In the Insider Trading & Market Manipulation Literature Watch, members of our Finance Practice provide summaries and links to published research about insider trading and market manipulation. The team will provide an update each quarter.
Insider Trading
Introduction to SEC v. Panuwat: Understanding “Shadow” Insider Trading
In the groundbreaking case SEC v. Panuwat, the Securities and Exchange Commission (SEC) successfully pioneered a legal theory referred to as “shadow” insider trading. This concept extends traditional insider trading paradigms to situations where an individual, privy to material non-public information (MNPI) regarding one company, capitalizes on that knowledge to trade securities in another company. The case against Matthew Panuwat, a former executive at Medivation, illuminates this novel application of the law.
According to the SEC’s complaint, Panuwat, an employee of pharmaceutical company Medivation, became aware that Medivation would soon be bought out. Just a few minutes after learning that information, Panuwat commenced purchasing out-of-the-money, short-term call options in another company, Incyte. The SEC argued that Incyte was a closely comparable company to Medivation, and therefore, these trades in Incyte constitute prohibited insider trading.
It is difficult to overstate the expansion Panuwat represents for potential liability for insider trading. To be sure, the defense bar will attack this unfair and unwise regulation-through-litigation, and the defense bar will be joined by academics, public interest groups, and supporters in the business community. In the meantime, every entity and individual involved in the capital markets—from public companies to retail traders—need to take head of the increased risks and perils that comes with trading in a post-Panuwat market. For companies, this includes at least re-evaluating insider trading policies and educating directors, officers, and employees on the new landscape. And securities lawyers need to adjust their advice to clients and strategies for defending insider trading investigations, regulatory actions, and prosecutions.
Ultimately, Congress needs to step in and define by legislation what is and is not illegal insider trading, which it has never done to date. One can debate what should and should not be permitted, but Congressional action would provide the best opportunity for consideration of the competing considerations of the scope and contours of the insider trading laws.
Verret, J. W. and Lawrence, Greg, Introduction to SEC v. Panuwat: Understanding “Shadow” Insider Trading (April 11, 2024). George Mason Legal Studies Research Paper No. LS 24-10, Available at SSRN: https://ssrn.com/abstract=4792069 or http://dx.doi.org/10.2139/ssrn.4792069
Current Trends in Insider Trading Prosecutions
It is now something of a common place to note that insider trading law is a doctrinal mess, very much in need of legislative reform. Insider trading law has been called “confusing,” “irreparably broken,” and “unjust, irrational, and in need of significant reform.” Insider trading bills aimed to fix the broken system have routinely passed the House, but never seem to get past the Senate. In the meantime, the SEC and criminal authorities are pushing full steam ahead in the insider trading arena using available and sometimes innovative tools to cover an increasing array of conduct.
In just the past year, government authorities have brought novel insider trading charges in cases involving trading in crypto-assets, so-called “shadow trading,” and even trading in assets that are neither securities nor commodities. The most notable recent development has been the criminal authorities use of the mail and wire fraud statutes and a similarly worded securities fraud statute to prosecute insider trading. This shift was occasioned principally by a series of decisions in the Second Circuit that created uncertainty over the application of what is known as the Dirks “personal benefit test” in traditional insider trading prosecutions under the federal securities laws. As a result, criminal and civil authorities are now frequently charging the same conduct under different statutory provisions, informed by different theories of liability, and with different elements that need to be satisfied. Ironically, this has led to a situation where it is sometimes easier to bring criminal insider trading charges than civil ones.
This Article describes the various bases of insider trading liability and how they have been used in recent cases. The Article also describes the theoretical foundations of insider trading liability and how we arrived at the current framework. Finally, the Article concludes by discussing the possible future of insider trading prosecutions.
Rosenfeld, David, Current Trends in Insider Trading Prosecutions (December 10, 2023). 26 U. Penn. J. Bus. L. 54 (2023), Available at SSRN: https://ssrn.com/abstract=4754582
Corporate Insider Purchases and the Options Market: Competition among Informed Investors
Corporate insiders have superior access to information; their trades, particularly purchases, should be informative. However, the extent of their informational advantage may be limited by the presence of other informed market participants. We document less frequent insider purchases in stocks with relatively high options trading activity. These purchases are followed by negligible abnormal returns. In contrast, stocks with less active options trading experience more frequent insider purchases, which yield positive abnormal returns over the subsequent six months. Our novel approach highlights the options market’s role in screening uninformed insider trades, which ultimately contributes to more efficient stock market price formation.
