Do Insider Trading Laws Increase Executive Pay?

Laws prohibiting insider trading are ostensibly designed to create a level playing field for investors.  However, according to a new study from the University of Pittsburgh, they also have the effect of leading firms to pack more stock options into top executive pay plans, which drives up the total compensation packages awarded to CEOs and top executives.

The positive association between insider trading restrictions and executive compensation exists because market competition compels companies to offer higher pay and stock options to executives in order to make up for revenue that they can't earn through their insider knowledge. Those who act on insider knowledge have the potential to earn enormous profits in the stock run-ups that occur immediately before a major sale or acquisition.  Countries with the strictest insider trading laws, such as the United States, tend to have the highest executive compensation packages. Consequently, companies whose executives can freely engage in insider trading, which occurs frequently in Mexico, Peru, South Africa, Taiwan, among other countries, tend to receive smaller compensation packages.

"Financial economists have struggled to explain why executive pay is so much higher in some countries than in others.  Our findings contribute to this debate by identifying insider trading laws as an important channel through which this cross-country variation in executive pay can be explained," says David J. Denis, the Roger S. Ahlbrandt Sr. Chair and Professor of Business Administration at the University of Pittsburgh Joseph M. Katz Graduate School of Business and College of Business Administration.

Denis and co-author Jin Xu, assistant professor of finance at the Purdue University's Krannert School of Management, published the findings in the paper, "Insider Trading Restrictions and Top Executive Compensation," which appeared in the July 2013 edition of the Journal of Accounting and Economics.

While past research has provided only limited, indirect evidence of the relationship between executive pay and insider trading — and only as it occurs among firms within the United States —the study by Denis and Xu is the first to establish an empirical connection across a broad set of countries. The study analyzed executive compensation in 41 countries, primarily drawing from a sample of top executives who were employed at 468 non-U.S. firms and 1,852 U.S. firms in the year 2006. Total pay was computed by combining compensation in the areas of salary, bonus, restricted stock awards, option grants, and pension, among other areas. All figures were converted into U.S. dollars.

To benchmark the level of insider trading restrictions, the study used two sources. The Global Competitiveness Report from the year 1999 featured responses from about 4,000 executives in 59 countries. The executives answered the question of how extensive they perceived insider trading to be in their domestic market. Second, the researchers constructed their own country-by-country measurement of insider trading, based on the insider trading statutes of each country. The researchers found that some countries have never enforced existing insider trading legislation, such as China and Colombia, while others have a long history of enforcement, such as France and the United States.

“It is difficult to get accurate measures of the strength of insider trading laws and their enforcement in some countries.  Our study tried to overcome this limitation by combining both survey data, which measures perceptions of market participants, with hard data on the actual enforcement of statutory restrictions."

The results were consistent with common perceptions: the United States was among the countries with the most restrictive insider trading laws, along with the United Kingdom and Luxembourg. Ultimately, the study found that firms in countries with stronger insider trading restrictions were characterized by a greater use of incentive pay, such as stock options, and higher total pay for executives. The study performed a statistical analysis that set a median level for the degree of a country's insider trading restrictiveness. Total pay for executives in firms below the median averaged less than $300,000, while executives in firms above the median received total pay of more than $1.6 million.  Additionally, the authors observed that when countries initially enforced their existing insider trading laws, there was a significant increase in both the level of total executive pay and the use of incentive pay.

“Our findings provide strong evidence that executive compensation contracts are affected by the nature of a country’s laws restricting insider trading.  This could be either because insider trading is a form of implicit compensation or because companies are able to use more incentive pay when there are greater restrictions on the ability of insiders to undo those incentives by trading in their own shares.  Ideally, we would like to know something about the extent to which stronger insider trading laws actually lead to lower insider trading profits, but unfortunately, that data is not available in most countries,” Denis says.