Legal Risk and Insider Trading

… Specifically, do illegally informed traders rationally internalize legal risks? If so, is this process reflected in their trades and prices? While addressing these issues is vital to assess insider trading regulations’ effectiveness, one faces a formidable empirical challenge: neither private information nor legal risks are readily observable.

To enhance our understanding, we contribute in three ways:

  1. We manually collect data on individual trades and the resulting legal outcomes from 530 illegal trading investigations prosecuted by the SEC. We characterize over 6,500 trades in 975 firms from 1995 to 2018, representing many assets and market conditions. We examine the information sets, timing, quantity traded, and penalties of illegal insiders.
  2. To benchmark the impact of legal risks on trading, we develop a stylized equilibrium framework of informed trading featuring an insider who internalizes his own trades’ effect on prices, the probability of being prosecuted by a regulator, and the conditional value of a legal fine.
  3. We exploit two plausibly exogenous sources of variation in legal risk exposure to test the model’s predictions. Controlling for various behavioral predictors, we provide consistent evidence that legal risk deters insider trading.

Source: Legal Risk and Insider Trading