Jeon, Byounghyun and Sulaeman, Johan, Corporate Insider Purchases and the Options Market: Competition among Informed Investors (June 13, 2024). Journal of Corporate Finance, volume 87, 2024 [10.1016/j.jcorpfin.2024.102613], Available at SSRN: https://ssrn.com/abstract=4864272 or http://dx.doi.org/10.1016/j.jcorpfin.2024.102613
Misappropriation of Confidential Government Information as a Property Crime
For nearly forty years, regardless of whether confidential information belonged to a government entity or a private-sector business, its misappropriation could be punished as a property crime. Lower federal courts relied on Carpenter v. United States (1987), a well-known U.S. Supreme Court decision holding that an employer’s confidential information constitutes “property” within the meaning of the federal mail and wire fraud statutes. Carpenter unanimously affirmed the mail and wire fraud convictions of a reporter and his co-conspirators who had traded securities based on prepublication information belonging to the Wall Street Journal. The Court then reaffirmed Carpenter in United States v. O’Hagan (1997), a decision that involved a law-firm partner who had purchased the securities of a tender-offer target on the basis of confidential client information. The agency-law principles that grounded the holdings in Carpenter and O’Hagan draw no distinction between selfserving employees in the public and private sectors. When confidential information is used for personal profit, both public and private entities are deprived of their information’s exclusive use, and the misappropriators are unjustly enriched.
Nagy, Donna M., Misappropriation of Confidential Government Information as a Property Crime (June 20, 2024). Indiana Legal Studies Research Paper No. 524, 77 Florida L. Rev __ (2025), Forthcoming, Available at SSRN: https://ssrn.com/abstract=4871927 or http://dx.doi.org/10.2139/ssrn.4871927
Unobservable Information Acquisition and Insider Trading
Insider trading within the stock market presents a complex challenge, exacerbated by the advent of big data. This phenomenon introduces heightened transparency, potential for algorithmic collusion, and the integration of artificial intelligence, complicating regulatory efforts to curb such activities. While recent studies on insider trading have predominantly adopted an empirical approach, a robust theoretical foundation is essential for understanding market dynamics and informing regulatory strategies. This paper expands Kyle’s (1985) insider trading model to incorporate the costs of acquiring unobservable information, showing no pure strategy equilibrium exists post-transaction, leading to early or late insider entry. Our findings highlight optimal deviations for insiders, either by trading on early information access or delaying information acquisition to reduce costs without impacting returns. Our theoretical insights provide a basis for further empirical validation and discussion, highlighting the need for adaptive regulatory frameworks in the digital age.
Zhang, Xiangguo and Chen, Shangrong and Xie, Danxia, Unobservable Information Acquisition and Insider Trading. Available at SSRN: https://ssrn.com/abstract=4855689 or http://dx.doi.org/10.2139/ssrn.4855689
Do Proprietary Costs Deter Insider Trading?
Insider trading conveys insiders’ private information to outsiders. This private information potentially benefits rival firms, which may reduce the competitive advantage of the insiders’ firms. Using a composite proprietary cost measure, we find proprietary costs are negatively associated with insiders’ purchases, especially when their trades are more likely to be informative to rivals. Consistent with proprietary costs increasing the costs of insider purchases and, hence, the expected benefits required to trade, insiders earn significantly higher abnormal profits when proprietary costs are higher. Exploiting settings with exogenous and event-driven variation in proprietary costs, we find insiders significantly reduce their purchases when noncompete agreement enforceability is high and before new product launches. Moreover, firms with higher proprietary costs are more likely to impose window-based insider trading restrictions and insiders with greater equity holdings reduce their purchases more strongly in the presence of proprietary costs. Finally, we provide evidence of real effects of insider trading on rivals’ investment decisions. We find that investments are associated with insiders’ purchases at rival firms, and these associations are stronger when proprietary costs at rivals are higher. Our findings indicate insiders and firms are aware of potential proprietary costs when insiders trade on private information, and respond accordingly.
Choi, Lyungmae and Faurel, Lucile and Hillegeist, Stephen A., Do Proprietary Costs Deter Insider Trading? (January 16, 2024). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4813090 or http://dx.doi.org/10.2139/ssrn.4813090
Can Machines Better Predict Insider Trading?
