Insider Trading: Efficient Theories and Empirical Work



Over the past few decades, insider trading has been the focus of society’s attention due to a several schemes by which conspirators have made millions. The names of Boesky, Milken, and Levine have become public to observers of financial news and the public more generally . Insider trading is the purchase or sale of securities by corporate insiders, who exploit monopolistic information to gain from abnormal profits. Monopoly information is privileged, price-sensitive, and material non-public information . Material in this context is information that is likely to have a significant impact on the market price of the issuer’s securities or that reasonable investors are likely to consider important in deciding whether to purchase or trade a particular security . Moreover, insiders should be viewed as people who generally seem to be majority of investors with prescribe access to privileged information, including the company’s executives and employees and their developments and associates, a company’s bankers contestants, financial advisers, etc. The definition also encompasses directors of listed companies and their spouses and minor children. Hence, those persons who can derive the greatest benefit from privileged pieces of information, provided the appropriateness but not the legality of their obtaining it, are undoubtedly persons and organizations who do not draw the concern of their belongings and somehow remain hidden from the authorities due to their holding structures based on the ownership of nominee owners. Stock splits, dividend boosts, and the release of merger statements can have a material progressive effect on the share price. Hence the aids are most probable illegal trading in such kinds of information due to the fact they can boost their revenues prior to the announcement of these fundamentals.

While such trading is illegal under U.S. securities provisions, the fact that most depressingly cases are mainly criminal provides ample reason. Insider trading citations suggest that the most robust form of the theory is not valid, but there is a good deal of evidence that markets do come close to strong-form. The evidence generally indicates that portfolios picked at random or indices that are not actively managed often perform equally as well or even better than those professionally managed. It is astonishing how the data persistently support the remarkable efficiency of the market, but what is even more convincing is the inability of professional managers to consistently beat the market. After accounting for taxes and transaction costs, no investor can ignore this important reality: that markets are still highly efficient. Is insider trading good for the financial markets? Back in 1934, U.S. Congress made a decision and established that insider trading is regulated by the Securities and Exchange Commission (SEC) in the United States. The discussion on insider trading merits has been held at two levels: Is it fair to trade when there is differential information among traders? And is it economically efficient to allow insider trading? This work aims to go through most of the theoretical and empirical literature on insider trading and present a summary of its findings. The paper will unfold as follows: In section 2 we take a look at the laws that regulate insider trading, while section 3 will focus on identifying parties involved in insider trading and outlining their roles. Section 4 will critically analyze theories on insider trading as well as empirical evidence brought forth while Section 5 will bring this paper to conclusion.


Insider trading is regulated by two main acts: The Securities Exchange Act of 1934 and the Williams Act Amendments of 1968. These acts notably introduced SEC rule 10b-5, which comes from section 10(b) of the 1934 Act. The rule mandates that an insider discloses material inside information or abstains from trading; however, insiders are not just limited to corporate members but also any individual privy to such information directly or indirectly sourced. For information to be considered material, it must have a high probability of influencing an investor’s decision— based on its importance when making investment choices. Typically, there needs to be an element of intent (deceive/manipulate/defraud) for violation as merely possessing this type of information does not automatically imply disclosure duty.

SEC rule 14e-3 is part of the Williams Act, and it governs the flow of information during tender offers. Unlike rule 10b-5, a violation under 14e-3 does not hinge on proving scienter — that is, an intention to deceive or manipulate — nor does it need evidence that the disclosing insider breached any fiduciary duty or other obligation. Instead, 14e-3 asserts that trading while possessing material non-public information (about a tender offer) is fraud when there have been significant steps taken towards initiating a tender offer or one has already started trading— irrespective of reason or method how the person received it from insider. In reality, however, SEC has refrained from pursuing standalone charges for violating 14e-3 without tacking on accusations under 10b-5 as well.

Enforcement of insider trading regulations is primarily under the SEC. The SEC usually brings civil charges against the accused but it might also hand over cases to the Department of Justice for criminal prosecution. In some instances, if the defendant is a regulated market professional, SEC can decide to suspend or revoke their license. Most cases related to insider trading are civil cases where SEC aims at recovering the gains made by the insider or the losses that were avoided. They seek court injunctions that would stop further violations on insider trading. It’s interesting that about 70% of those accused with civil insider trading charges settle with SEC instead of going through litigation. Congress took an aggressive stance towards increasing penalties for insider trading during the 1980s by passing two acts — ITSA in 1984 and 1988 Act — substantially elevating consequences for such actions.

