Creating Incentives for Financial Analysts 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, new research finds a positive association
between the initial enforcement of insider trading laws and
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
In the new 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, study 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
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
"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 investors' rights."
Financial analysts play a key role in any capital market, but
how do they make their recommendations, and who uses their findings?
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 their investments.
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 earnings
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 information.
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
has enacted insider trading restrictions, and whether or not
the country has enforced these laws, noting the year in each
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 laws.
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'
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 governance.
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
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
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 assistant 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.