Innovation and restrictions on insider trading

Ross Levine, Chen Lin, Lai Wei

27 May 2016

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The strong connection between technological innovation and long-run economic growth has spurred researchers to explore which factors drive technological innovation. The finance and growth literature has discovered that better developed financial markets foster economic growth primarily by boosting productivity growth and technological innovation.1 In turn, the law and finance literature shows that legal systems that protect small investors from corporate insiders enhance the operation of financial markets.2

An open question, however, is whether legal systems that protect outside investors from corporate insiders by restricting insider trading — trading by corporate official or major shareholders on material non-public information — accelerate or slow technological innovation. Theory offers differing perspectives. Leland (1992) stresses that trading by corporate insiders quickly reveals their information in public markets, improving stock price informativeness. Thus, restricting insider trading can hinder price discovery and reduce the efficiency of resource allocation, especially among opaque activities such as innovation. Demsetz (1986) argues that for some firms, insider trading is an efficient way to compensate large owners for exerting sound corporate control over management. Thus, restricting insider trading can impede effective governance and investment. Stein (1988) and Shleifer and Summers (1988) explain how highly liquid markets can attract myopic investors and facilitate hostile takeovers, which can in turn incentivise managers to forgo long-run, profit-maximising investments to satisfy short-term performance targets. From these perspectives, restricting insider trading slows innovation.

Other theories, however, highlight mechanisms through which restricting insider trading accelerates innovation. Fishman and Hagerty (1992) and DeMarzo et al. (1998) stress that restricting insider trading reduces the ability of corporate insiders to exploit other investors, which encourages those outside investors to expend resources assessing and valuing firms. This can improve the valuation of difficult to assess activities, such as technological innovation, and enhances the quality of investment. In addition, if restricting insider trading boosts market liquidity, this can make it less costly for investors who have acquired information to profit by trading in public markets, which can in turn encourage investors to acquire information on firms. Furthermore, Edmans (2009), Manso (2011), Ederer and Manso (2013), and Ferreira et al. (2014) show that improvements in stock price informativeness can enhance managerial incentives and foster investment in long-run, value-maximising endeavours, such as innovation.

Existing evidence has not yet resolved these conflicting views. For example, two sets of empirical findings suggest that restricting insider trading slows innovation. First, Bhattacharya and Daouk (2002) find that restricting insider trading boosts stock market liquidity, and Fang et al. (2014) show that greater stock market liquidity slows technological innovation by facilitating takeovers and encouraging managerial myopia. Second, Bushman et al. (2005) find that restricting insider trading encourages more analyst coverage, and He and Tian (2013) demonstrate how increases in the number of analyses covering firms slows the rate of technological innovation. In contrast, other work suggests that restricting insider trading will accelerate innovation. Specifically, researchers find that restricting insider trading lowers the cost of capital (Bhattacharya and Daouk 2002) and enhances stock price informativeness (Fernandes and Ferreira 2009), both of which can stimulate innovation.

In a recent paper, we provide the first assessment of the impact of insider trading restrictions on innovation (Levine et al. 2015). To conduct our study, we use the staggered enforcement of insider trading laws across countries. For 103 countries starting in 1961 (US), Bhattacharya and Daouk (2002) provide the date when a country first prosecutes a violator of its insider trading laws. Thus, for each country, we create an enforcement indicator that equals one after a country first enforces its insider trading laws and zero otherwise. We use the date on which a country first enforces it insider trading laws, rather than the date on which a country enacts those laws, because Bhattacharya and Daouk (2002) show that it is enforcement, not enactment, that matters for the functioning of financial markets.

To measure innovation, we construct six patent-based indicators. We obtain information on patenting activities at the industry level in 94 countries from 1976 through 2006 from the European Patent Office’s Worldwide Patent Statistical Database. We compile a sample of 76,321 country-industry-year observations and calculate the following proxies for technological innovation:

  1. The number of patents to gauge the intensity of patenting activity;
  2. The number of forward citations to patents filed in this country-industry-year to measure the impact of innovative activity;
  3. The number of patents in a country-industry-year that become ‘top-ten’ patents (i.e., patents that fall into the top 10% of citation distribution of all the patents in the same technology class in a year, to measure high-impact inventions);
  4. The number of patenting entities to assess the scope of innovative activities;
  5. The degree to which technology classes other than the one of the patent cite the patent to measure the generality of the invention; and
  6. The degree to which the patent cites innovations in other technology classes to measure the originality of the invention.