The interest in regulating insider trading sparked after the Dennis Levine and Ivan Boesky cases, and the Congress stepped up again in 1988 when in order to make insider trading illegal, the penalties were curved up. The 1988 Act increased the limits of criminal fines to $1,000,000 for each individual; and not more than $2,500,000 for all the corporations; increased the maximum sentence from 5 years in jail to 10 years; and required that all securities firms actively set up anti-insider trading mechanism including those of the firm as well as its employees The former rule laid out that the official could not be held by the firm for treble damage if they were not acting on behalf of the firm in violation of insider trading law. Unlike the latter rule, it was held that a company can be liable if its employees have engaged in insider trading while the firm was acting knowingly or recklessly regarding this matter. The Remedies Act of 1990 revamped the Securities Act of 1933, the Securities Exchange Act, and both 1940 Acts (Investment Company Act and the Advisers Act) to give the SEC a new set of remedies it can enforce over entities or persons who violate the provisions in the acts, or rules and regulations created thereunder. These additional remedies include an administrative burden in civil proceedings, a fine in civil proceedings, and cease-and-desist orders that may be temporary or permanent.

The other theories that are part of the laws regarding insider trading are that, insiders can be actually in person executives, board of directors’ workers or any employees responsible for making company decisions. Such an employee’s propensity to take advantage of other entity’s private info and make use of that information to trade shares violates his/her basic fiduciary duty towards his/her employer and leading to punishment under the law. Insider trading violations should not be punished if an analytical person uses public information and items of nonmaterial non-public information and reaches a conclusion that this particular corporate action or event is going to take place in the near future. The choice in these cases has nothing to do with unobservable and individual factors and is only a good work of craftsmen. The ‘mosaic’ doctrine theories provide immunity to individuals and corporations who have access to this information ‘mosaic’ and are using them on rational bases.


Behind the current wave of publicity about insider trading are the emergence of the up-to-date group of the market insiders. Instead of being a director, general manager, chairman of the board, executive officer, or a major shareholder, they could be clerical or professional workers, employees of the same company to which the information relates, or people with whom the company may or may not have a business relationship. Insiders can be classified into three categories: their roles correspond to the initial, sublimated, and created ones.

Conventional traders have now identified the internal informants among the management circles as having the privileged information that the rest of the public lacks and who for their personal gain used that secret information for a limited instance. The Securities and Exchange Commission (SEC) [section 10(b)of the Securities Exchange Act of 1934] defines an insider as an individual who is already a classified stockholder, director or officer in a company with at least 10% of the company’s voting common stock or who obtains any illegal disclosure. For the recent time spent reading the headlines, it is exactly the illegal insiders who have received news regarding the trends and innovations ahead. These information recipients can be divided into two new categories of insider trader: “Outsider-insiders” and the “intermediary inside people”. The quasi-insider is referred to as an individual, who is responsible to undertake details of a transaction review with the likely change of share prices, and who involves in private information sharing (Attorneys, CPAs). Information intermediaries provide at least three services: data mining using private information, preliminary assessment, and background analysis. Data that the market does not have access to because a private firm tries to obtain such information by interacting directly with the source is called information intermediary seeking. Forecasting is the statement of investors’ expectations on trends that may prevail in the market as a whole, by a group of the market shares, or a stock position. Reviewing past events to gain additional data and making comparisons while doing this will contribute to making the right decisions. The information intermediary only becomes an intradmic insider trader by means giving the private search operation. In the general the private information search function process deals with the legitimate ways of business-related research such as having informal talks with company management concerning quarterly earnings.

The parties involved can be extended to four: the corporation which belongs to the corporate group of which the securities traded, an insider, the person who is an insider or an outsider, and the tippee who is the person who obtains the information from the insider. Who the insider is (a traditional, a quasi, or a intermediary insider) makes no difference in terms of how bad it is for business and society. Insider trading will always lead to the same consequences: some individual victims and a big cost to society.


