chief Justice Burger’s dissent in Chiarella vs. United States (1980) case, where he said, ““a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading.” 12 13

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public information has the duty to disclose the information before trading or abstain from trading16. The definition of an insider for the purpose of regulation was subsequently expanded to include ‘constructive insiders’ where lawyers, consultants and others who could receive confidential information in the normal course of business are automatically implied to assume the fiduciary responsibility of the company insiders17. Over time, the scope of the misappropriation theory has widened to cover misappropriation of confidential information in securities trading, arising out of a breach of duty to source of information18 as well. Thus, even if the misappropriator owes no duty to the uninformed trading shareholders, he is regarded a nominal insider under ITR. Apart from Sec 10(b) and Rule 10b-5, ITR is also covered under Sec 1619 which places restrictions on the trading of registered insiders20. Further, in 2000, rule 10b5-1 was introduced, where an insider in possession of MNPI and subsequently trades in securities is assumed to have used the insider information for trading. Proof of ‘use’ of information is not necessary. Insider Trading Sanctions Act (ITSA, 1984) and Insider Trading and Securities Fraud Enforcement Act (ITSFA, 1988) have enhanced the penalties for offenders charged under ITR. Monetary penalties have been raised to the greater of US$1mn or three times the profits earned or losses avoided while criminal charges involve a jail term of up to 10 years. Europe has generally lagged behind the US with regard to the enactment of ITR and only recently has intensified both standardization and enforcement. ITRs across Europe were passed only in the past few decades- UK (1980), France (1970), Germany (1994) and Switzerland (1998). The EU members were mandated to enact ITR only by 1992. In the UK, ITR is governed by the Criminal Justice Act (1983) and Financial Services and Markets Act (2000). In contrast to the US, the UK has a broader definition of ‘market abuse.’ In the UK, the onus lies with the insider in avoiding both intentional and unintentional violation of ITR. Kylie (2013) asserts that ITR in the UK is more grounded on the ‘possession theory’ wherein any person who trades with confidential information is deemed to have violated ITR even if there was no fiduciary agreement. It is considered ‘criminal’ if an insider violates deliberately and a civil offense if it involves inadvertent violations. The EU considers IT as a criminal offense in accordance with the European Community Directive Regulations on Insider Trading (1989). In late 2013, EU approved the Market Abuse Regulation (MAR) which is expected to replace the Market Abusive Directive (MAD) introduced in 200521. 16

United States vs. Newman (1981) - Second Circuit Court of Appeals ruled employees of the investment bank, who had confidential information on tender offers, guilty under the misappropriation theory of insider trading in target company securities even though they owed no fiduciary duty to target company shareholders 17 In Dirks vs. SEC (1984), the Supreme Court noted, “Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes. . . . For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty” 18 In United States v. O'Hagan (1997), a partner in a law firm acquired information on a planned takeover by a client of his firm but he himself was not part of the specific assignment. He had used the knowledge acquired simply by virtue of his employment for trading in the relevant target company shares without informing his firm of the use of the information. The Supreme Court opined, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” Accordingly, the court ruled O’Hagan guilty of insider trading. 19 Rule 16(a) requires disclosure of trades by registered insiders within 10 days from the last day on the month the trade happen. Rule 16(b) mandates a compulsory 6-month holding period (aimed at preventing short-swing profits) and Rule 16(c) bans on short-selling respectively. 20 Registered insiders include directors, officers and principal shareholders owning more than 10% of any class of equity shares. 21 Note that Market Abuse Regulation (MAR) is self-executing while the new Market Abuse Directive (MAD II) is an instruction to EU members to adopt a law. MAD II requires EU members to introduce criminal sanctions while MAR dealt with administrative sanctions. October 2013

