Insider trading rules

Contact: Jeffrey Bendix, 216-368-6070, jxb34@po.cwru.edu

Posted 8/12/97

INSIDER TRADING DISCLOSURE RULES MAY BE COUNTERPRODUCTIVE

Rules compelling corporate insiders to disclose their trading in their company's stock may be creating incentives for informed insiders to manipulate such trades to their advantage, according to two finance experts.

Writing in a leading academic business journal the researchers -- Ranga Narayanan, assistant professor of banking and finance at the Weatherhead School of Management, Case Western Reserve University; and Kose John, professor of banking and finance at the Stern School of Business, New York University -- contend that disclosure rules create incentives for an informed insider to exploit knowledge for financial gain.

Market manipulation occurs, say the authors, when an insider trades in the "wrong" direction; that is, buying when the insider has bad news about the company or selling on good news. This contrarian trading reduces the informativeness of subsequent trade disclosures by causing the market to be unsure of whether the trade indicates good or bad news. Consequently, the insider maintains information superiority over the market for a longer period of time, and uses it later to reap large profits by trading in the "right" direction -- more than offsetting the losses from the initial "wrong" trade.

In support of their argument, the authors note that companies' announcements of good and bad news frequently are preceded by insider trading in the wrong direction, or by the absence of insider trading in the right direction.

The authors add that the "short swing profit" rule, requiring insiders to return any profits from a sell-buy or buy-sell transaction made within six months, reduces the incidence of market manipulation and improves market efficiency. Greater enforcement of the rule, which is now voluntary, would help to reduce market manipulation. Manipulation could be further reduced by compelling disclosure of trades before they are executed, rather than afterward.

The study, "Market Manipulation and the Role of Insider Trading," appears in the April 1997 edition of the University of Chicago's Journal of Business.