In our baseline analyses, we find that the enforcement of insider trading laws is associated with a material and statistically significant increase in each of the six proxies of innovation. For example, the number of patents rises, on average, by 26% after a country first enforces its insider trading laws and the citation counts rise by 37%. Figure 1 illustrates the dynamic relationship between the citation-based measure of innovation and the first time that a country enforces its insider trading laws. For each country, we calculate the average citation counts received by patents filed by its residents in each year. We then trace out what happens to this innovation measure in the years before and after an average country enforces the insider trading laws. As shown, there is a significant increase in innovation after a country starts enforcing its insider trading laws. Figure 1 indicates that there is not a trend in innovation prior to the year in which a country first enforces its insider trading laws. The overall pattern suggests that enforcing insider trading has an immediate and enduring simulative effect on innovation.

Figure 1 Dynamics of insider trading law enforcement and innovation

Citation

The figure plots the dynamic impact of the enforcement of insider trading laws on country-level innovative activities. Citation equals the natural logarithm of one plus the total number of truncation-adjusted citations to ultimately granted patents in country c, and in year t, where t is the application year. The figure provides a 25-year window spanning from 10 years before to 15 years after the year of initial enforcement of insider trading laws. The year of initial enforcement, year zero in the figure, is excluded and serves as the benchmark year. The dotted lines represent the 95% confidence interval of the estimated effect of enforcement on citations, where standard errors are clustered at the country level. The analyses control for the economic size of the country, its growth rate, measures of the development of the country’s stock market and banks, as well as country and year fixed effects.

We augment the baseline analyses to test whether the cross-industry changes in innovation after the enforcement of insider trading laws are consistent with two theoretical perspectives of how insider trading shapes innovation. First, if insider trading curtails innovation by dissuading potential investors from expending resources valuing innovative activities, then enforcement of insider trading laws should have a particularly pronounced effect on innovation in naturally innovative industries—industries that would have experienced rapid innovation if insider trading had not impeded accurate valuations. Second, if insider trading discourages innovation by impeding market valuations, then the enforcement of insider trading laws is likely to exert an especially large positive impact on innovation in industries with a high degree of informational asymmetries between insiders and potential outside investors. Put differently, there is less of role for greater enforcement of insider trading limits to influence innovation through the valuation channel if the pre-reform information gap is small. We use several proxies of the natural opacity and innovativeness of industries to test whether more naturally opaque and innovative industries experience a bigger jump in innovation after a country starts enforcing its insider trading laws.

We find that all six of the patent-based measures of innovation rise much more in naturally innovative and naturally opaque industries after a country starts enforcing its insider trading laws. For example, citations to patents filed after a country first enforces its insider trading laws jump about 43% more in its industries that have above the median level of natural innovativeness according to our proxies. This is illustrated in Figure 2. The same is true when splitting the sample by the natural opacity of industries. Thus, insider trading restrictions are associated with a material increase in patent-based measures of innovation and the cross-industry pattern of this increase is consistent with theories in which restricting insider trading improves the informational content of stock prices.

Figure 2 Dynamics of insider trading laws and innovation: High-tech intensive vs. non-high-tech intensive industries

Citation

The figure plots the dynamic impact of the enforcement of insider trading laws on innovative activities in high-tech intensive and non-high-tech intensive industries, respectively. Citation equals the natural logarithm of one plus the total number of truncation-adjusted citations to ultimately granted patents in industry i, in country c, and in year t, where t is the application year. The figure provides a 25-year window spanning from 10 years before to 15 years after the year of initial enforcement of insider trading laws. The year of initial enforcement, year zero in the figure, is excluded and serves as the benchmark year. The lines indicated by circles represent the estimated effect of enforcement on innovation in high-tech intensive industries. The lines indicated by triangles represent the estimated effects of enforcement on innovation in low-tech industries. The analyses control for the economic size of the country, its growth rate, measures of the development of the country’s stock market and banks, industry exports to the U.S., as well as country, industry, and year fixed effects.

We extend these analyses by examining equity issuances. One mechanism through which enhanced valuations can spur innovation is by lowering the cost of capital for investment in innovation. Consistent with this view, we find that equity issuances rise much more in naturally innovative industries than they do in other industries after a country first enforces its insider trading laws. As illustrated in Figure 3, equity issuances increase 40% more in naturally innovative industries than in other industries after a country starts enforcing its insider trading laws. These findings further support the view that legal systems that protect outside investors from corporate insiders facilitate investment in technological innovation.

Figure 3 Dynamics of insider trading laws and equity issuance: High-tech intensive vs. non-high-tech intensive industries

Total Proceeds

The figure plots the dynamic impact of the enforcement of insider trading laws on equity issuances in high-tech intensive and non-high-tech intensive industries, respectively. Total Proceeds equals the natural logarithm of one plus the total value of equity issuances in industry i of country c in year t. The figure provides a 25-year window spanning from 10 years before to 15 years after the year of initial enforcement of insider trading laws. The year of initial enforcement, year zero in the figure, is excluded and serves as the benchmark year. The lines indicated by circles represent the estimated effect of enforcement on equity issuances in high-tech intensive industries. The lines indicated by triangles represent the estimated effects of enforcement on equity issuances in low-tech industries. The analyses control for the economic size of the country, its growth rate, measures of the development of the country’s stock market and banks, industry exports to the U.S., as well as country, industry, and year fixed effects.

