How does insider trading affect the market – Insider trading can undermine confidence in the market. This practice can generate abnormal profits for insiders to the detriment of outside investors. This study analyses the behavior of the stock returns of five Chilean companies involved in insider trading between 2004 and 2014.
These cases are related to information about the company’s businesses, the publication of financial statements, merger agreements, and firm acquisitions. By studying the events, abnormal returns were calculated before and after the announcements made by the companies to the Commission para el Mercado Financier. Four of the five analyzed cases observed positive and significant abnormal returns in the days before the announcement. In addition, the average daily abnormal return is 6.85% between the day before and the day of the announcement, which is statistically report above shows the benefits that the leak of private information could generate.
Keywords insider trading; event study; abnormal event; emerging market
In Chile, there is anecdotal evidence of some investors or groups of investors using privileged information in the stock market. Confidential information or insider trading refers to a situation in which an individual is within an organization ( insider ), has access to relevant and non-public information, and uses said information to conduct a commercial transaction ( trading ).
The financial press illustrates what is happening in Chile. For example, Miguel Medill, director for Latin America of the consultancy Omega IGF, referring to the practices and regulations of share transactions in Chile, points out that “the perception quite bad within the corridors of developed stock markets; there is a lot of information confidential, and the volumes that are traded are tiny” ( Torre alba, 2018, p. 44 ). Diego Pardew, a lawyer from the Ferrada-Nehme law firm, mentions that “in the United States, for example, there is a lot of caution to avoid the use of privileged information.
But in Chile, there is no such fear, nor of the sanction that may fall” ( Torre alba, 2018, p.45). In addition, Ximena Chong, head of the High Complexity Prosecutor’s Office, believes that “Chile still constitutes tiny and minimal markets, where the actors are the same, they know each other, they maintain links between them, and therefore they turn out to be fertile grounds for information transferred” ( Torre alba, 2018, p. 46 ). On the other hand, in recent years, Chile has lost positions in the Doing Business ranking ( World Bank Group, 2017, 2019 ) regarding the minority investor protection item: in 2017, Chile’s ranking was 32 (among 190 economies ); and in 2019 it was 64, below other countries in the region such as Argentina (ranking 57), Brazil (48), Colombia (15) and Peru (51).
How does insider trading affect the market?
These cases were not the only ones that occurred in the country during that period. Still, they were chosen for this study because they meet two characteristics: extensive coverage by the press and an impact on public opinion. Information on these cases is available from different sources for analysis.
The use of privileged information in Latin America is a less studied topic. It should noted that although confidential information covered in the financial literature, most studies focus on the United States. In this regard, from a legal perspective, Gonzalo Garcia Palominos ( 2013, 2015 ), Antonio Bascuñán Rodríguez (2017) and Maria Fernanda Vasquez Palma ( 2010a, 2010b ) study the use of privileged information in Chile; and Jorge Tornado Angria (2008) explores it in Colombia. Also, in Chile, Luis Amnestic-Rivas et al. (2017) suggest a leak of private information in acquisition announcements.
In Brazil, Orleans Silva Martins et al. (2013) and Luis Gyro et al. (2014) study insider trading. This study contributes to the emerging markets literature. In addition, the novelty of this study is the analysis of five cases of use of privileged information that, unlike the analysis of large samples and in general, allows us to observe the characteristics of the operation (information about the company’s business, the publication of Financial Statements, and merger and acquisition agreements) and examine their effect on stock returns.
Formulation of the Problem and Literature Review – how does insider trading affect the market
The problem with the use of privileged information is that it negatively affects the efficiency, competitiveness and transparency of a stock market since it is an activity that is presumed to be unfair and also implies a breach of fiduciary duty by those who use privileged information.
Who uses privileged information? In the context of using confidential information in emerging markets, and based on the analysis of the cases addressed in this study, it seeks to answer the following investigation questions: how do stock returns behave in the days before the events or advertisements?; And are there extraordinary benefits for insiders? To answer these questions, we examine the reaction of stock prices to company announcements. Said reaction measured by calculating abnormal returns over days around the date of the information or event in question. This methodology has been used in previous studies, such as Man-Yin Cheek et al. (2006) and An up Agrawal and Tommy Cooper (2015).