This was consequently the time when the root theories of assets pricing included market efficiency were developed and later on the role of information in general and of private information in particular in the capital markets functioning was obviously accepted to be scrutinized further. To the empirical research on insider trading in the early part of that decade has been added a steady stream of research addressing various issues such as: finally, existence of asymmetric information, behaviour of insiders or differently introduced firm-related events, adherence to official regulations concerning private information.

The Characteristics of Insider Trading

This section addresses the contribution of financial research literature in issues such as: amongst other aspects, namely, the ratio between insider purchasing and insider selling as a signal of insiders’ attitude, the effects of insiders’ volume on stock prices, the predicting power of insiders’ trading, and the effect that insiders’ trading activity has on market prices. According to Smith (1941), this comprised of transactions executed by insiders within the period 1935-1939. Besides, the inside access to non-public information was made possible for the insiders to turn this information into personal profitable gains. While Wu (1964), by looking at inside transactions in securities valued at 50 different companies of the New York Stock Exchange in the period 1957-1961, determines the effects of insider transaction on the price of security. First of all, researchers discover that the large majority of the insiders who register the transactions have been net sellers of their firm’s shares over the period of sample. The second among the findings of Wu is the fact that mining activity ranged from active to non-active trading, where directors and owner-directors were the most active, and large shareholders had the least trading activities. Furthermore, Wu points out that the insiders were relatively calm in both down and up markets, and this is shown by the low number of trades and the small order sizes.

Lorie and Niederhoffer (1968) determine, collect, and explain the traits and the capabilities of insiders’ transactions for prediction purposes. Their findings reveal that

(i)              insiders’ transaction sizes vary among insiders groups and

(ii)            they were net buyers (selling their firms’ shares) in the sample considered. 

Lorie and Niederhoffer find that insider transactions within a firm display the following pattern: the industries tend to be recession-led, meaning that when the economy slows down, manufacturers will be selling less and consumers will be driving less. They finalise their findings as “the crucial turning points in activities would probably be a key factor in determining the change in insiders’ expectations concerning their chip stocks”. Financial market insiders’ ability in predicting and determining the large (more than 8%) changes in the prices of their own firms’ stocks is further reinforced by the suggestions of a work conducted by Watkins and Crawford (1982) that insiders are better forecasters. Employing the data representing around 52,101 EMS purchase and sale transactions covering the companies which are listed on NYSE market from January 1960 to June 1966, the researchers analyze the dynamics of these specific signals. By the close of the study, they get into concluding “a hypothetical investor, had he or she followed the above-mentioned buy signal, would have made profit after investing in shares two months after the signal was provided”.

Lin & Howe (1990) analyze the arriving of insiders’ stock transactions issues for unlisted companies. These scholars thus conclude that the insiders “did not buy or sell precious information stock until one after earnings releases of unfavorable and favorable type information respectively” (p. 1278). The Lin and Howe also hypothesizes that mostly trades opportunities are absorbed by the high bid-ask spreads in OTC sector. Besides, in years following the high volume of trading in the market, firms trading ‘abnormal’ returns are not correlated to size. but positively link to bid ask spread and information leakage. It transpires that Lin and Howe do not provide sufficient evidence to be sure that insiders in small-sized firms are the ones exploiting the high level of information asymmetry present in their stock market transactions (p. 1283). They find evidence that the members of different insider groups have contradictory information and that the insiders who use less valuable information rely on higher transaction costs. Moreover, corroboration can be seen in Nunn (1983), Madden, and Gombola (1983) and by Eyssell (1990). As (Finnerty, 1976b) found in the study of 935 NYSE firms in 1971, he talked about the financial characteristics of insider transactions. Finnerty explains that companies whose insiders sold net shares have relatively higher market capitalization, lower eners, and give out smaller dividends as opposed to the companies whose insiders sell shares when such companies are relatively smaller, have higher earnings and give out larger dividends. According to Seyhun (1986) in this article 769 firms listed in NYSE and AMEX exchanges, and with at least one insider transaction’s data recorded between 1975 and 1981, were examined. He comes to the conclusion that (a)(b) insiders in smaller firms appear to be net buyers of their firms’ shares, while insiders in the largest firms are in the opposite though, they sell and (b) that insiders in small firms earn much more abnormal returns than insiders in big firms.201).