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ITR laws across Asia and the emerging markets have lagged the developed markets in terms of regulations and enforcements: Japan (1988), China (1993), Hong Kong (1991) and India (1992). The Financial Markets Abuse Act (1988) in Japan is considered lenient in comparison with the US and the UK. While IT is not a strict offense, only willful misconduct is considered a severe breach of ITR. The law does not explicitly prohibit corporate insider from tipping, it would be deemed criminal only if traded by the tippee22. China’s ITR is governed by Establishment of Securities Companies with Foreign Equity Participation Rules (1993 & 2006). In contrast to the U.S, China has adopted the codification method to regulate ITR. Also, China has opted to ground the premise of IT based on ‘equal access theory’ than the ‘misappropriation theory’. Prohibitions of Insider Trading Regulation (1992 & 2002) are the key ITR laws in India and are currently enforced by Securities and Exchange Board of India (SEBI). The amendments to the Act in 2002 required companies to frame a model of conductors for corporate insiders and define MNPI. Further significant changes were made in 2008 leading to (a) widening the definition of an ‘insider’ (b) reduction of the disclosure period from 5 days to 2 days and (c) increase in holding period for round trip transactions from 1 month to 6 months. A new ordinance passed in October 2013 empowers SEBI with explicit powers to settle administrative and civil proceedings.

V. Effectiveness of ITR Opinion is quite divided among academicians on the effectiveness of ITR. While some researchers like Ackerman and Maug (2008) have taken a reasonably generic stance that ITR enactment works, Muelbroek (1992), and Bettis et al (1998) among others have argued against the overall success of ITR. They contend that despite the regulations, insider trading remains and insiders continue to generate significant abnormal returns. A vast majority of researchers have looked at exploring a specific aspect of ITR - seeking answers to queries such as what has changed with the introduction of ITR23, when and where ITR works24 and what elements of ITR works25. William Schwert (1996) believes that ITR has only led to a change in trading pattern of insiders. As insiders are quite aware of the enforcement mechanisms, they tend to trade over a prolonged period, in smaller volumes, over multiple accounts with multiple brokers, a trend named ‘stealth trading.’ Arshadi and Eyssell (1993) assert that insiders now trade less around corporate events so as to not attract unwarranted attention. However, they believe that insiders still continue to earn abnormal returns. Seyhun (1992), on the contrary, believes that registered insiders have reduced trading overall, while ‘outside-insiders’ (akin to constructive insiders in the law, like lawyers and accountants) continue to trade despite the regulation26. In fact, the author contends that insider trading volume has grown in-line with the overall trading volume. Jagolinzer et al (2007) brings out how only the trading pattern of insiders have changed to post-earnings periods while abnormal profits earned by them have not declined over the years. A more recent study by Frino et al (2013) highlight that insiders make a trade-off between potential benefits and costs including the extent The key aspect of the revised regulation is to accommodate (a) new technological and market development such as multilateral trading facilities (b) alignment with Markets in Financial Directive (MiFID) and (c) standardize ITR regimes across EU-28. 22 A Global comparison of Insider Trading Regulations – James H. Thompson (2013) 23 To quote a few examples – Arshadi and Eyssell (1993), Seyhun (1992), Jeng et al (2002) 24 Bhattacharya and Daouk (2002) 25 Beny (2005), Durnev and Nain (2007) 26 Alexandre Padilla (2002) also highlights the changing trading pattern of insiders, where they seem to be trading less around corporate events to avoid detection. A view also supported by Frino et al (2013) October 2013

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of penalty and probability of being detected, before making a trade. Their trading volume, the authors assert, is directly proportional to the value of the information in their possession. Some researchers have observed deterioration in the investment environment with the introduction of ITR. Bris (2003) empirically argues that with the introduction of ITR, both the incidence and profitability of insiders actually rises27. Padilla (2002) believes that disclosure requirements among large shareholders (those with more than 10% ownership) could discourage investors from acquiring a significant position, weakening the governance mechanism offered by the active investors and worsening the agency cost between shareholders and managers. On the positive front, Bhattacharya and Daouk (2002) have documented a decline in the cost of equity with the implementation of ITR. Beny (2005) argues that stricter ITR leads to more diffused ownership, more efficient stock prices and higher market liquidity28, drawing support from an empirical study of 33 countries. Jeng et al (2003) contend that while IT has not been eliminated completely with ITR, the cost borne by uninformed traders29 due to insider activity has declined considerably driven by improved confidence among investors of a fair market with ITR in place.