It should be kept in mind that the existence of abnormal returns is also associated with other events, for example, with the first day of an initial public offering of shares ( Ritter and Welch, 2002 ), the intervention of regulatory bodies in the context of the combination of business ( Aktas et al., 2004 ), credit rating improvements ( Amin et al., 2020 ), and with large economic shocks such as the one caused by the containment measures to face the COVID-19 pandemic ( Pandey and Kumara, 2021 ).
Use of Privileged Information
In Chile, privileged information is any information referring to a securities issuer (to its business or to the issued securities), not disclosed to the market and knowledge of which may influence the price of the issued securities, for example, shares ( Law 18,045, 2014, article 164 ). It also the information “that held on decisions of acquisition, disposal and acceptance or rejection of specific offers of an institutional investor in the stock market” ( Law 18,045, 2014, art. 164 ).
It is understood that the operation in the stock market ( trading/dealing ) carried out by someone who possesses privileged information due to a unique personal quality ( insider ). In a broad sense, trading/dealing covers not only the operation in the stock market carried out in possession or use of privileged information but also the disclosure of privileged information and the recommendation to operate; As of 2014, common European law also covers the operation carried out by the recipient of the offer, the disclosure of the request, and the cancellation or modification of orders to operate. Likewise, in a broad sense, the insider encompasses not only those with a unique personal quality but also all possessors of privileged information. ( Bascuñán Rodríguez, 2017, p. 934 )
How does insider trading affect the market?
The line between what is fair and what is unfair has been the subject of considerable legal argument. According to Hayne Leland (1992), the United States Congress decided in 1934 that using privileged information was unsuitable for financial markets. Since then, this matter has regulated by the Securities and Exchange Commission (SEC). The Securities Exchange Act of 1934 justifies insider trading regulation on the presumption that such activity is unfair to investors outside the organization. Therefore, US insider trading cases emphasize breach of fiduciary duty by employees using insider information rather than unfairness (Leland, 1992 ).
Regarding the effects of privileged information on the markets, Fugato Chakra arty and John McConnell (1999) point out that the main argument against using confidential information is that it operates to the detriment of external investors, who would then leave the market. They would take their capital, while the argument in favour of allowing insider trading is that it leads to more informational pricing. Bascuñán Rodríguez (2017) points out that there are two approaches to insider trading: 1) the macro-approach of European law, which considers it an attack on the integrity and efficiency of the stock market, and 2) the micro-focus of US jurisprudence, which conceives it as an attack against an individual interest corresponding to a fiduciary expectation.
Concerning insider trading and its legislation, Opal Bhattacharya and Haze Datuk (2002) argue that the existence and enforcement of laws regulating insider trading in stock markets is a phenomenon of the 1990s. The authors find that, of the 103 countries with stock markets, 87 of them have insider trading laws, but these apply only in 38 countries. Before 1990, 34 countries had insider trading laws., but these applied in only 9 of them (in Chile, Title XXI of the Securities Market Law, “Of privileged information”, introduced in 1994 with Law No. 19,301).
In another study, Nano Fernandez and Miguel A. Ferreira (2009) investigate the relationship between the first-time application of insider trading laws and stock price information, using data from 48 countries from 1980-2003. These authors argue that a country’s capital cost does not change after introducing insider trading laws but decreases significantly after the first trial. The authors conclude that with insider trading laws, The informative capacity of prices improves, but this increase concentrated in developed markets. Applying these laws fails to improve the information capacity of prices in countries with deficient legal institutions.
How does insider trading affect the market?
Regarding the empirical evidence on insider trading, Arthur J. Keon and John M. Pinkerton (1981) provide evidence for the US about the excess return earned by investors in acquired companies before the first public merger announcement. This study shows that insider trading was a pervasive problem, occurring at a significant level up to 12 days before the first public announcement of a merger. Later, However, bhang Balasubramnian et al.
(2016) examine the effect of regulatory changes? By the US SEC in the year 2000? About the leak of private information before the merger announcements. Balasubramanian et al.. find that the volume of abnormal transactions due to differences in information quality reduced after regulation. This indicates less information leaking after the new law. The authors also find a higher return from post-regulation announcements. The above shows that the merger announcements were a big surprise for the market due to the decrease in the leaking of private information after the regulatory changes.