Insiders and the Law: The Impact of Regulatory Change on Insider Trading
Gilbert, Aaron, Tourani-Rad, Alireza, Wisniewski, Tomasz Piotr, Management International Review
Abstract and Key Results
* Despite the importance of insider trading laws in promoting a strong financial market, the impact of regulations in minimizing the detrimental effects of insider trading is unsettled.
* We add to the literature by examining the impact of the introduction of the Securities Market Amendment Act 2002 in New Zealand on several aspects of the market, namely bid-ask spreads, liquidity, price volatility and the cost of capital.
* We find strong evidence of predicted reductions in the cost of capital, bid-ask spreads and volatility accompanied by increases in liquidity. We conclude that the change in regulations has had a positive impact on the market.
Insider Trade, Regulatory Change, New Zealand
The literature on corporate governance has shown that the structure of laws within a country has a profound effect on the business environment. In particular, poor investor protection can lead to more concentrated share ownership and generate problems for businesses that seek external financing for worthy projects (La Porta et al. 1998). Given the importance of catering to the financing needs of companies and the huge benefits of a strong stock market to an economy in general, countries have had to examine all factors that reduce their appeal to savvy international investors. This has been especially important for areas that are not easily addressed by private contracting and/or enforcement between the company and its stakeholders (La Porta et al. 2000). One area in particular that has come under intense scrutiny over the previous decade and a half is insider trading regulation.
Insider trading profits come at the expense of other traders, resulting in investors either purchasing shares only at a discount or avoiding investing altogether (Manove 1989, Ausbel 1990). This lack of confidence in the integrity of the market may not only reduce the liquidity, but also slow down the pace of share offerings, affect the efficiency of resource allocation and raise the cost of capital for companies, thereby reducing their value (La Porta et al. 2000, Bhattacharya/Daouk 2002). Consequently, businesses may find themselves at a disadvantage to competitors in better regulated markets. In an effort to improve investors' protection a significant number of countries have enacted insider trading restrictions in recent years. Prior to 1990 only 34 countries had insider trading laws, whereas by 1998 these laws were present in 87 of the 103 countries with capital markets (Bhattacharya/Daouk 2002).
While some research has been done to explore the effects of regulation on controlling insider trading and the harm to markets it causes, the literature is far from complete, especially for markets outside of the US. In this paper we explore the impact that efficient regulation can have on several aspects of the market in the New Zealand context. New Zealand makes for an interesting case study for a number of reasons. It has similarities to many emerging and developing markets in terms of its size and turnover (Bhattacharya/Daouk 2002). The recent change in regulations also marks a major change both in the structure of the laws and the political will to enforce insider trading sanctions. These two factors are the most likely causes for the poor enforcement record in developing markets. Only 25 percent of emerging markets, compared to 82 percent of developed ones, had prosecuted an insider by 1998 (Bhattacharya/Daouk 2002). Given this fact, it is clear that further efforts to combat insider trading are needed and the experience of New Zealand can provide valuable guidelines for other markets that are poorly regulated at present.
There are a number of areas where the existence of insider trading laws has an impact on the market. It has been found that the first enforcement of insider trading laws resulted in a significant decrease in the cost of capital within a country and an increase in the number of analysts that follow local companies (Bhattacharya/ Daouk 2002, Bushman/Piotroski/Smith 2005). …