Machine learning models predict the likelihood and magnitude of insider trading strikingly better than linear models such as OLS and logistic regression. We utilize hybrid model SHAP values alongside machine learning methods including Random Forest and Extreme Gradient Boosting (XGBoost), and linear models encompassing logistic regression and LASSO, optimized through Bayesian hyperparameter tuning, and find that machine learning models can boost R2 for the models that predict the magnitude of insider selling between 200% and 585% over OLS models. Further, machine learning models can predict the likelihood of insider selling with accuracy, recall, and precision of 66%, 87%, and 68%, respectively. Additional tests indicate that machine learning models can better predict the trading behavior of females and insiders belonging to the Silent Generation.
batebi, solmaz and Elnahas, Ahmed, Can Machines Better Predict Insider Trading? (May 23, 2024). Available at SSRN: https://ssrn.com/abstract=4839465 or http://dx.doi.org/10.2139/ssrn.4839465
Do Corporate Insiders Respond to Variation in SEC Scrutiny
We rely on a roughly one-month period when SEC activity ground to a halt during a U.S. government shutdown to examine whether corporate insiders respond in their trading activities to variation in SEC scrutiny. Relying on Becker’s (1968) analysis of the economics of criminal activity, we predict that insiders internalize a lower likelihood of detection during the SEC shutdown and thus are more likely to exploit their information advantage in trading their firms’ shares. Our results suggest insiders earn abnormal profits, especially on sales of shares, during the shutdown. Findings are robust to comparing these insider trading profits to other time periods when the U.S. government shut down but the SEC did not, as well as to the profits of insiders from other countries trading in their home market at the time of the shutdown. As a mechanism underlying these results, we find that other SEC regulatory activity drops persistently with the shutdown, as reflected in the absence of SEC-issued comment letters. We also document an abnormally low frequency of comment letters after the shutdown ends, suggesting that the SEC does not make up for a lack of activity during the closure.
Bens, Daniel A. and Cassar, Gavin and Huang, Ying and Keusch, Thomas, Do Corporate Insiders Respond to Variation in SEC Scrutiny (April 30, 2024). Available at SSRN: https://ssrn.com/abstract=4836095 or http://dx.doi.org/10.2139/ssrn.4836095
Operational Losses and Insider Trading: Evidence from U.S. Financial Institutions
The stock market typically reacts negatively to the announcements of operational losses at U.S. financial institutions. We find significant evidence of opportunistic insider trading, with insiders saving an average of $67,357 through timely selling in the two months before the announcement of an operational loss. The results are concentrated among top executives and directors. Opportunistic behavior is muted for insiders with legal expertise. The results have implications for the U.S. Security and Exchange Commission’s goal of tightening restrictions on insider trading in an environment of intensifying operational risks from cyber threats and new financial technologies.
Chernobai, Anna and Curti, Filippo and Mihov, Atanas and Xiong, Xun, Operational Losses and Insider Trading: Evidence from U.S. Financial Institutions (May 20, 2024). Available at SSRN: https://ssrn.com/abstract=4834650 or http://dx.doi.org/10.2139/ssrn.4834650
Inferring Corporate Insiders’ Beliefs About Firm Value from Tax Withholding Elections
Exploiting tax withholding elections around equity compensation transactions, we find that transactions involving tax withholdings predict annualized next month returns that are 4% – 8% lower than other transactions. The informativeness of tax withholding elections is stronger in the presence of greater information asymmetry and following personal tax rate changes. Tax withholding elections are more likely to occur in blackout trading periods than sales and are more predictive of earnings announcement surprises. Insiders eventually sued by the SEC change their tax withholding elections more frequently, and the informativeness of withholding is lower in the year of an SEC enforcement action.
Clark, Ryan and Kubick, Thomas R. and Wintoki, Modupe Babajide, Inferring Corporate Insiders’ Beliefs About Firm Value from Tax Withholding Elections (May 14, 2024). Available at SSRN: https://ssrn.com/abstract=4829387 or http://dx.doi.org/10.2139/ssrn.4829387
Corporate Culture and Insider Trading Profitability
We examine the relation between corporate culture and insider trading profitability. We use the competing value framework (CVF) of Cameron et al. (2006) and classify corporate culture into external culture consisting of creation culture and competition culture and internal culture consisting of collaborative culture and control culture. Firms characterized with external cultures are likely to be more market oriented and are therefore more prone to cater to the external market and in particular respond to investor demands to attract resources to the firm. Hence, we argue that firms with higher levels of external culture will seek to restrain insiders’ access to and/or ability to exploit their private information set in an effort to booster investor confidence and increase their readiness to invest in the firm. We, therefore, expect a negative association between external culture and insider trading profitability. Using a US sample for the period 2002-2018, we find support for our hypothesis.
