Insider Trading in Connected Firms during Trading Bans

There is an extensive body of studies that documents that corporate insiders with access to insider information are able to earn abnormal returns by trading their firms’ shares. Insiders’ sales and purchases are considered by the market to be important signals about a firm’s prospects such that those trades are often followed by other market participants.

A less extensive literature has demonstrated that illegal insider trading, whereby insiders trade on price-sensitive information not yet disclosed to the market, can generate substantially higher abnormal returns. Still, regulation intends to create a level-playing field for all investors. This is why, prior to information releases by companies, there may be trading bans to prevent insiders from exploiting their informational advantage. For example, in the UK, there are trading bans – so-called “close periods” – in place during the 30 days before an earnings announcement.

Insiders violating insider trading regulations can face severe consequences. For instance, in 2016, two investment bankers were convicted of insider trading in the UK and sentenced to 3.5 and 4.5 years of imprisonment, respectively, along with the seizing of their assets (valued at £1.7 million), as part of Operation Tabernula led by the Financial Conduct Authority (FCA).

While insiders are prohibited from trading the shares of their firms during such close periods, they can still trade the shares of other firms. Importantly, insiders may be motivated to do so when their insider information is material and likely affects the price of other firms’ shares. Since insiders are not obliged to disclose share transactions in other firms in which they are not insiders, observing their overall trading while they are subject to a trading ban in their firm is typically not possible.

However, there is one important exception, as the trades of so-called “connected directors,” who sit on multiple boards as executive or nonexecutive directors, can still be observed. In other words, when connected directors are prohibited from trading before an earnings announcement in one of their firms, information on their transactions in their other connected firms is available.

Studying insider trades in connected firms is interesting for at least two reasons. First, directors subject to a close period in one of their firms may still be able to exploit the insider information they hold about that firm in their other firms. Hence, the results from this study have the potential to generate important insights for regulators and investors. Indeed, in April 2024, in the United States, Matthew Panuwat was found liable for purchasing stock options in a competing firm based on private information about the impending announcement of his firm’s upcoming acquisition. This is the Securities Exchange Commission’s (SEC’s) first instance of action taken against so-called “shadow trading”. It is likely that regulators from other countries, including the United Kingdom, will follow suit in the near future by taking similar actions as more evidence of shadow trading is uncovered. Second, studying insider trading in connected firms should further our understanding of how stock prices are correlated.

Our analysis is based on the London Stock Exchange, where firms are subject to a close period prior to their earnings announcements. We refer to firms subject to close periods as “close firms,” while those firms with insider transactions are referred to as “traded firms.” While in the United States, trading bans (also known as “blackout periods”) are set by each firm and therefore vary across firms, in the United Kingdom, the close period is stipulated by regulation.

We attempt to answer the following three research questions: First, are directors more likely to trade in their connected firms when prohibited from trading because of a close period in one of their firms? Second, are such transactions influenced by information that emerges in the close firm during the close period? Finally, do investors effectively utilize the information from insider transactions in connected firms to trade in close firms?

What do we find? First, we observe that of the slightly more than 86,000 insider transactions during the period between 1999 and 2019, a staggering 41% were made by connected directors. Moreover, 21% of the latter type of transactions were made when one of the firms of the director who was trading was subject to a close period. Second, and importantly, we find that when their trading is restricted by a close period, directors tend to trade more frequently in their connected firms. Third, the direction of the trade in the connected firms (i.e., a purchase or a sale) is determined by whether the insider information about the firm subject to a close period is positive or negative, as measured by the subsequent earnings surprise and the subsequent market reaction to the earnings announcement. Finally, we find that the market reactions in the traded firms are positively correlated with the market reactions in the close firms. We assess the market reactions to insider trades via the cumulative abnormal returns (CARs) around the announcement date of the trades. For the close firms, we compute the CARs over the same event window as used for the traded firm.

It could still be the case that the positive correlation is brought about by broader market trends that cause synchronized movements in share prices. Hence, we perform a placebo test consisting of creating artificial connections between pairs of unconnected firms. However, this test fails to reveal a correlation between the market reactions in the artificially paired firms. We conclude that the positive correlation between the market reactions stems from connected directors’ transactions rather than from wider market movements.

To understand the mechanisms behind the positively correlated market reactions, we conduct two analyses, consisting of controlling for the type of relationship that exists between the connected firms and the effects of institutional ownership on the market reaction.

We did the following. First, the positive correlation between the market reactions is strengthened if there is a friendly relationship between the connected firms. We define friendly relationships in two ways. Firstly, there is a friendly relationship between two connected firms, if the FactSet database considers both firms to be partners. Secondly, alternatively, we consider connected firms from the same highly concentrated industry to have a friendly relationship.

Second, the positive correlation is more pronounced when the connected firms have high institutional ownership. This suggests that institutional investors closely monitor the trading activities of connected directors, especially during the close periods. When connected directors trade shares in their other connected firms, institutional investors seize the opportunity and trade in the close firms, thereby creating the positive correlation between the market reactions. Further analysis reveals that the stock market reactions in the connected firms do not occur synchronously, as the market reaction in the firm subject to a close period happens shortly after the market reaction in the traded connected firm. Hence, the market reactions are synchronized, but not synchronous.

To conclude, this study extends the existing insider trading literature by highlighting the exploitation of informational advantages by insiders during close periods across the multiple firms on whose boards they sit. Insiders are able to bypass the trading ban in one of their firms by trading in their connected firms. While such insider trades are not illegal, are they ethical? Policymakers may consider extending the close period that applies to one firm to all the other firms that share the same director.

1. Insider Trading Propensity
   When trading is restricted by a close period (blackout period) in one firm (the close firm), connected directors are more likely to trade in their other connected firms (the traded firms).
2. Insider Trading Direction
   The decision to buy or sell shares in the traded firms is determined by the nature of the insider information about the close firm. Positive information about the close firm increases the likelihood of purchases in the traded firm, while negative information increases the likelihood of sales.
3. Correlated Market Reactions
   The market reaction to insider transactions in the traded firms is positively correlated with the market reaction in the close firms. This positive correlation suggests that sophisticated investors, i.e., institutional investors, observe the insider trading in one firm and then mimic it in a connected firm that is subject to a trading ban.
4. Business Relationships
   The positive correlation between the market reaction in the traded firms and the market reaction in the close firms is stronger if the connected firms have a friendly relationship.
5. The Effect of Institutional Investors:
   Greater institutional ownership amplifies the correlation between the market reaction in the traded firms and that in the close firms.