Insider Trading And Innovation

Ross Levine

UC Berkeley; Milken Institute; National Bureau of Economic Research (NBER)

Chen Lin

The University of Hong Kong – Faculty of Business and Economics

Lai Wei

The University of Hong Kong – Faculty of Business and Economics

October 5, 2015

Abstract:

This paper assesses whether legal systems that protect outside investors from corporate insiders increase or decrease the rate of technological innovation. Based on over 75,000 industry-country-year observations across 94 economies from 1976 to 2006, we find that enforcing insider trading laws spurs innovation — as measured by patent intensity, scope, impact, generality, and originality. Consistent with theories that insider trading slows innovation by impeding the valuation of innovative activities, the relationship between enforcing insider trading laws and innovation is much larger in industries that are naturally innovative and opaque, and equity issuances also rise much more in these industries after a country starts enforcing its insider trading laws.

Insider Trading And Innovation – Introduction

The finance and growth literature emphasizes that financial markets shape economic growth primarily by boosting productivity growth (e.g., King and Levine, 1993a, b, Levine and Zervos, 1998, Rajan and Zingales, 1998, Beck et al., 2000 and Levine, 2005), and this literature has recently found a strong link between finance and the rate of technological innovation (Amore et al., 2013, Chava et al., 2013, Fang et al., 2014, Hsu et al., 2014, Acharya and Xu, 2015 and Laeven et al., 2015). Partially motivated by research on finance and growth, the law and finance literature stresses that legal systems that protect the voting rights of minority shareholders and limit the ability of large shareholders and executives to expropriate corporate resources through self-dealing transactions enhance financial markets (e.g., La Porta et al., 1997, 1998, 2002, 2006 and Djankov et al., 2008). What these literatures have not yet addressed is whether legal systems that protect outside investors from corporate insiders influence a crucial source of economic growth—technological innovation. In this paper, we focus on one such protection. We examine whether restrictions on insider trading—trading by corporate officials, major shareholders, or others based on material nonpublic information—influences technological innovation.

Theory offers differing perspectives on whether restricting insider trading would accelerate or slow innovation. One set of theories suggests that restricting insider trading enhances the valuation of and hence improves investments in technological innovation. This view builds from the premise that technological innovation is difficult for outside investors to evaluate (e.g., Holmstrom, 1989, Allen and Gale, 1999), so that improving incentives for acquiring information enhances valuations, lowers the cost of capital, and improves investment in innovative activities (Merton, 1987, Diamond and Verrecchia, 2012). One way that restricting insider trading can increase incentives for acquiring information is by reducing the ability of corporate insiders to exploit other investors, which encourages those investors to devote more resources to valuing firms and improves the informativeness of stock prices, as modeled by Fishman and Hagerty (1992) and DeMarzo et al. (1998) and shown empirically by Bushman et al. (2005) and Fernandes and Ferreira (2009). Another way that restricting insider trading can improve valuations is by boosting market liquidity (Bhattacharya and Doauk, 2002). Greater liquidity can make it less costly for investors who have acquired information to profit by trading in public markets (Kyle, 1984), which encourages investors to devote more resources toward collecting information (Holmstrom and Tirole, 1993). Furthermore, market liquidity can facilitate arbitrage trading activities and correct the pricing of mis-valued stocks (Chordia, Roll, and Subrahmanyam, 2008). Thus, restricting insider trading can improve the valuation of and enhance investment in innovation.

Other theories, however, suggest that restricting insider trading can deter effective price discovery, with adverse effects on innovation. For example, Leland (1992) stresses that insider trading quickly reveals that information in public markets, improving the informativeness of prices and the allocation of resources. And, Grossman and Stiglitz (1980) argue that when liquid markets immediately reveal information to the public, this reduces the incentives for investors to expend private resources acquiring information on firms. From these perspectives, restricting insider trading could slow innovation by increasing informational asymmetries about novel endeavors.

By influencing price discovery and market liquidity, insider trading can also affect managerial incentives. To the extent that restricting insider trading enhances the efficiency of stock prices, this can reduce the disincentives of investing in opaque and risky, albeit value-maximizing, innovative endeavors, as suggested by the work of Manso (2011), Ederer and Manso (2013), and Ferreira et al. (2014). In contrast, highly liquid markets can both (a) attract myopic investors who chase short-run profits (e.g., Bushee, 1998, 2001), which can incentivize managers to forgo profit-maximizing long-run investments in order to satisfy short-term performance targets (Stein, 1988, 1989) and (b) facilitate takeovers (Kyle and Vila, 1991), which can encourage managers to choose investments that boost short-run profits instead of longer gestation investments in innovation (Shleifer and Summers, 1988). Thus, theory suggests that restricting insider trading can either enhance or harm managerial incentives, with correspondingly conflicting predictions about the impact of insider trading on innovation.