Insider trading: are all company directors treated equally?

There is currently no consistent ethical standard that companies adhere to when it comes to opportunistic insider trading

Earlier this year, Elon Musk and his brother Kimbal Musk were investigated by the US Securities and Exchange Commission (SEC) regulator (the US equivalent to the Australian Securities and Investments Commission (ASIC))  for alleged insider trading. Kimbal, who sits on Tesla’s board of directors, sold US$108 million (A$150 million) of Tesla shares one day before Elon polled Twitter users about whether he should sell 10 per cent of his stake in the company, pledging to abide by the vote’s results. The tweet resulted in Tesla’s share price falling significantly. Did Kimbal sell his Tesla shares because he knew about Elon’s poll in advance?

Insider trading in financial markets is increasingly complex with stories of insider trades concerning cryptocurrencies and even NFTs now surfacing. While there is no law preventing insiders from trading shares in their own company, there is a law preventing them from trading when in possession of "material non-public information" (i.e., price-sensitive information that is not known to the public). Most companies have trading policies to regulate the trading of shares by directors and other senior executives who have direct access to information that would not generally be available to investors. The aim is to reduce exposure to and avoid the appearance of insider trading and market manipulation, which is generally seen as bad for business.

“These board members and executives, we want them to have share ownership in their own company because it makes them more engaged and more likely to pursue long-term value if they have share ownership. If you give them shares as part of their compensation, they need to be able to sell them if they need to pay for big expenses,” explains Dr Sander De Groote, lecturer in the School of Accounting, Audit and Taxation at UNSW Business School.

In a recent paper Are all directors treated equally? Evidence from director turnover following opportunistic insider selling, Dr De Groote and co-authors examine the likelihood of director turnover following opportunistic insider selling. The study shows it is possible to distinguish patterns of insiders’ transactions to find when opportunistic trading is more likely to occur, and how companies treat those directors that are engaging in this behaviour. The findings provide evidence that not all directors are treated equally, and whether or not they leave the company depends more on the connections and relationships (like family members) that they have with others at the firm than ethical standards.

How do you know when there is opportunistic trading?

In the study, Dr De Groote and colleagues examine whether a sample of US company directors left a company faster if they engaged more in transactions that were likely to be based on inside information. One giveaway of this opportunistic trading is when trading occurs outside of regular trading patterns; whatever is irregular or occurs outside of normal trading times for that person, is more likely to occur based on non-public information.

“So, if insiders sell shares at the same time every year, for instance, if they have a kid in college, that's very expensive, and you must pay very high amounts of tuition at regular intervals. So, often, insiders, if they must pay tuition in January, will sell shares every January to pay for that tuition,” explains Dr De Groote.

On the other hand, transactions occurring outside regular intervals are more likely to have been based on other material information. “We find that members of the board of directors that sell shares more in a random pattern, so when there is no yearly reoccurrence, those are the ones that leave boards faster. So that is a sign that boards do not appreciate this opportunistic trading behaviour,” says Dr De Groote.

While companies do generally have some level of ethics and care when it comes to insider trading, the extent and treatment of directors vary.

Read more: Inside this insider trading loophole: What shareholders need to know

Do company directors leave following opportunistic trading?

Insider trading is generally considered unethical and leads to negative public sentiment and reputational costs that can damage a company’s legitimacy, explains Dr De Groote. It is in the company's interest to ensure insider trading does not seem exploitative to outside shareholders. Yet, the study shows that director turnover decisions after opportunistic trading are more likely to be influenced by the cost of replacing and retaining that director versus a purely ethical consideration. The study concludes that the likelihood of director turnover varies with their value to the board and the company's size.

To find this, the researchers compare the treatment of more “important board members” to the “less important board members” after they sold shares opportunistically. Dr De Groote explains that important board members might be the chairman of the board or an executive director, or directors with a very specific kind of expertise that is difficult to replace.

“The sign overall is that [on average] boards care about this ethical signal, but they don't care about it that much, because if you're an important board member, you don't leave the board faster if you're selling more shares, only if you're a less important board member,” says Dr De Groote. 

It’s also important to note that the study examines insider trades of company shares within the US legal framework. While all examples of insider trading were legal and not investigated by the SEC, some trades were borderline, says Dr De Groote. This suggests that companies self-regulate to an extent. “The way we interpret this is that companies and company directors care about ethical behaviour, but they don't enforce it equally across everyone, so it's not a fair standard,” he says.

Higher ethical standards are needed to stop directors' insider trading

The findings suggest there is currently no consistent ethical standard that firms adhere to when it comes to insider trading. “If you're drawing a line in the sand to say, we think that insider trading behaviour is bad and you shouldn't be doing it then it needs to be equal for everyone; it doesn't matter if the CEO is doing it,” says Dr De Groote.

Interestingly, there also seem to be hard indicators of value for the board of directors (for example, the expertise of being an executive or being the chairman). In addition, board members that are “very friendly” with the CEO or are family members of the CEO don't tend to leave firms either. “If they sell more shares opportunistically, then they don't get replaced faster either. It’s only those that don't have that social connection with the CEO who get replaced faster,” says Dr De Groote.

Finally, he notes that part of the problem is also that US and Australian companies never mention insider trading when replacing directors (even in annual reports) so there is very little knowledge or transparency of instances where it is happening.

“Insider trading behaviour is never mentioned when executives leave a firm. While the findings show that, to some extent, firms self-regulate and do care about this, there could be some firms that care about this very much and others that don’t care at all. But there's no act of communication about this when it happens so it's very hard to say with certainty that this director was selling a lot of their shares and then the next year to have to leave because of this,” explains Dr De Groote.

What does all of this say about insider trading and corporate governance? “If we as a society think that it's important that everyone is held by the same standard when it comes to their inside trading behaviour, then we do have to apply more rules because while firms do self-regulate to an extent, they don't do so equally for everyone,” concludes Dr De Groote.

Dr Sander De Groote is a lecturer in the School of Accounting, Audit and Taxation at UNSW Business School. He studies insider trading using it as a measure of director diligence and ethics, and his research focuses on corporate governance with a specific interest in director behaviour in the firm information environment. For more information, please contact Dr De Groote directly.