References

Acharya, V V and Z Xu (2015) “Financial dependence and innovation: The case of public versus private firms”, Journal of Financial Economics, forthcoming.

Amore, M D, C Schneider and A Žaldokas (2013) “Credit supply and corporate innovation”, Journal of Financial Economics, 109: 835-855.

Beck, T, R Levine and N Loayza (2000) “Finance and the sources of growth”, Journal of Financial Economics, 58: 261-300.

Bhattacharya, U and H Daouk (2002) “The world price of insider trading”, The Journal of Finance, 57: 75-108.

Bushman, R M, J D Piotroski and A J Smith (2005) “Insider trading restrictions and analysts' incentives to follow firms”, The Journal of Finance, 60: 35-66.

Chava, S, A Oettl, A Subramanian and K V Subramanian (2013) “Banking deregulation and innovation”, Journal of Financial Economics, 109: 759-774.

DeMarzo, P M, M J Fishman and K M Hagerty (1998) “The optimal enforcement of insider trading regulations”, Journal of Political Economy, 106: 602-632.

Demsetz, H (1986) “Corporate control, insider trading, and rates of return”, American Economic Review, 76: 313-316.

Djankov, S, R La Porta, F López de Silanes and A Shleifer (2008) “The law and economics of self-dealing”, Journal of Financial Economics, 88: 430-465.

Ederer, F and G Manso (2013) “Is pay-for-performance detrimental to innovation?”, Management Science, 59: 1496-1513.

Edmans, A (2009) “Blockholder trading, market efficiency, and managerial myopia”, Journal of Finance, 64: 2481-2513.

Fang, V W, X Tian and S Tice (2014) “Does stock liquidity enhance or impede firm innovation?”, The Journal of Finance, 69: 2085-2125.

Fernandes, N and M A Ferreira (2009) “Insider trading laws and stock price informativeness”, Review of Financial Studies, 22: 1845-1887.

Ferreira, D, G Manso and A C Silva (2014) “Incentives to innovate and the decision to go public or private”, Review of Financial Studies, 27: 256-300.

Fishman, M J and K M Hagerty (1992) “Insider trading and the efficiency of stock prices”, The RAND Journal of Economics, 23: 106-122.

He, J and X Tian (2013) “The dark side of analyst coverage: The case of innovation”, Journal of Financial Economics, 109: 856-878.

Hsu, P H, X Tian, Y Xu (2014) “Financial development and innovation: Cross-country evidence”, Journal of Financial Economics, 112: 116-135.

King, R G and R Levine (1993) “Finance and growth: Schumpeter might be right”, The Quarterly Journal of Economics, 108: 717-737.

La Porta, R, F López de Silanes, A Shleifer and R Vishny (1997) “Legal determinants of external finance”, The Journal of Finance, 52: 1131-1150.

La Porta, R, F López de Silanes, A Shleifer, R Vishny (1998) “Law and finance”, Journal of Political Economy, 106: 1113-1155.

Laeven, L, R Levine and S Michalopoulos (2015) “Financial innovation and endogenous growth”, Journal of Financial Intermediation, 24: 1-24.

Leland, H E (1992) “Insider trading: Should it be prohibited?”, Journal of Political Economy, 100: 859-887.

Levine, R, C Lin and L Wei (2015) “Insider trading and innovation”, NBER working paper, No 21634.

Levine, R and S Zervos (1998) “Stock markets, banks, and economic growth”, American Economic Review, 88: 537-558.

Manso, G (2011) “Motivating innovation”, The Journal of Finance 66: 1823-1860.

Shleifer, A and L H Summers (1988) “Breach of trust in hostile takeovers”, in Corporate takeovers: Causes and consequences, University of Chicago Press, 33-68.

Stein, J C (1988) “Takeover threats and managerial myopia”, Journal of Political Economy, 96: 61-80.

Endnote

[1] On the impact of finance on productivity growth, see King and Levine (1993), Levine and Zervos (1998), Beck et al (2000). On the connections between finance and innovation, see Amore et al (2013), Chava et al (2013), Fang et al (2014), Hsu et al (2014), Acharya and Xu (2015), and Laeven et al (2015).

[2] See La Porta et al (1997, 1998) and Djankov et al (2008).

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Topics:  Financial markets Frontiers of economic research Productivity and Innovation

Tags:  innovation, patents, patenting, insider trading, enforcement, investment

Willis H. Booth Chair in Banking and Finance, Haas School of Business, University of California, Berkeley

Professor in Finance at Department of Finance, Chinese University of Hong Kong

Assistant Professor, Department of Finance and Insurance in Lingnan University (from August 2016)

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