The Response of Insider Trading to Changes in Regulatory Standards

By Allen, Steven A. | Quarterly Journal of Business and Economics, Autumn 1990 | Go to article overview

The Response of Insider Trading to Changes in Regulatory Standards


Allen, Steven A., Quarterly Journal of Business and Economics


The Response of Insider Trading to Changes in Regulatory Standards

Abstract

This study reconsiders the question addressed in Jaffe[10]: Does the

trading behavior of insiders respond to changes in regulatory standards?

Contrary to Jaffe's conclusion, this study finds that insiders adjusted

their willingness to exploit negative, nonpublic information concurrent

with major events in the Texas Gulf Sulfur (TGS) litigation. The

difference in findings is attributable to two improvements upon Jaffe's

study: the appropriate specification of the effect of the District Court's

opinion in the TGS case on the profitability of insider trading and the

separate analysis of the unexpected returns associated with purchase and

sales transactions.

Introduction

Reports of the misuse of inside information by securities traders have increased dramatically in recent years. In response to these allegations, Congress and the Securities and Exchange Commission (SEC) enacted several changes to the Securities Laws and the procedures used to enforce them. Although a major objective of these changes was to reduce or eliminate the exploitation of the investing public by insiders, to date there is little empirical support for the proposition that insiders alter their trading behavior in response to changes in the regulatory environment. In the only detailed study of the effects of changes in regulatory standards on the trading behavior of corporate insiders, Jaffe[10] finds that neither the indictment nor the federal District Court's opinion in the landmark SEC v. Texas Gulf Sulfur and Company (TGS)(1) case affected the trading profits earned by insiders. The appropriateness of Jaffe's research design and, consequently, the validity of his inferences, however, are open to question.

This paper reports the results of a reexamination of the effects of the TGS litigation on the trading profits earned by corporate insiders. After incorporating several modifications to Jaffe's[10] research design, this study finds that an association did exist between specific events in the Texas Gulf Sulfur litigation and changes in the profitability of sales transactions by insiders. This association is consistent with the hypothesis that corporate insiders altered their trading behavior as the courts shifted the stringency of the material fact standard governing the significance of the nonpublic information required to be disclosed prior to corporate officials being able to trade legally in their firm's shares.

Jaffe's Study of SEC v. Texas Gulf Sulfur

The influence of one particular set of investors, corporate officials and beneficial owners (insiders),(2) on the securities markets is of particular concern to regulators and legal and financial researchers. This concern appears to arise from a belief that investor confidence in the fairness and integrity of these markets is reduced if corporate officials are not constrained from exploiting nonpublic information about their firms[22].

Beginning in the early 1960s, the SEC initiated a program of rigorous enforcement of the antifraud provisions of the Securities Acts of 1933 and the Securities Exchange Act of 1934. A major goal of this program was to reduce, if not totally eliminate, speculative trading by corporate insiders[13]. Jaffe[10] investigates the effects on insider trading behavior of three important events in this program: the SEC's administrative ruling In The Matter of Cady, Roberts and Co., the TGS indictment, and the Trial Court's opinion. Based on a series of pre- and postevent comparisons, he concludes that his results "do not suggest that regulatory changes had an effect on the profitability of insider trading"[10, p. 109].(3) Although Jaffe's results have been neither replicated nor extended, they have been cited frequently as evidence that changes in regulatory standards do not affect the trading behavior of insiders[4,21]. …

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