VI. Elements of ITR There are multiple elements that make up the ITR and a majority of literature effort is focused on what works and what does not among the various facets of ITR. Enactment and Enforcement of ITR Bhattacharya and Daouk (2002) studied 103 countries across the developed and emerging market universe and concluded that ITR enactment alone is not enough to see a positive impact (on cost of equity). They stressed on a favorable relationship between the first enforcement of ITR and a reduction in the cost of equity30. Ackerman and Maug (2008) while largely restricting themselves to the developed world found that enactment itself leads to an improvement in the information environment. Beny (2005) and Frijns et al (2007) have stressed on stricter enforcement of ITR rather than on timing of the first enforcement. Beny (2005) constructed a numeric metric to capture the toughness of ITR31 in a country by considering among others the nature of persons covered under ITR, what activity constitutes a violation of ITR and the subsequent sanctions available. Based on this ITR toughness metric, the author concluded tough laws are necessary to reap the benefits of ITR in the nature of diffused ownership, price efficiency and market liquidity. Others, including Bris (2003) and Durnev (2007) have applied this index on other countries and time periods and have arrived at the same results. Right insiders to target Seyhun (1986) highlighted that insiders such as the chairman and directors, who are well aware of the overall affairs of the business, are most likely to benefit the most from insider trading and that 27

Bris (2003) however contends that with tougher laws extent of profitability declines Ausubel (1990) and Bhattachary and Spiegel (1991) are among others arguing for improved price efficiency and higher market liquidity 29 Jeng et al (2003) estimate cost to uninformed trader due to insider activity is just 10 cents for a $10000 transaction. They contend regulators’ objective is to ensure a fair market and ITR has managed to reasonably achieve this objective 30 Argument on reduced cost of equity with ITR enforcement is also supported by Ferriera and Fernandes (2006) 31 Toughness of IT law is measured as a summation of five metrics (with 1 assigned to each metric on existence): 1) Tippees can be prosecuted under the country’s ITR; 2) Tipper can be prosecuted; 3) IT could be prosecuted as a criminal offence; 4) Monetary damages for ITR violation is proportional to insider trading profits and 5)investors have private right of action 28

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their trading activities should be strictly regulated. Bettis et al (1998) are in favor of extending the disclosure requirements to nominal insiders such as lawyers and consultants as well. Georgakopoulos (1993) put together an interesting argument that definition of insiders should be set in such a way that it delays inside information reaching public domain but does not constrain it completely. He believed that if informed trade occurs among a competitive group of members, it would motivate them to seek more information and bring it quickly to markets. In this regard, Georgakopoulos advocated that security analysts should be allowed to trade while trading by company insiders be restricted. Civil versus criminal penalties Beny (2005) analysis showed that the extent of criminal sanctions and monetary fines are the biggest factors in influencing ITR effectiveness in a country. Frijns et al (2007) highlighted existence of financial liabilities is an overriding factor over criminal liabilities as a deterrent for an insider to trade. Bris (2003) argued against civil suits for IT, especially involving out-of-court settlement as they render ITR ineffective. Frino et al (2013) pointed out that insiders evaluate the probability of getting caught and extent of penalty into consideration before a trade and hence it was critical to place penalties significantly high. Bettis et al (1998) suggested the imposition of penalties on companies whose insiders trade illegally for failing to put the necessary checks. Disclosure and holding period requirements Fishman and Hagerty (1992) argued in favour of disclosure of MNPI prior to trading by insiders rather than employing a complete ban on their trading activities. They feared the latter would deter insiders from sourcing information for any purpose. To the contrary, a mandatory disclosure requirement32 would dis-incentivize sourcing information for trading while continuing to encourage sourcing of information for business purposes. Bettis et al (1998) have suggested extending the disclosure requirements to a bigger group, including legal, accounting and investment banking advisors. Jeng et al (2002) believe that immediate trading disclosure requirement aids in significantly reducing cost borne by uninformed traders on account of insider activity. Padilla (2011), however, provides a contrary view that disclosure requirements are a negative as they dissuade investors from taking a significant (>10%) position and weakens the governance offered by active investors. Impact of holding period restrictions has not been explored much in literature. This could be due to the fact that registered insiders comply with the regulation while the data on holdings by illegal insiders is not available and they will probably also be not bound by such a restriction. From a policy perspective, Jeng et al (2002) highlight that, along with immediate trading disclosure, 6month holding period restrictions on trades by registered insiders in the US has also helped reduce costs for the uninformed trader. Monitoring mechanisms Numerous researchers33 have brought out the changes in trading behaviour of insiders as they try to hide their activities in the crowd by trading over a longer time frame in smaller volumes and with multiple accounts. Given the existing statistics based checks to identify potential insider trading activities, the researchers believe that insiders play the system and manage to stay out of 32 33

