Profits to opportunistic insider trading before and after the Dodd-Frank act of 2010
| DOI | https://doi.org/10.1108/JFRC-02-2021-0018 |
| Published date | 31 July 2021 |
| Date | 31 July 2021 |
| Pages | 43-59 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Partha Gangopadhyay,Ken Yook |
Profits to opportunistic insider
trading before and after the
Dodd-Frank act of 2010
Partha Gangopadhyay
Herberger Business School, St. Cloud State University,
St. Cloud, Minnesota, USA, and
Ken Yook
Johns Hopkins Carey Business School, Baltimore, Maryland, USA
Abstract
Purpose –The authors examine if opportunisticinsider trading profits decrease after the enactment of the
Dodd-FrankAct (DFA) in 2010. The DFA expands legal prohibitionson insider trading in the USA.
Design/methodology/approach –The authors identify opportunistic insider trades following a
method that is outlined in Cohen et al. (2012). The authors examine univariate statistics and perform
multivariate regression tests to examine opportunistic trading profits before and after the DFA.
Similar multivariate regression tests have been used widely in the literature to examine the
profitability of insider trades.
Findings –The authors find that opportunistic insider purchaseswere highly profitable before the DFA.
Profits after opportunisticpurchases were significantly lowerafter the DFA. Opportunistic insider sales were
contrarian trades both before andafter the DFA. However, share prices kept increasing after insiders sold
their shares.
Originality/value –To the best of the authors’knowledge, the paperis the first study that compares the
profitability of opportunisticinsider trades, as identified by Cohen et al., before andafter the DFA. The study
contributesto the literature thatfinds that insiders change their strategic trading behaviorwhen the potential
costs of the illegaltrading increase due to regulatory action.
Keywords Opportunistic insider trading, Compliance and regulation
Paper type Research paper
1. Introduction
Many studies have documentedthat insider trading generates abnormal profits (Rozeff and
Zaman, 1998;Lakonishok and Lee, 2001;Piotroski and Roulstone, 2005;Cohen et al.,2012;
Wang et al.,2012;Skaife et al., 2013;Ali and Hirshleifer, 2017). Corporate insiders who are
involved with managing their businesses arguably have better information about the
intrinsic value of their firms thanother market participants. The exploitation of such private
price-sensitive information by insiders is illegal in most countries, including in the USA
(Fernandes and Ferreira,2009). Under section 16 of the Securities and Exchange Actof 1934,
insiders in the USA must report their trades to the Securities and Exchange Commission
(SEC). Sifting through the voluminousnumber of trades that are reported each year to detect
illegal insider tradingis a daunting challenge for the SEC.
Cohen et al. (2012) demonstrate a relatively simple method of detecting information-rich
opportunistic insider trades amongthe large number of trades that are reported to the SEC.
They provide evidence that the opportunistic trades “contain all the predictivepower in the
insider universe”(page 1010) [1]. Cohen et al. (2012) also report that opportunistic insiders
Profits to
opportunistic
insider trading
43
Received18 February 2021
Revised3 June 2021
Accepted22 June 2021
Journalof Financial Regulation
andCompliance
Vol.30 No. 1, 2022
pp. 43-59
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2021-0018
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1358-1988.htm
change their trading behavior drastically after news releases of SEC enforcement action,
concluding that opportunistic tradersare very sensitive to the potential costs and penalties
associated with illegaltrading.
In this paper, we use Cohen et al.’s (2012) approach to identify opportunistic insider
trades in the US firms. We, then examine the profitability of the opportunistic trades before
and after the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010 (DFA) [2]. The main goal of the DFA is to place stringent regulations on banks
and financial institutions (Akhigbe et al.,2016). However, section 746 of the DFA also
significantly broadens criminalinsider trading prohibitions that were already in the federal
code before the DFA [3]. Sections 922, 923 and 924 of the DFA also provide significant
financial incentives and protectionfor corporate whistleblowers who report securities fraud,
such as insider trading to the authorities (Kerschberg, 2011;Devine, 2014;Brink et al.,
2017)[
4]. Brink et al. (2017) report that there has been a steady increase in tips from
whistleblowers since the SEC initiated the program in 2011. The information available on
the SEC’s website show that 26,076 whistleblower tips were submitted between 2011 and
2018 in the USA, resulting in over $2bn in financial remedies and more than $300m of
financial awards to whistleblowers (sec.gov/page/whistleblower-100million). SEC Rule 21 F
makes any retaliation against a whistleblower who files a complaint under the DFA an
independent securities law violation (Devine, 2014). Enochs et al. (2018) report that the
Commodity Futures Trading Commission is also aggressively pursuing insider trading
cases using the significantlyenhanced enforcement authority under the DFA.
The enactment of new legislation such as the DFA allows us to examine insider trading
profits in two enforcement regimes:low enforcement regime (pre-DFA) vs high enforcement
regime (post-DFA). The primary motivation for our study comes from Cohen et al.’s (2012)
finding that opportunistic traders are sensitive to the costs and penalties associated with
illegal trading, and that they change their trading behavior when the potential costs of
illegal trading increase. There is also some evidence in earlier literature that information-
based strategic traders alter their trading behavior after the enactment of new securities
legislation, and after news releases about SEC enforcement actions. Seyhun (1992) finds
evidence that insiderswere reluctant to exploit private information about corporateearnings
and takeovers in the 1980s due to increased SEC enforcement and sanctions. Garfinkel
(1997) finds that increased sanctions deterred insider trading before earnings
announcements. Piotroski and Roulstone (2005) report that information-related insider
trading declined after the enactment of the Insider Trading and Securities Fraud and
Enforcement Act in 1984 and the SecuritiesEnforcement Remedies and Penny Stock Reform
Act in 1990. Piotroski and Roulstone (2005) argue that the potential costs of illegal insider
trading increased after these laws were passed, and that this led to changes in the trading
behavior of insiders. In a similar vein, we hypothesize that if the potential costs of illegal
trading increased after the enactment of the DFA, then profits to opportunistic trading
should be attenuated after the DFA. This is exactly what we find in our empiricaltests [5].
Our study adds new evidence to this literature that examines information-based strategic
insider trading in differentregulatory environments.
Relatively recent literature has also begun to explore linkages between news
dissemination by the media and subsequentchanges in the trading behavior of insiders. The
main argument is that media broadcasts of regulatory events increase fear and anxiety
among insiders about the potential costs and penaltiesassociated with getting caught after
trading illegally. This has a disciplining effect on insiders and causes insiders to eschew
strategic trading strategies, which leads to lower trading profits. For example, Dyck et al.
(2008) argue that the news media puts pressure on managers to act in socially responsible
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