Costa, Mabel D and Habib, Ahsan and Harris, Terry and Ranasinghe, Dinithi and Tan, Eric K. M., Corporate Culture and Insider Trading Profitability (May 2, 2024). Available at SSRN: https://ssrn.com/abstract=4814861
Mind the Trade: Senators’ Disclosure and Stock Returns
The trading behavior of U.S. Senators has faced growing public scrutiny due to potential misuse of insider information. I document a novel empirical fact: stock trades by U.S. Senators predict abnormal returns in the same direction after disclosure — exceeding 90 bps in a month — but not after the actual transaction. I reconcile this evidence by isolating a set of potentially speculative trades (multiple purchases and sales of the same stock), which frequently originate from industries under considerable governmental oversight and public controversy. Realized returns on speculative trades earn more than 9 bps daily. Since the speculative nature becomes apparent only ex-post, there is uncertainty on the trade type at the disclosure time. Consequently, the market may overreact or mistakenly replicate also uninformed trades. In accordance, the price impact after disclosure is only temporary. Nonetheless, a trading strategy timed on disclosure yields substantial financial gains, even while being agnostic about the nature of the underlying trade. Overall, this study suggests a re-evaluation of the effectiveness of public disclosure as a disciplining mechanism for insiders. Indeed, politicians are still able to profit abnormally on many of their trades. At the same time, disclosure may unintentionally act as a catalyst in fostering noise trading.
Lazzaretto, Pietro, Mind the Trade: Senators’ Disclosure and Stock Returns (March 15, 2024). Available at SSRN: https://ssrn.com/abstract=4816497 or http://dx.doi.org/10.2139/ssrn.4816497
Firm-level Sentiment and Insider Trading
We find that insiders use a contrarian trade-timing strategy based on firm-level sentiment as proxied by two independent sentiment metrics extracted from newspapers, websites, and social media and from overnight returns. The baseline relations are stronger for windows proximate to earnings announcements with lower litigation risk, and are weaker after months of more intense insider trading actions by the SEC. The baseline relations between the sentiment proxies and the likelihood of insider trades are related to firm attributes, such as R&D intensity or number of analysts, and are similar for trades in or out of an SEC 10b5-1 plan. We observe consistently positive and significant abnormal returns and dollar paper profits for not-round-trip transactions by insiders and significantly positive (negative) actual abnormal-return (dollar) profits for round-trip insider transactions. We find weak support that trade-timing based on sentiment significantly affects insider trading profitability. Overall, the study contributes to our understanding of the motives behind insider trading decisions and emphasizes the role of different types of firm-level sentiment and role of litigation risk in shaping insider trade behavior.
Kryzanowski, Lawrence and Rouhghalandari, Ali and Wu, Yanting, Firm-level Sentiment and Insider Trading (April 14, 2024). Available at SSRN: https://ssrn.com/abstract=4794121 or http://dx.doi.org/10.2139/ssrn.4794121
Market Manipulation
Short and Synthetically Distort: Investor Reactions to Deepfake Financial News
Recent advances in artificial intelligence have led to new forms of misinformation, including highly realistic “deepfake” synthetic media. We conduct three experiments to investigate how and why retail investors react to deepfake financial news. Results from the first two experiments provide evidence that investors use a “realism heuristic,” responding more intensely to audio and video deepfakes as their perceptual realism increases. In the third experiment, we introduce an intervention to prompt analytical thinking, varying whether participants make analytical judgments about credibility or intuitive investment judgments. When making intuitive investment judgments, investors are strongly influenced by both more and less realistic deepfakes. When making analytical credibility judgments, investors are able to discern the noncredibility of less realistic deepfakes but struggle with more realistic deepfakes. Thus, while analytical thinking can reduce the impact of less realistic deepfakes, highly realistic deepfakes are able to overcome this analytical scrutiny. Our results suggest that deepfake financial news poses novel threats to investors.