Manove (1989), Georgakopoulous(1993), Dr.Georgios among others have stressed on the importance of disclosure provision Dr.Georgios, William Schwert (1996) and Frino et al (2013)

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the radar. Researchers argue for more investment in sophisticated monitoring and one that does not rely on simple statistical anomalies. Spiegel and Subhramanyam (1995) have stressed on the need for regulators to enhance monitoring to gather hard evidences or ‘smoking guns’ rather than rely on circumstantial evidences. They believe that the current rules can only prosecute innocent and marginal insiders. Support system requirements A wealth of literature resides on the support systems that are critical for ITR to be effective. Most of these studies are cross-sectional analyses that pit countries against each other to evaluate the importance of support systems. Ackerman and Maug (2008) stressed on the law enforcement capabilities and judicial effectiveness as critical for ITR to function effectively. Ferriera and Fernandes (2006), in their analysis, highlighted the role of investor protection laws and financial reporting standards to be a significant precursor apart from the judicial systems. Durnev and Nain (2007), in fact, spelt out that enforcement of ITR without suitable governance mechanisms and investor protection laws could be counter-productive as it could trigger more private informationbased trading. Public versus private regulation of IT Carlton and Fischel (1983) argued in favor of insider trading being part of a private negotiation between shareholders and managers as it dealt with property rights to information 34. This thought was opposed by Easterbrook (1985) who felt the individual shareholders did not have adequate enforcement mechanisms and favored government regulating IT35. Padilla (2011) however highlighted that government possessed only the scientific knowledge and lacked the experiential knowledge to know where MNPI is generated and control it. The author considered stock exchanges and to some extent, corporations themselves to be better placed to contain MNPI as they are close to the source of information and would know what could be subject to insider trades and restrict accordingly. Jagolinzer et al (2007) empirically showed the need for firm-level restrictions like trade windows to support public regulation for ITR to be effective.

VII. Methodologies to study IT and ITR Most of the analysis on IT and ITR has revolved around testing some aspect of whether IT exists and how effective ITR has been. Such tests are made either from the point of view of capturing insider actions over time or around corporate events (Arshadi and Eyssell, 1993). Cross-sectional tests across countries have also been employed to capture the effect of variation in elements of ITR and related parameters. Most of these studies have focused on the US market drawing from SEC filings, due to rich availability of data. In recent years, ITR has been studied in an international context, especially to understand what works and what does not with ITR. IT and ITR studies have broadly adopted one of the three approaches: Determining portfolio CAR around an event, multiple regression and a non-empirical analysis involving demand functions or decision-making models. Most of the initial studies focused on testing the existence of IT have adopted a Portfolio CAR approach. A few other recent studies with a similar objective have also used this approach. The methodology involves computing excess return earned by an insider over a benchmark model for 34 35

Javier Estrada (1994) was also supportive of a private negotiation between shareholders and managers Frijns et al (2007) was also for public rather than private negotiation