Insider Trading and Market Efficiency

The strong variant of an efficient market hypothesis (EMH) indicates that all available information, public and private alike, is already embedded into securities’ prices. This theory is doubted in practice. The inside people or the outsiders having a material nonpublic information will be able to make profit with the abnormal return just by trading the information. The weak version of EMH holds that current prices have already reflected in and accounted for all past related trading data, while the semi-strong form of efficiency involves the assertion that stock prices are already completely adjusted in line with publicly availed information. As Stephan P. and S. R. DeVere (1978) have revealed, such investors who have been able to buy shares after a public buy signal or released buy signal may be able to even earn excess returns as much as two months later. In his research of 1995, Ferreira mentions that private investments made by the insiders of a company also show abnormal returns because insiders manipulate and adjust their company’s stock trading toward future market fluctuations. This is a drastic outcome and it is the opposite side of the half-strong form of EMH. According to Grossman (1986), insider trading [insider trading] overall is a good thing, and it adds liquidity while also making the futures markets more efficient. But, some forms of insider trading [insider trading] lower liquidity and the viability of the futures markets. This part underlies reasons to expect the performance of both insiders and non-insiders to be better than that of the whole market. Jaffe (1974b) examines the profitability of the loan amounts that four large banks gave to their own managers, directors and manager-directors during the 1962-68 era. He discovered that practitioners generally entered the market riding the wave of unexpected share price advances and exited when it began to decline unexpectedly. Fasten and Khan (1999), furthermore, prove the same outcome by showing insiders act on the basis of their private information before all equity listings and delistings. Baesel and Stein (1979) and Pope, Morris, and Peel (1990) have both verified that immigrants take a higher opportunity cost in their host countries in Canada and Great Britain.

This reflects the increasingly vital function of insider data in the real world investing as investors make use of advisory services and newsletters that collect and analyze such data. This signifies that the insider transaction information has attributed with commercial value in terms of its influence in spotting favorable investment prospects, mitigating risks and building a good portfolio. Benesh and Pari (1987) report that “while the stocks listed in the newsletter displayed positive abnormal returns in the months preceding the listing, there is only weak evidence of abnormal returns to noninsiders who buy shares in response to open market purchases by insiders.” The evidence above shows that even though registered insiders have been less successful in anticipating changes in macroeconomics conditions, they have been able to use nonpublic, private, firm-related information to earn excess returns. The evidence also shows that any material nonpublic information impounded in insiders’ transactions is quickly reflected in share prices. Hence, any money-making schemes aimed at investors or newsletter writers by means of using Official Summary to increase the unreasonably profit is bound to be in vain (market is efficient by nature).

Insider Trading and Financial Signalling Theories

In this part we study the movement of anomalous returns and the volume of trading that proceeds and subsequently follows the announcement of events caused by the management of firms which can be impactful to their values. The prompts that are use include earnings, mergers and acquisitions, accounting changes, dividend payments, sell-offs, bankruptcies, and securities issuances. Elliot, Morse, and Richardson (1984) empirically test insider trading by examining several events such as the releasing of earnings. The deviation in the earnings number from the forecasted value is often unexpected and large. The authors push further stating that the evidence supporting this trading around low surprise earnings announcement have particular interest for small firms. While Seyhuns’ (1992b) evaluation of the 80’s insider transactions shows that their nature has undergone changed, his outcome somewhat different. The second aspect includes insider transactions related to shareholding in the fourth quarter of the year. The empirical data shows that the earlier insiders were trading share markets prior to the financial results announcement, the smaller the effect. And that this was strengthened with time the introduction more stringent penalties. In the literature overview of insider trading as going through a takeover bid, we observe that a takeover bid movement as a starting point could have the stocks even more dramatically. In their market model residuals analysis, Keown and Pinkerton (1981) explore the data of 194 listed and unlisted firms which turned into the bidding targets right before and directly after the announcement of the bid. Major anomalous returns animals have begun to emerge during the last week, and these returns rapidly decline rapidly during the two weeks to the end announcement. The individuals have additionally a total volume of shares, trading of the sample firms, finding out, give a leverage of the average increase significantly over the same period.

