Insiders with legal education may be less likely to engage in illegal insider trading

April 4, 2021

Law school makes you less likely to get involved in insider trading. (AP Photo/Andrew Harnik)

Insiders with legal expertise may be less likely to exploit private information when they buy their own company's stocks, according to a new study that examines the nexus between insider trading behavior and the legal education and expertise of corporate executives and directors.

Insider trading involves the trading of a public company's shares by insiders, who are privy to nonpublic, material information about those shares for any reason. This includes corporate executives, directors or others who own more than 10% of a company's equity securities. 

Insider trading is illegal when the material information on those stocks is not public. The Securities and Exchange Commission is the chief U.S. governmental entity responsible for the regulation of insider trading. 

When it comes to conversations about the regulation of insider trading, "People are always talking about more punishment — harsher punishment," said Chao Jiang, a co-author of the study and an assistant professor of finance at the University of South Carolina. "If you look at the laws, they mostly contain fines and prison time for this type of behavior."

Jiang told The Academic Times that he was "interested in seeing what other effective ways we could regulate insider trading," perhaps with less punishment and more education of insiders to make them aware of the issues. 

To examine this broader hypothesis on whether more legal education would decrease illegal insider trading behavior, the researchers used corporate directors and executives with legal education and expertise as a proxy. 

"I thought, maybe, let's examine their education," Jiang said. "Let's use legal expertise or legal education as a lab to see how people's understanding of law affects their insider trading behavior. If they know more about the law and understand it better, their perspective will likely be different."

To engage in this analysis, the researchers gathered a large amount of data: Stock returns data came from the Center for Research in Security Prices; financial information about companies was obtained from the Compustat database; and insider trading data came from Thomson Reuters, which obtains data from the SEC, because insiders are required to report insider trading within two business days of trading. The researchers also used the BoardEx database, which contains experience and education information on corporate insiders, to identify which insiders have law degrees. 

With this broad range of data, spanning from January 1997 to December 2012, the researchers could examine insider trading behavior and compare lawyers versus nonlawyers, according to Jiang. 

The study found that insiders with legal expertise earned significantly lower abnormal returns than nonlawyer-insiders when they purchased their own company's shares; lawyers made, on average, .63% less compared with other insiders, suggesting that lawyer-insiders were more conservative in their insider trading. 

"While less than 1% does not seem like a big deal, if you contextualize this, overall, into how much money you can make, half a percent is not a small number," Jiang said. "Especially if you accumulate over one year, you'll find you can make 7% if you follow these [insiders]." 

Moreover, while the statistical models used do not lend themselves well to cut-and-dried numbers, the study found that stock purchases by lawyer-insiders were associated with lower future earnings surprises and firm profitability than purchases by their nonlawyer counterparts and, interestingly, that lawyer-insider purchases were more muted following months with high levels of SEC enforcement activity. 

These results suggest that insiders with legal education may be more conservative in exploiting private information when making insider trades, according to the researchers. 

"Because they're lawyers, they are going to be more careful especially," Jiang said. "As a lawyer, you have this legal training. You know how serious this thing is. You want to be careful."

One limitation to this study, however, is that it is difficult to ascertain whether lawyers are a self-selecting group that makes them different from others who do not have an interest in pursuing law, according to Jiang. 

"For example," the researchers wrote, "it is possible that individuals who choose to attend law school and who subsequently find themselves serving as corporate insiders tend to be more honest, righteous, and concerned with ethics and laws, in comparison with the average corporate insider."

Notwithstanding this limitation, the implications of this research are still palpable, and the study's lessons for the finance industry are twofold. 

For regulators, Jiang said, "Maybe rather than always going after people and punishment, we should make the laws more clear and educate people about the laws. We should remind them of the easy mistakes that people tend to make and remind them to avoid that."

"Maybe in the future, the SEC can send out a newsletter every month or so to the insiders, reminding them of the new cases they got, explaining why certain cases were being prosecuted, and remind [the insiders] that you are not supposed to engage in that behavior," Jiang said, adding that this "would be a really low-cost solution."

As for the firm, Jiang said, "If you are the owner of the firm or one of the directors, you do not want the CEO to do this. You want to hire people with legal expertise. And even if they don't have that, the general counsel should have a training for them."

The study "Insider Trading and the Legal Expertise of Corporate Executives," published March 25 in the Journal of Banking and Finance, was co-authored by Chao Jiang, University of South Carolina; M. Babajide Wintoki, University of Kansas; and Yaoyi Xi, San Diego State University.

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