Emett, Scott A. and Eulerich, Marc and Pickerd, Jeffrey Scott and Wood, David A., Short and Synthetically Distort: Investor Reactions to Deepfake Financial News (June 18, 2024). Available at SSRN: https://ssrn.com/abstract=4869830 or http://dx.doi.org/10.2139/ssrn.4869830
Fraud on the Social Media Market
An increasing amount of securities fraud is perpetrated using social media. A common scheme involves a pump and dump, where a perpetrator purchases stock at a low price, shares false information about the issuer’s future prospects that prompts others to buy the stock, that buying activity inflates the price, at which point the perpetrator dumps their shares at a profit. Social media provides a convenient means to reach and defraud thousands of investors. Moreover, established securities law doctrine prohibits pump and dump schemes regardless of the medium used to disseminate misleading information.
A recent case has called this fundamental doctrine into question. United States v. Constantinescu raises a structural barrier to recovery for pump and dump schemes that effectively immunizes fraud perpetrated on social media. By ruling that the victim must have directly surrendered property to the fraudster, any investor who purchased stock in the stock markets on the basis of a fraudster’s misinformation cannot recover. This ignores longstanding tenets of economic theory and contradicts established securities law doctrine. Further, because the structural reality of today’s markets means that nearly every pump and dump using social media will involve investors purchasing stock on the stock market, the ruling would effectively immunize nearly all fraud perpetrated on social media.
Guan, Sue, Fraud on the Social Media Market (March 25, 2024). Northwestern University Law Review Online, Forthcoming, Santa Clara Univ. Legal Studies Research Paper No. 4857628, Available at SSRN: https://ssrn.com/abstract=4857628 or http://dx.doi.org/10.2139/ssrn.4857628
Price Inflation and Price Maintenance in Securities Fraud Class Actions
Most securities fraud class actions are based on allegations that the defendant company made some misrepresentation of material fact that had the effect of maintaining stock price at a level higher than what it would have been if the market had known the whole truth about the company. But some scholars have argued that this definition of fraud is inconsistent with the fact that there is no general duty under federal securities law requiring disclosure of information simply because it is material – because reasonable investors (like enquiring minds) would want to know: If the company can simply remain silent rather than voluntarily (mis)speaking to the market, it cannot be held liable simply because stock price would have fallen if investors had known the whole truth. How then can a company be liable if it does speak to the market in some way that merely confirms what the market already thinks? Thus, scholars who question the price maintenance theory argue that absent a duty to speak, a misrepresentation must cause stock price to increase to state a claim for fraud. Nevertheless, the courts have consistently upheld claims based on a theory of price maintenance without much explanation as to why they reject the argument that literal price inflation should be required to state a claim. Rather, the courts have relied on a general duty not to lie – at least in cases involving affirmative misrepresentations – together with a duty to update information that has become misleading and a duty to correct rumors (for example) that originate from sources within the company. SCOTUS has never opined on the price maintenance theory of fraud, although it has expressly recognized this gap in its securities fraud jurisprudence.
The implications of this debate extend far beyond the mere definition of fraud. Scholars who advocate for the price inflation requirement argue that the company should be held liable only to the extent of price inflation. In contrast, the price maintenance theory suggests that the remedy should be based on the price paid and the price at which the stock settles following corrective disclosure. Price inflation is clearly a more precise (albeit limited) measure of loss. But it excuses even outrageous lies that merely maintain stock price. In contrast, the price maintenance theory depends on corrective disclosure to reveal the effect of the fraud. And since corrective disclosure may be accompanied by other items of good (or bad) news that have the effect of muting (or magnifying) price change, the price decrease following corrective disclosure often reflects more than merely undoing the misrepresentation. Mostly, scholars have worried that savvy companies will wait until they have some good news to announce before they correct an earlier misstatement – and thus soften the effects of bad news. But the much more common scenario is that corrective disclosure will come with additional bad news, which often permits buyers to make much larger claims, especially when corrective disclosure comes in the form of a dramatic event that reveals the earlier (alleged) misrepresentation. To recognize such claims means that investors will be that much more encouraged to sue, and companies will be that much more deterred from voluntary disclosure. Indeed, the primary policy motivation for requiring literal price inflation seems to be to limit the potential for compensatory damages to investor loss based on mispricing at the time of purchase – to net out the consequential losses that flow from corrective disclosure.
Booth, Richard A., Price Inflation and Price Maintenance in Securities Fraud Class Actions (May 1, 2024). Available at SSRN: https://ssrn.com/abstract=4813897 or http://dx.doi.org/10.2139/ssrn.4813897
The authors’ own abstracts are included in the newsletter and are unedited. Links to the full paper are provided. The inclusion of a paper in this newsletter does not signify that CRA or any of its experts agree or disagree with the content or conclusions therein.