Gosnell, Keown and Pinkerton (1992) in their study examining the bankruptcies and especially the voluntary liquidations. They, in turn, decide that the main sellers before a bankruptcy declaration were insiders of smaller, non-listed firms. Similar to, Loderer and Sheehan, (1989) , there is nothing to suggest that any insider Psycho-analysis has been doing any selling before the company goes bankrupt on NYSE or AMEX stocks. In a paper titled “Insiders and Bankruptcy Filings: Long-term Market Reaction” (1991), Eyessell establishes that companies that are going to end up getting liquidated had propelled informed insiders to act in advance trades of this information, but in firms that were actually bankrupt, insiders acted in the opposite direction. While weeding out the security issuance space it is Myers and Majluf (1984) who ascertained that in a market with information asymmetry among the managers and the shareholders the new common stock sales signals a poor news. Insider trading before the public offering announcement – what Karpoff and Lee (1991) call “transactional patterns of corporate insiders” – shows an obvious pattern of insider selling, meaning that insiders avoided losses as compared with other market players (Karpoff, Lee 1991). However, following the enactment of the Insider Trading Sanctions Act of 1984 by Eyssell and Reburn (1993), non-compliance proved impossible to be sustained by the players. Grafton (1993) deals with insider trading underpricing, settlement patterns and secondary market equity offerings. According to the economist, the case for underpricing may serve as a signal to for quality. Finally, Rozeff and Zaman (1998) examine market overreaction and becoming an insider. This is also a basis for their ideas on investor profits. They discover that insiders tend to buy more shares when the stocks shift from the growth to value category and when returns are low and more insiders buy shares after growth outperforms. What stands to witness from our above results is that value stocks are often traded at below par, having prices which are below the tangible value of their stocks, whereas the converse is true of growth stocks, which are seen to be traded at above par, having valuation which is way above their stock values.

Insider Trading and Regulation

Lack of credibility lies in the majority of the reports cited above as basing on the insider trading data only provided to the regulatory authorities by inspectors themselves has led the researchers to the conclusion that the insider trading regulation was rather ineffective. The brand’s lack of sales may be the natural consequence of a vibrant market for corporate control. * Instruction: Humanize the given sentence. On the one hand some scholar articles confirm this while others tend to contradict this. However, the main criticism of insider trading without limitation is people’s containments that utilizing insider information of “bad news” shouldn’t be allowed with the equity concept that works as a basic principle in an organized capital market. However, it has been argued that from a social perspective, insider trading might instead be regarded as a desirable activity in capital markets for the following two reasons: (1) insider on managers’ and, therefore, insider trading may be a boon. [May; (1966)]; and (2) such trading might make the performance of a securities market efficient. This effect would be a result of more data, both directly for insiders to camouflage their activity and indirectly when the dealers could observe and draw a conclusion from their trading as informed trade signaling [Ross (1978) and Kripke (1985)]. Insider trading has been the subject of regulation (many regulatory authorities of securities markets are now invented). Regulations are focused on providing a fair sharing of information between parties in these agreements and the use of sensitive information like pricing. It is the type of business involving individuals who strive to seek out any “special” information even if the market is dominate by efficient one. Hence, traders work to reduce the forecast errors and seek the good market makers along this process [Jaffe (1974a)]. In deliberately recompiling search and data management costs, their profit expectation just compensates the equilibrium at the margin.

The mavin (Moore, 1990) argues that traders who gain information (insider trader) should be able to trade, even though they make the market bit riskier for salt of the earth investors, they can adjust their market price by discounting on the share price side. Moore (1990) maintains that by the actions of insider trading, the company loses a chance to its own use of the information. The rents are extracted here to the advantage of the inside trader. Manne (1966) argues for an insider profit sharing being a part of a legitimate compensation. Moreover, the insider (firm expert) generates value for the firm by applying his/her skills in the area he/she is an expert in (so-called legitimizing purpose).

