1. The Real Effect of the Initial Enforcement of Insider Trading Laws Zhihong CHEN (City University of Hong Kong) Yuan HUANG (Polytechnic University of Hong Kong)* Yuanto KUSNADI (City University of Hong Kong) K.C. John WEI (HKUST) 2012 NTU ICF 1

2. Research Questions Does the initial enforcement of insider trading laws affect firm’s investment-to-price sensitivity? – If yes, what are the underlying reasons? Does the initial enforcement of insider trading laws affect firm’s performance? – If yes, is the effect of the enforcement on firm’s performance positively associated with the effect of the enforcement on investment-to-price sensitivity? 2

3. Main findings The sensitivity of investment to price is higher after the initial enforcement of insider trading laws The effect of the enforcement is positively associated with the change in private information in stock prices after the enforcement. The enforcement effect is not positively associated with – The extent of firms’ agency problem – The extent of firms’ financial constraints or external financing activities The sensitivity of investments to a non-price-based signal of investment opportunity (sales growth rate) does not increase after the enforcement The improvement in firms’ performance after the enforcement is positively correlated with the improvement in investment-to-price sensitivity. 3

4. Data and Sample Selection All firm year observations over 1982-2003 in 45 countries covered in WorldScope database. – Delete financial institutions – Require total assets and market value of equity greater than $10 mil US dollar – 175,968 firm-year observations (24,149 firms) 153,066 firm-year observations (19,713 firms) in 23 developed markets 22,902 firm-year observations (4,436 firms) in 22 emerging markets. 4

5. Regression Specification INVEST: change in PPE, change in inventories, and R&D, scaled by lagged total assets ITENF: =1 if year> initial enforcement year; =0 otherwise Q: natural logarithm of Tobin’s Q, computed as market value of equity plus total assets minus book value of equity, divided by book value of total assets CF: operating cash flows, computed as income before extraordinary items plus depreciation and amortization, scaled by total assets PROTECT: composite investor protection index, defined as average of (1) the anti-director rights index, (2) disclosure requirement index and liability standard index, and (3) anti-self-dealing index. 5

6. Adjust for the trend in investment-to-price sensitivity There could be a time series trend in the investment-to-price sensitivities. Failing to control for this trend may induce spurious association between investment-to-price sensitivities and the enforcement. We use the data in the 6 countries whose initial enforcement occurred before 1982 (Brazil, Canada, France, Singapore, U.K. and U.S.) to estimate this time series trend in the investment- to-price sensitivities. Adj.INVEST c,f,t = INVEST c,f,t –  t Q c,f,t-1 –  t CF c,f,t. where  t and  t indicate the estimated trend in investment-to-price and investment-CF sensitivities.

7. Pooled Sample Regression (Table 3) 7

8. Event-time analysis (Table 5) We conduct a short-window event study, where the sample only includes firm year observations with non-missing values in year [-2,+3] around the initial enforcement year. Each country should have at least one non-missing value 8

9. Change in the trend-adjusted investment-to-price sensitivity over year [-2,+3] (Panel B, Figure 1) 9

10. Managerial learning hypothesis Restriction on insider trading encourages outside investors to acquire and trade on private information, thus leads to more informative prices. As a result, managers learn more from stock prices to guide investment decisions. The enforcement effect should be positively associated with change in private information in the prices after the enforcement. Proxies for private information: – Non-synchronicity (NSYNCH) – A measure of information based trading developed by Llorente, Michaely, Saar, and Wang (2002) (LMSW) – Proxies for public information (Inverse measures of private information): Public information crowds out private information acquisition Absolute value of discretionary accruals (ABSDAC), Earnings opacity (OPACITY) Number of sell-side analysts following a firm (NAF)

11. Cross sectional test of managerial learning hypothesis (Table 7) 11

12. Market friction hypothesis The enforcement mitigates the adverse selection/moral hazard problems associated with insider trading – Managers’ interests are more aligned with investors so that they are more likely to make value-maximizing investment – External financing constraints are relieved The enforcement effect is more pronounced in firms With more severe agency problem (large WEDGE between voting rights and cash flows rights) More financially constrained (Whited and Wu index) Raised more external finance (TOTAL_ISSUE, EQUITY_ISSUE, DEBT_ISSUE)

13. Cross sectional tests market friction hypothesis (Table 8, Panel A) 13

14. Cross sectional tests market friction hypothesis (Table 8, Panel B) 14

15. Cross sectional tests market friction hypothesis (Table 8, Panel C) 15

16. A Falsification test: change in the sensitivity of investment to sales growth rate If the enforcement increases managerial learning from stock price, – By definition, managers cannot learn from past sales growth rate (SGRW). – There should be no change in investment-SGRW sensitivity. If the enforcement reduces market frictions, – Investment should be more sensitive to any reasonable proxy for investment opportunities. – We should observe similar increase in investment-SGRW sensitivity.

17. Test results on investment-to-sales growth sensitivity (Table 9)

18. Change in accounting performance after the enforcement PERFORMANCE: ROA or Sales growth  c : change in the investment-to-price sensitivity after the enforcement in country c. TA: book value of total assets. LEV: leverage CASH: Cash and cash equivalent scaled by total assets. PPE: property, plant and equipment scaled by total assets 18 We test if the increase in investment-to-price sensitivity after the enforcement reflects improved investment efficiency by checking If there is an improvement in operating performance after the enforcement and if this improvement is correlated with the improvement in the investment-to-price sensitivity

19. The enforcement and accounting performance (Table 10) 19

20. Contributions The first large sample study on the real-side effect of insider trading regulation – Shed light on the long-lasting analytical debates on the real effect of insider trading regulation – Extend the studies on insider trading regulation from financial market side, information side to the real side of the economy – Identify the channel Contribute a line of research investigating how the of country-level legal, institutional and regulatory factors affect corporate investment – Other studies investigate the effects of legal protection, financial development, financial liberalization, accounting information and disclosure quality – We study the impact of insider trading regulation and – We find insider trading regulation takes effect via managerial learning channel, rather than mitigating adverse selection and moral hazard problems Contribute to the learning literature – Document how insider trading regulation affects managerial learning in an international setting 20

21. Thank you!

22. Estimate  c In pool regressions: In event-time regressions: 22

23. Country level analysis (Table 6) Two-step regressions – First step, estimate the following annual regression for each country-year with at least 50 firms INVEST c,f,t (Adj.INVEST c,f,t )=b c,t Q c,f,t-1 + c c,t CF c,f,t +  i +  c,f,t – Second step, estimate the following regression b c,t =  0 +  1 ITENF c,t-1 +  c +  c,t 23