Firm Reputation and Insider Trading: The Investment Banking Industry

Article excerpt

Firm reputation is an important concern among investment banks. This study examines insider trading of the investment banking industry to determine whether the concern for firm reputation can effectively restrain insider behavior. We find that in the early aftermarket post initial public offering, investment banks act to support the initial price levels of their IPOs but insiders refrain from exploiting their privileged position in this period. For the five-year post-IPO period, however, the results indicate that insiders may have acted on privileged information. We find the cumulative abnormal returns are significantly positive (negative) following insiders' report of buying (selling) activities. The results further show that insiders of prestigious investment banks are less likely to trade on inside information, voluntarily or involuntarily, than those of the less-prestigious investment banks.

Introduction

Reputation is an important issue among investment bankers. Hayes (1971) showed that the investment banking industry is subject to a rigid hierarchy that ties an investment bank's reputation to its influence in the industry. According to Hayes (1971), those investment banks in the upper bracket of this hierarchy (e.g., Morgan Stanley & Co.; Goldman, Sachs & Co.; Salomon Brothers, Merrill Lynch White Weld; and First Boston Corp.) enjoy a more prestigious and lucrative position than their counterparts in the lower bracket (e.g., Wall Street West, Inc.). It was suggested that investment banks would aggressively defend their place in the hierarchy, even to the point of pulling out of profitable deals. [1] Unfortunately, the junk bond fiasco of the mid 1980s, the market rigging activities of Salomon Brothers, [2] and the lawsuits about the losses suffered by some major corporations in trading financial derivatives under the advice of their investment bankers, [3] have tarnished the reputation of the investment ban king industry.

The above-mentioned incidents may represent one-time events tarnishing the reputation of the investment banking industry. If reputation is so important in the investment banking industry, however, it will be a surprise to observe systematic activities that undermine the public's confidence in the industry. This paper examines insider trading of investment banks to determine the effectiveness of firm reputation in restraining members of the investment banking industry from systematically exploiting their superior information regarding their own firms. This study tracks insider trading of the investment banking industry over a five-year period after an investment bank has gone public. In short, we study insider-trading activities in the short run [4] (the 60-day interval after going public) and in the long run (the five-year period after IPO). If reputation of an investment bank is as important as suggested by Hayes (1971), then insider trading of the investment banking industry should not show systematic patte rn of abnormal profits. In the extreme, it is possible that we do not observe any insider activity among investment banks.

Our results, similar to those of Ruud (1993), show that investment banks engage in activities to support the price of their IPOs in the early aftermarket. There is no strong evidence of insiders taking advantage of the price support in the immediate aftermarket, however, as revealed by the small number of insider trades recorded in the Securities and Exchange Commission (SEC) reports. For the three-year period after going public, we find evidence that investment bankers buy common stocks of their own companies more often than they sell. An analysis of abnormal insider trading activities, similar to the one performed by Karpoff and Lee (1991), shows insiders are net buyers during the first month following the IPO, as well as in 11 of the first 36 months of trading after the IPO. Abnormal net sale activity only occurs occasionally. …