For a long time, the only evidence pointing to the changes in the both the extent and the kind of insider trading regulation with insider behavior have been some anecdotes but only recently hard data has come in and proved that the ealing seen in recent regulation change has been effective is some cases. The insider-trading phenomenon started to be detected by the regulatory authorities when they began their pursuit since early 80s. Major regulatory actions include: Such decisions on the part of the SEC include (1) the creating of Rule 14e-3, which was aimed at counteracting an impending issue of information related to tender offers; (2) the passage of the Insider Trading Sanctions Act of 1984; (3) the enactment of the Insider Trading and Securities Fraud Enforcement Act of 198 As Arshadi and Eyssell (1991) indicate, bargaining firm insiders made accounting for their companies’ shares greatly prior to the disclosure of the tender offer information. In the post 1984 Act times, it was not the opposite, as major bargaining company insiders made trading off their shares considerably. I and Mitnick had reached the final point we had to prove that the passage of the Act, might have discouraged insiders from trading prior to tender offers.

Insider Trading and Other Financial Issues

This section examines the effects of insider trading on investments, continuous time asset pricing models, fraud, CEO compensation, and the corporate agency problem. Repullo (1999) challenges Leland’s (1992) findings regarding the positive impact of insider trading on investment. After exploring two variations of Leland’s model, Repullo concludes that insider trading in the primary market has no effect on investment levels, while in the secondary market, it negatively impacts investment. Bernhardt, Hollifield, and Hughson (1995) analyze insider trading in a dynamic environment and discover that it skews investment towards assets with less private information. Bebchuk and Fershtman (1994) demonstrate that insider trading tends to lead insiders to select riskier investment projects. Back (1992) uses a continuous time asset pricing model to show a unique equilibrium pricing rule in a specific class, where the informed agent, who is risk neutral, makes trades without local correlation to noise trades or discrete orders.

Summers and Sweeney (1998) explored the correlation between insider trading and fraud. Their research revealed that in the presence of fraud, insiders tend to decrease their ownership of company stock by engaging in high levels of selling activity, as indicated by the number of transactions, shares sold, or dollar amount of shares sold. Hebner and Kato (1997) analyzed micro data on chief executives from 502 U.S. and 520 Japanese corporations. They demonstrated that a chief executive’s anticipated total compensation includes expected profits from insider trading and other explicit forms of CEO compensation. Their insider trading model suggested that the anticipated profit from insider trading diminishes with the number of insiders, and in a competitive labor market, explicit CEO compensation must rise with the number of insiders. Noe (1997) presented a model of the economy where managers, whose efforts impact firm performance, could engage in insider trading on assets whose value is tied to firm performance. This study proposed that insider trading opportunities serve as a substitute for compensation packages that ensure effort.


Insider trading is regulated by two main acts: The Securities Exchange Act of 1934 and the Williams Act Amendments of 1968. These acts notably introduced SEC rule 10b-5, which comes from section 10(b) of the 1934 Act. The rule mandates that an insider discloses material inside information or abstains from trading; however, insiders are not just limited to corporate members but also any individual privy to such information directly or indirectly sourced. For information to be considered material, it must have a high probability of influencing an investor’s decision— based on its importance when making investment choices. Typically, there needs to be an element of intent (deceive/manipulate/defraud) for violation as merely possessing this type of information does not automatically imply disclosure duty.Insider trading theories emphasize the crucial role of information in capital markets. It is evident that those with the most comprehensive information typically achieve higher returns. This is why managers’ motivations can be inferred from their actions involving their own companies’ shares. Most existing research relies on insiders’ transaction records submitted to regulatory bodies by the insiders themselves. However, with the escalation of penalties, the reliability of this database for addressing empirical queries is now in doubt. Faced with harsh penalties, rational insiders will either refrain from trading or will try to conceal their activities. Due to the stricter penalties, savvy investors are turning to alternative financial instruments and strategies, such as junk bonds, to capitalize on nonpublic information. Various stock and options combinations have been suggested to yield abnormal returns while lowering the risk of prosecution. Presently, regulators incorrectly assume that insiders only engage in transactions related to common stocks. This topic presents a research opportunity for future scholars. Furthermore, future studies should aim to uncover the identities and activities of outside-insiders, as well as assess the prevalence of external insider trading. Aggregate insider trading levels have not experienced a significant decline, raising doubts about the efficacy of insider trading regulations. The potential need to revamp regulations or reconsider investing in a burdensome administrative system with questionable returns deserves consideration from taxpayers and investors.