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the chosen holding period. While the approach appears quite straight-forward, various researchers have adopted their own individual techniques while computing CAR. In arriving at the portfolio returns, equal weighting36 (Jaffe, 1973; Finnerty, 1974) or transaction weighting (Jeng et al, 2002) of portfolio constituents have been adopted. The CAPM model (Jaffe, 1973; Finnerty, 1974; Arshadi and Eyssell, 1993) is the most commonly chosen benchmark. Market model was used by Muelbroek (1992) while Jeng et al (2002) utilized multiple benchmark models. Instead of considering all insider transactions, Pratt and Devere (1970) used an intensity criterion, where only companies with more than 3 trades in a single direction were included in the portfolio. Every researcher has adopted a unique holding period / event window of study. For instance, Jeng et al (2002) analyzed based on a 6-month holding period while Finnerty (1974) sensitized his analysis with multiple holding periods. Jaffe (1973) based his analysis on net trades while most of the other researchers viewed insider buys and sells separately. Multiple regression has generally been utilized for testing the effectiveness of ITR and more specifically, identifying the elements of ITR and related factors that worked well. Researchers have adopted a host of dependent variables to capture the extent of effectiveness of ITR - cost of equity (Bhattacharya and Daouk, 2002), firm specific return variation (Ferriera and Fernandes, 2006), first-level serial correlation (Durnev and Nain, 2007), post-earnings trading volume (Jagolinzer et al, 2007) and probability of informed trades (Frijns et al, 2011). Some like William Schwert (1996) and Ackerman and Maug (2008) have used CAR as a dependent variable. This apart, researchers have used a host of independent variables and control variables relating to ITR, economic environment and financial market condition to drive the analysis. Bhattacharya and Spiegel (1991) adopted a non-empirical approach in analyzing a potential market breakdown using aggregate demand and supply function. Fishman and Hagerty (1992) attempted to model risk-neutral returns while Glosten (1985) used a distribution function that factored in trader arrival rate, nature of the trader, utility function of the trader and information available with the trader to model bid-ask spreads. Ausubel (1990) employed a two-stage decision marking model, involving an investment stage and testing stage, to support his analysis.

VIII. ITR studies in the Indian context Studies on ITR exclusively catering to the Asian or Indian context have been quite limited in literature. A couple of case studies on the Indian markets are worth highlighting. Merger Announcements and Insider Trading Activity in India: An Empirical Investigation (2006) by Manish Agarwal and Harminder Singh The key objective of the research was to investigate if insider trading activities could be observed prior to M&A announcements in India. The analysis was based on a sample of 42 companies during the period 1996-99. It examined the trends in the pattern of stock price movement and trading volume. The abnormal returns were measured using a modified market model. The study found evidence for the presence of insider trading activities in companies belonging to the same business group. It recommended investigation on six companies for the existence of insider trading. Eight companies did not exhibit evidence of insider trading activity. All the remaining companies were placed in the uncertain category where further investigation was required. 36

All companies with insider trades carried equal weights under equal weighting while transactions were weighted based on individual insider transaction value under transaction weighting technique October 2013

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Market Imperfections and Regulatory Intervention: The Case of Insider Trading Regulation in the Indian Stock Market (2012) by Yogesh Chauhan, Kiran Kumar Kotha and Vijaya B. Marisetty The key objective of this research was to ascertain the impact of regulatory action (a) on insider trading profits and information content of disclosures and (b) its variability across firms with different organizational structure. The study analyzed nearly 22,571 insider trades that occurred during 2007-11. The abnormal returns were measured using the Fama-French Model. The effectiveness of the regulatory intervention was measured using multiple regression. It concluded that (a) regulatory intervention reduced profiteering activities (b) regulatory intervention significantly improved production of information and (c) regulatory intervention was predominantly felt among standalone firms.

IX. Further research There is a wealth of research on the various facets of ITR pertaining to the US market and the developed universe. We could use the wealth of learnings from the western world to analyze and better understand local markets as well as suggest possible policy recommendations that could be adopted by Asian and Indian regulators. A case-study based approach exploring the various case facts of Indian ITR in detail, similar to the study of Muelbroek (1992) could be a good starting point. This apart, we could possibly explore regulatory definition variations across Asian countries and evaluate their impact on ITR effectiveness. A CAR based analysis on ITR policy effectiveness in India and other Asian peers could also be worth exploring.

X. Conclusion In this report, we present a quick summary of the key elements from literature that we have captured in the review through a Q&A framework. This, we believe, should serve as a ready reckoner for understanding ITR and contemplating appropriate policy recommendations. Q1. Is Insider Trading beneficial? Should it be regulated? Arguments against ITR – IT helps achieve price efficiency, motivates entrepreneurs, promotes innovation and serves as a compensation alternative to costly renegotiations. ITR leads to reduced social welfare with greater price volatility, lower risk sharing and inefficient resource allocation. Arguments in favour of ITR – From a market participant perspective, ITR limits injury to uninformed investors, prevents moral hazard as insiders could otherwise benefit from good and bad news, and improves investor confidence. From a market perspective, ITR leads to greater liquidity, price efficiency, lower transaction costs, diffused ownership and reduced price volatility. From a firm perspective, ITR prevents firms from investing in risky projects and leads to corporate underinvestment and limited availability of capital for investment. Q2. Does ITR work? There is no one answer to this question as arguments exist on both the sides. More importantly, it has to be viewed from the point of view of factors necessary for ITR to be effective. Q3. What has been the impact of ITR? It has led to a change in the trading pattern of insiders. Insiders seem to trade less around corporate events, engage in stealth trading where they trade in small volumes across multiple October 2013

