Information Networks: Evidence from Illegal Insider Trading Tips

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Information Networks: Evidence from Illegal Insider Trading Tips

Kenneth R. Ahern

University of Southern California – Marshall School of Business


This paper exploits a novel hand-collected dataset to provide a comprehensive analysis of the social relationships that underlie illegal insider trading networks. I find that inside information flows through strong social ties based on family, friends, geographic proximity, and ancestry. On average, inside tips originate from corporate executives and reach buy-side investors after three links in the network. Inside traders earn prodigious returns of 35% over 21 days, with traders farther from the original source earning lower returns, but higher dollar gains. More broadly, this paper provides some of the only evidence on information networks that employs direct observations of person-to-person communication.

Information Networks: Evidence from Illegal Insider Trading Tips – Introduction

In March 2007, a credit analyst at UBS learned through his job that the private equity firm, Hellman & Friedman, would acquire the software company, Kronos. On March 14, the UBS analyst tipped this information to his friend, Deep Shah, an analyst at Moody’s. On the same day, Shah tipped the information to his roommate’s cousin, Roomy Khan. The following day, Khan tipped two former business associates: Jeffrey Yokuty and his boss, Robert Feinblatt; and two friends: Shammara Hussain and Thomas Hardin. On March 19th, Hardin tipped his friend, Gautham Shankar, who tipped Zvi Goffer, David Plate, and unidentified traders at the investment firm Schottenfeld Group. Plate subsequently tipped others at Schottenfeld and Goffer tipped his long-time friend, Joseph Mancuso. After the acquisition was officially announced on March 23, the group of inside traders had realized ill-gotten gains of $2.9 million in nine days.

Figure 1 shows that these trades are a small part of a larger network of 50 inside traders centered around Raj Rajaratnam, the former hedge fund manager of the Galleon Group. In turn, this network is just one of many networks of inside traders. Who are inside traders? How do they know each other? What type of information do they share, and how much money do they make? Existing research provides few answers to these basic questions. Yet, illegal insider trading is an important component of the stock market. Augustin, Brenner, and Subrahmanyam (2014) suggests that 25% of M&A announcements are preceded by illegal insider trading. Similarly, the U.S. Attorney for the Southern District of New York believes that insider trading is “rampant” (Frontline, 2014). More broadly, a better understanding of illegal insider trading might provide insight into how social relations influence the activity of market participants in general (Hong and Stein, 1999).

To provide answers to these basic questions, this paper provides a comprehensive analysis of 183 insider trading networks. I identify networks using hand-collected data from all of the insider trading cases filed by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) between 2009 and 2013. The case documents are highly detailed. They include biographical information on the insiders and descriptions of their social relationships, such as family, friends, and business associates. They also include the specific information that is shared, the date the information is shared, the amount and timing of insider trades, and the types of securities traded. To complement the case documents, I collect a sample of counterfactual observations from the LexisNexis Public Records Database (LNPRD). This sample includes insiders’ broader social networks of family members, neighbors, and associates, including people not named as insiders in the case documents. The data cover 1,139 insider tips shared by 622 insiders who made an aggregated $928 million in illegal profits. In sum, the data assembled for this paper provide an unprecedented view of how investors share material, nonpublic information through word-of-mouth communication.

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