Research by Joseph D. Piotroski and Abbie J. Smith
Theories predict that the restriction of insider trading
activity will increase incentives for analysts to follow firms.
Consistent with these theories, recent research finds a positive
association between the initial enforcement of insider trading
laws and analyst coverage.
Information plays a key role in the growth and efficiency
of economies and their capital markets. In spite of this widely
acknowledged belief, there has been little research on how
and why information systems vary around the world.
One such system is the flow of information from companies
to financial analysts to investors. Previous research shows
that greater analyst following is associated with an improved
flow of information to outside investors. Insider trading
is expected to obstruct this information channel, making it
potentially more costly for the average investor to gather
information about the performance and risk of individual firms.
Such information also may be less beneficial to ordinary investors,
since the trading benefits of knowledge about a firm will
go first to insiders.
In the study "Insider Trading Restrictions and Analysts'
Incentives to Follow Firms," University of Chicago Graduate
School of Business professors Joseph D. Piotroski and Abbie
J. Smith, along with Robert M. Bushman of the University of
North Carolina Kenan-Flagler Business School, examine whether
analyst coverage of publicly traded firms increases after
the adoption of insider trading laws and/or the initial enforcement
of these laws. Their study is motivated by theories predicting
that allowing insiders to trade on their private information
decreases trading profits available to outside investors,
which decreases outsiders' demand for analyst forecasts and
other forms of firm-specific information.
Nearly all past research on insider trading has focused on
the United States. However, Piotroski notes, "It is difficult
to get comparable data within the United States since federal
insider trading laws have existed since the Great Depression.
In the United States, there are limited opportunities to examine
regime changes, such as when a market shifts from the tolerance
of rampant insider trading to the credible enforcement of
insider trading restrictions."
By comparing insider trading internationally, the authors
are able to observe countries where insiders previously had
the opportunity to trade legally, and what happens to analyst
coverage when new insider trading laws are enacted and enforced.
Piotroski, Smith, and Bushman use data on analyst following
for 100 countries from 1987 to 1998. They find that both the
intensity of analyst coverage (the average number of analysts
covering firms within a country) and breadth of coverage (the
proportion of domestic listed firms followed by analysts)
increase upon the initial enforcement of insider trading laws.
"Insider trading may contribute to a lack of corporate
transparency, whereby insiders have superior information to
make investment decisions," says Smith. "Our preliminary
results are consistent with the prediction that restrictions
on insider trading increase demand for information by outsiders,
and therefore higher levels of analyst coverage."
While the authors find that the enforcement of insider trading
laws is associated with an increase in analyst following,
there is no clear relation between the enactment of such laws
and analyst following.
"It's an issue of credibility," says Piotroski.
"The enactment of the insider trading law is a nonevent
in our study, suggesting that the analyst community views
the writing of such laws with skepticism. In contrast, the
initial enforcement of these laws is associated with an increase
in analyst coverage, consistent with enforcement being viewed
as a real change in the government's protection of outside
Financial analysts play a key role in any capital market,
but how do they make their recommendations, and who uses their
Financial analysts serve as intermediaries who gather, interpret,
and analyze financial data to make recommendations about the
quality of a firm's stock. They base their recommendations
on information from the firm, the firm's competitors, suppliers,
and customers, and broader macroeconomic trends. Analysts
synthesize this information into assessments of the firm's
products, profitability, and valuation with the ultimate goal
of helping investors and capital market participants allocate
Rather than researching firms themselves, investors can rely
on analysts to help them choose where to invest and determine
the risk of their investment. Analysts may think that a stock
is overvalued or undervalued at any point in time, and therefore
issue a buy, sell, or hold recommendation based on their view
of whether the stock is correctly priced. Analysts also produce
reports of varying lengths that discuss a company's profit
margins, short-term earnings, share forecasts, and long-term
Analysts' recommendations may be biased for any number of
reasons, but perceptions of financial analysts have recently
taken an especially negative turn. Part of the growing skepticism
is due to cases where analysts have investment banking relationships
with the same firms for which they forecast earnings and issue
stock recommendations. There have been allegations that analysts
may have been less than independent and objective in these
cases, and were more concerned with currying favor with their
investment banking clients than with the accuracy and truthfulness
of their forecasts and recommendations.
Despite the prominent insider trading scandals of recent
years, analysts play a fundamental role as specialists in
the collection, interpretation, and analysis of financial
Enactment vs. Enforcement
For the 100 countries with stock markets in their study,
Piotroski, Smith, and Bushman measured analyst coverage and
how enactment and enforcement of insider trading laws shifted
in each country over the twelve year period 1987 to 1998.
Interestingly, the enactment and initial enforcement of insider
trading legislation was a wide-spread phenomenon during the
early 1990s across a broad set of both developed and emerging
The authors measured the number of analysts covering public
firms in a given country. They then noted whether or not a
country had enacted insider trading restrictions, and whether
or not the country had enforced these laws, noting the year
in each case.
Prior to 1990, only 32 countries had adopted insider trading
legislation, and only 9 of these countries had enforced these
laws. By the end of 1998, 87 countries in the sample had enacted
insider trading laws, and 38 countries had enforced these
Whether or not a country enforced its insider trading restrictions
turned out to be the defining event in the study. Penalties
may be vastly different across countries. For example, in
the European Union, insider trading cases are enforced through
the criminal courts and require proof beyond a reasonable
doubt. In the United States, the SEC enforces insider trading
restrictions through civil penalties.
Given the growing trend in analyst following across the globe,
there may be several alternative explanations for the positive
relation between analyst following and insider trading restrictions.
The authors find that their results still hold even when controlling
for year, as well as important country characteristics, including
the date when a country liberalized its equity market. They
also include two measures of a country's financial flows:
the level of foreign direct investment and the openness of
countries' product markets.
Liberalization of equity markets is a profound policy reform
that opens a country's market to the free flow of capital.
Liberalization can result in an inflow of foreign capital,
which can improve risk sharing and pressure firms to improve
After insider trading laws are enforced, the increase in
analyst following is much more dramatic for emerging market
countries than developed countries. The authors' measures
of analyst following are also much lower in years prior to
financial market liberalization.
For emerging market countries, Piotroski, Smith, and Bushman
find that enforcement of insider trading restrictions may
be associated with a more fundamental shift in a country's
property rights regime than in developed countries. Enforcing
these new laws in emerging markets may signal political commitment
and encourage market participants, including analysts, to
transition to a new property rights regime.
"In emerging markets, prosecuting someone for insider
trading is a powerful signal in an environment without much
prior rule of law," says Smith. "The implication
of prosecuting for the first time is more dramatic than in
a developed country."
The authors furthermore explore the economics of analyst
following by isolating characteristics that are associated
with the level of analyst response following enforcement of
insider trading restrictions. They look at three characteristics
of each country: legal origin, political structure, and concentration
of economic activities.
With respect to legal origin, the authors find that the introduction
of insider trading restrictions is associated with a greater
increase in analyst coverage in civil and socialist origin
countries than in common-law origin countries, presumably
due to the lower levels of preexisting investor protections
in those economies. A country's political structure is not
related to analyst response. Finally, they find that the reaction
of analysts to the enforcement of insider trading laws is
much stronger in countries that have diverse economies, suggesting
that analyst activity may have greater value when guiding
capital across different sectors in an economy.
Joseph D. Piotroski is associate professor of accounting at the University of Chicago Graduate School of Business. Abbie J. Smith is Boris and Irene Stern Professor of Accounting at the University of Chicago Graduate School of Business.