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accounts, push their trading to post-earnings period and engage more in long-term trades. Registered insiders have reduced their trading volume while ‘outside-insiders’ continue to trade normally. There is also empirical support for a decline in the cost of equity and trading costs as well as for more diffused ownership, improved liquidity and better price efficiency. On the other side, there are also arguments for weaker governance with a reduction in active investors. Q4. How important is enactment and enforcement of ITR? Mere enactment is not adequate. There is a need for strict enforcement. Law, by definition, will have to be tough, encompassing a wider group of potential insiders with strict deterrents. Q5. How should the penalties be structured? Penalties should be strict enough to serve as a significant deterrent. No consensus on whether monetary or criminal sanctions work better. Monetary penalties should be large and proportional to the extent of profits earned or losses saved by the insider. Q6. Are mandatory disclosure and holding period requirements helpful? In general, both the mandatory disclosures and holding period restrictions seem to have significantly helped to reduce the injury costs borne by uninformed traders due to insider action. Q7. How should the monitoring requirements be framed? Well-informed insiders are well aware of the existing statistical monitoring system and ensure that their trades do not get noticed. Regulators should look to implement a more sophisticated monitoring system and should look to gather hard evidences rather than circumstantial evidences. Q8. What are the support systems required for the effective implementation of ITR? Law enforcement capabilities, judicial effectiveness, investor protection laws, financial reporting standards and corporate governance rules are the critical infrastructure for an effective ITR. Q9. Are firm-level restrictions necessary? Public regulation should be backed by firm-level regulation such as the use of trade windows, as corporates are in a favorable regulatory position, being closer to the source of information. Q10. How has the effectiveness of ITR been evaluated? Three common approaches are adopted – Portfolio CAR computation around corporate events or based on actual insider trades, multiple regression of a market or return-based variable against a host of ITR and related factors or a non-empirical modeling-based approach.

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References A. Durnev, Art, and S. Nain, Amrita, 2007, 'The Effectiveness of Insider Trading Regulation: International Evidence', CESifo DICE Report, pp. 10-15. A. Jeng, Leslie, Metrick, Andrew, and Zeckhauser, Richard, 2003, 'Estimating the returns to insider trading: a performance-evaluation perspective', The Review of Economics and Statistics, May 2003, 85(2), pp. 453-471. Ackerman, Abraham, van Halteren, Jörn, and Maug, Ernst, 2008, 'Insider Trading Legislation and Acquisition Announcements: Do Laws Matter?', EFA Zurich Meetings – working paper series, http://ssrn.com/abstract=868708. Bhattacharya, Utpal, and Spiegel, Matthew, 1991, 'Insiders, Outsiders and Market Breakdowns', The Review of Financial Studies, Vol. 4, No.2, pp. 255-282. Bhattacharya, Utpal, and Daouk, Hazem, 2002, 'The World Price of Insider Trading ', The Journal of Finance, Vol. LVII, No. 1, pp. 75-108. Bris, Arturo, 2003, 'Do Insider Trading Laws Work?', European Financial Management, Vol. 11, No. 3, pp. 267–312. Carr Bettis, J., and A. Duncan, William, 1998, 'The Effectiveness of Insider Trading Regulations', The Journal of Applied Business Research, Vol. 14, No. 4, pp. 53-70. D. Jagolinzer, Alan, and T. Roulstone, Darren, 2007, 'The Effects of Insider Trading Regulation on Trade Timing, Litigation Risk, and Profitability’. Dolgopolov, Stainslav, 2008, 'Insider Trading ', The Concise Encyclopedia of Economics, David R. Henderson, ed., pp. 276-281. E. Finnerty, Joseph, 1974, 'Insiders and Market Efficiency ', Journal of Finance 31(4), pp. 1141-48. E. Leland, Hayne, 1992, 'Insider trading: Should it be prohibited?', The Journal of Political Economy, Vol. 100, No. 4 (Aug., 1992), pp. 859-887. Estrada, Javier, 1994, 'Insider Trading: Regulation, Deregulation and Taxation', Swiss Review of Business Law 5, pp. 209-218. Fernandes, Nuno, and A. Ferreira, Miguel, 2007, 'Insider Trading Laws and Stock Price Informativeness', ECGI Finance Working Paper No. 161/2007. Frino, Alex, Satchell, Stephen, Wong, Brad, and Zheng, Hui, 2006, 'How much does an Illegal Insider Trade?', International Review of Finance, 13:2, pp. 241-263. Hu, Jie, and H. Noe , Thomas, 1997, 'The Insider Trading Debate', Federal Reserve Bank of Atlanta Economic Review Fourth Quarter, pp. 34-45. I Zekos, Georgios, 2005, 'Is the law effective in protecting markets from insider trading?', Hertfordshire Law Journal 3( 2), pp. 2-17. I Zekos, Georgios, 2008,’ Logistics of Information is the antidote against insider trading', Hertfordshire Law Journal 6( 1), pp. 49-72. J. Fishman, Michael, and M. Hagerty, Kathleen, 1992, 'Insider Trading and the Efficiency of Stock Prices', The RAND Journal of Economics, Vol. 23, No. 1. (Spring, 1992), pp. 106-122.

