Strong enforcement of insider trading laws doesn’t just protect investors – it encourages businesses to be more innovative, according to our new peer-reviewed research.
In fact, we found that after a company is hit with an insider-trading indictment, it generally produces more patents – which in turn are cited more by other patents – than it did before the indictment. It’s also likely to outperform other companies – at least in terms of innovative activities and operating performance – that haven’t faced any such charges.
Wait – what is insider trading?
Insider trading is when a director or employee of a company trades their public stock or another security based on important or “material” information about that business. While people often wrongly think all insider trading is against the law, it’s actually legal for insiders to trade stocks and earn profits based on information that’s also available to the public. What’s illegal is trading based on “nonpublic,” or secret, information.
The idea is that in a fair and transparent market, all investors should have access to the same information. But while insider trading restrictions are intended to help investors, a growing body of research suggests they may also help foster innovation within businesses, which is a central driver of economic growth.
Our new work, spanning from 1993 to 2017, backs that up. Specifically, we found that stringent enforcement of insider trading restrictions by the U.S. Securities and Exchange Commission result in enhanced investor protection, improved operating efficiency and greater innovation as measured by patent grants and citations.
An indictment-to-innovation pipeline?
It’s reasonable to ask: Why would enforcing insider trading restrictions affect innovation?
We think the increased protection they offer against rent-seeking – which is when corporate insiders gain at the expense of outside investors – contributes to greater trust among investors, encouraging more investment, and boosts profitability. With a more stable and trusting investor base, companies are better capitalized. As a result, they’re better positioned to direct resources toward research and development initiatives and other innovative projects. That can lead to the discovery of new and improved technologies, resulting in more patents, which create incentives for more innovation by protecting inventions.
We observe that companies operating under stringent insider trading restrictions are able to prioritize growth and innovation, due to outside investors valuing the protections and trusting the firm’s leadership. Managers, aware of increased oversight, prioritize maintaining investor trust, which can facilitate long-term investments. Our study also highlights that firms with strict insider trading policies tend to have lower costs when raising equity.
Why lawmakers and businesses should care
For policymakers, these findings show the value of robustly enforcing insider trading laws. Using them to ensure a fair and transparent market not only protects investors; it also fosters long-term investment and innovation.
And for businesses, understanding the benefits of these restrictions can lead to more strategic decisions that prioritize long-term growth and innovation. While most insider trading is legal, healthy restrictions on the practice remain valuable for firms and investors.
More broadly, this study shows why it’s important to weigh the benefits of regulations and consider how they can strengthen markets. This is particularly important given how complex modern financial markets are. We think there’s wisdom in taking a view of finance that goes beyond just generating returns for investors, emphasizing the need to support productive enterprise.
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