The Decoupling of Voting and Economic Ownership (IVOR nr. 88) 2012/1.2.3:1.2.3 Extending the Framework to Insider Trading

The Decoupling of Voting and Economic Ownership (IVOR nr. 88) 2012/1.2.3

1.2.3 Extending the Framework to Insider Trading

Documentgegevens:

mr. M.C. Schouten, datum 01-06-2012

Datum: 01-06-2012
Auteur: mr. M.C. Schouten
JCDI: JCDI:ADS598271:1
Vakgebied(en): Ondernemingsrecht / Rechtspersonenrecht

The previous sections have described the mechanisms through which ownership disclosure by major shareholders can improve market efficiency and corporate governance. This section extends the analytical framework to insider trading. It demonstrates that ownership disclosure by insiders essentially performs the same tasks, through the same mechanisms.

First and foremost, disclosure of insider trading may improve market efficiency. To begin, the mere fact that insiders (particularly managers) own shares constitutes fundamental information. A survey among institutional investors shows that they consider inside ownership key in making investment decisions.1 Why? Presumably because the lower the level of insider ownership, the higher the potential agency costs due to misalignment between the incentives of outside investors and management.2 On the other hand, significant inside ownership causes entrenchment, which could increase agency costs. There is some empirical research suggesting that firm value does indeed vary according to the level of inside ownership.3 Disclosure of inside ownership, by signaling the potential for increased or reduced agency costs, enables investors to assess the implications of inside ownership for the value of the share. By the same token, disclosure of transactions changing the level of inside ownership allows investors to reassess incentive and entrenchment effects and to assess the implications for the value of the share.

Disclosure of transactions by insiders also contributes to market efficiency through a different mechanism. As with disclosure of transactions by major shareholders, disclosure of transactions by insiders may convey underlying fundamental information driving the transactions.4 Even though the prohibition on trading on non-public information applies, managers can be expected to possess such information and their trades therefore potentially convey new information on the firm's prospects.5 This is evidenced by studies showing that insiders tend to purchase stock prior to an abnormal rise in stock prices and sell stock prior to an abnormal decline in stock prices.6 It may come as no surprise, then, that markets tend to respond to disclosure of insider trading.7 Moreover, the evidence suggests that the direction and magnitude of the response depends on the information the transaction likely conveys regarding the firrn's prospects as well the expected incentive and entrenchment effects.8

There is also a case for transparency of disproportionality between voting rights and cash flow rights. As with large shareholders, the extent to which managers' interests are aligned with the interests of other shareholders is influenced by their financial interest in share price performance. Just as the incentives of large shareholders may be distorted if they have disproportionally little capital at stake, so may the incentives of managers who have hedged their equity interest.9

Finally, disclosure of transactions by insiders can improve corporate governance, by facilitating enforcement of the prohibition to trade on non-public information. This mechanism is acknowledged in the recitals of the Market Abuse Directive10 and a related directive, which states that the information is not only valuable to market participants, but also constitutes a means for authorities to supervise markets.11

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McCahery & Sautner, supra note 88, at 50.

See Jensen & Meckling, supra note 24, at 313. To be sure, the efficacy of certain forms of equity based compensation currently awarded can be questioned. See generally Lucian A. Bebchuk & Jesse M. Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation (2004). Moreover, the recent financial crisis has given skeptics reason to believe that equity based compensation may distort incentives rather than align them.

See Randall Morck et al., Management Ownership and Market Valuation: An Empirical Analysis, 20 J. Fin. Econ. 293 (1988) (fmding that Tobin's Q first increases, then declines, and finally rises slightly as ownership by the board of directors rises). For a discussion of the issue of endogeneity, see supra note 33.

This notion is reflected in the recitals of the Market Abuse Directive, which contains the European rules on insider trading and states that the publication of transactions by insiders can be a 'highly valuable source of information to investors.' Market Abuse Directive, supra note 100, at 22.

Of course, insiders' trades can also be conducted for other reasons, including for diversification and liquidity reasons.

See, e.g., H. Nejat Seyhun, Insiders' Profits, Costs of Trading, and Market Efficiency, 16 J. Fin. Econ. 189 (1986); Josef Lakonishok & Inmoo Lee, Are Insider Trades Informative?, 14 Rev. Fin. Stud. 79, 93 (2001).

See, e.g., Jana P. Fidrmuc et al., Insider Trading, News Releases, and Ownership Concentration, 61 J. Fin. 2931, 2949 (2006) (finding that UK directors' purchases and sales generate statistically significant abnormal returns of 3.12% and -0.37% respectively, measured over the two-day window starling with the announcement day). See also Jesse M. Fried, Reducing The Profitability Of Corporate Insider Trading Through Pretrading Disclosure, 71 S. Cal. L. Rev. 303, 354 (1998) (explaining how investors use information on insider trading to determine whether the company's insiders believe (based on their inside information) that the stock is over- or under-valued). But see Lakonishok & Lee, supra note 154, at 82 (do not observe any major stock price changes when studying US stock market response to insider trading);Notice that the fact that markets tend to respond to insider trading allows insiders to anticipate — and exploit — the market's likely response to their trading. See Michael J. Fishman & Kathleen M. Hagerty, The Mandatory Disclosure of Trades and Market Liquidity, 8 Rev. Fin. Stud. 637 (1995

Fidrmuc et al., supra note 155, at 2933; McConnell et al., supra note 33, at 104.

See Michael L. Lemmon & Karl V. Lins, Ownership Structure, Corporate Governance, and Firm Value: Evidence from the East Asian Financial Crisis, 4 J. Fin. 1445 (2003) (studying a sample of East Asian firms during the region's recent fmancial crisis and Onding that stock returns of firms in which managers have high levels of control rights, but have separated their control and cash flow ownership, are 10-20 percentage points lower than those of other firms, consistent with the view that ownership structure plays an important role in determining whether insiders expropriate minority shareholders); Henry Hu & Bernard Black, Equity and Debt Decoupling and Empty Voting Importance and Extensions, 156 U. Pa. L. Rev. 625, 706 (2008).

10.

Market Abuse Directive, supra note 100, at 26.

11.

Commission Directive 2004/72/EC, As Regards Accepted Market Practices, the Defmition of Inside Information in Relation to Derivatives on Commodities, the Drawing Up of Lists of Insiders, the Notification of Managers' Transactions and the Notification of Suspicious Transactions, at 7, 2004 O.J. (L 162) 70.