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J. Keown, John M. Pinkerton, Arthur, 1981, 'Merger Announcements and Insider Trading Activity: An Empirical Investigation', Journal of Finance, Vol. 36, Issue 4 (Sep., 1981), pp. 855-869. K. Meulbroek, Lisa, 1992, 'An Empirical Analysis of Illegal Insider Trading', The Journal of Finance, Vol. 47, No. 5 (Dec., 1992), pp. 1661-1699. L. Georgakopoulos, Nicholas, 1993, 'Insider Trading as a Transactional Cost: A market microstructure justification and optimization of insider trading regulation', Connecticut Law Review, Vol. 26, No. 1, pp. 1-51. M. Ausubel, Lawrence, 1990, 'Insider Trading in a Rational Expectations Economy', The American Economic Review, Vol. 80, No. 5 (Dec., 1990), pp. 1022-1041. M. Bainbridge, Stephen, 2001, 'The Law and Economics of Insider Trading: A Comprehensive Primer', University of California, Los Angeles (UCLA) - School of Law. Manne, Henry G., 1966, 'Insider trading and the stock market', New York Free Press, 1966. Manove, Michael, 1989, 'The Harm from Insider Trading and Informed Speculation', The Quarterly Journal of Economics, November 1989, pp. 823-845. Nejat Seyhun, H., 1986, 'Insiders’ Profits, Costs Of Trading, and Market Efficiency', Journal of Financial Economics 16, pp. 189-212. Nyantung Beny, Laura, 2005, 'Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence', University of Michigan Law School. Padilla, Alexandre, 2006, 'The Regulation of Insider Trading as an Agency Problem', Florida State University Business Review, Volume 5 (2005-2006), pp. 63-79. Padilla, Alexandre, 2011, 'Should The Government Regulate Insider Trading?', Journal of Libertarian Studies Volume 22 (2011), pp. 379–398. R. Glosten, Lawrence, and R. Milgrom, Paul, 1985, 'Bid, Ask and Transaction Prices In a Specialist Market With Heterogeneously Informed Traders', Journal of Financial Economics 14, pp. 71-100. Spiegel, Matthew, and Subrahmanyam, Avanidhar, 1995, 'The Efficiency of Insider Trading Regulation', Working Paper 257, Berkeley, University of California, Institute of Business and Economic Research. W. Carlton, Dennis, and R. Fischel, Daniel, 1983, 'The Regulation of Insider Trading', Stanford Law Review, Vol. 35: 857, pp. 857-895. William Schwert, G., 1996, 'Markup Pricing in Mergers and Acquisitions ', Journal of Financial Economics 41, pp. 153192.

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