Insider Trading in Germany — Do Corporate Insiders Exploit Inside Information?

BuR - Business Research Official Open~ Journal of VHB Ve<band der Hochschullehrer fur Betriebswirtschaft e.v. Volume 1 1 Issue 2 1December 20081188·205 Insider Trading in Germany Do Corporate Insiders Exploit Inside Information? Bjorn M. Dymke, De]Xlrtment of Banking, University ofTiibingen, Ge•·many, E-Mail: bjoem.dymke@ uni-tuebingen.de Andreas Walter, Department ofBanking, Uniuei'Sity ofTiibingen, Ge•·many, E-Mail: andreas.walte•·ai tmi-tuebingen.de Abstract Our study focuses on the question whether corporate insiders in Germany exploit inside information while trading in their company's stock. In contrast to prior international studies, which are not able to link insider transactions to aformal definition of inside information, we relate insider transactions to subsequent releases of inside information via ad-hoc news disclosures. We find evidence that corporate insiders as a group seem to trade on inside information. Moreover, members of the supervisory board seem to be most active in exploiting inside information, since they realize exceptionally high profits with their frequent front-running transactions. Keywords: insider trading, inside information, §15a WpHG, German stock market, regulation of.financial markets Manuscript received July 13, 2007, accepted by Christian Schlag (Finance) May 6, 2008. 1. Introduction The question whether corporate insiders exploit inside information while trading in their company's stock attracts the attention of academia and the public alike.1 Moreover, the answer to this question is also crucial for regulatory authorities, since on a capital market there is a loser for each winner. In particular, if corporate insiders exploit inside information, profits received by corporate insiders reduce the returns of all other uniformed traders (including the market maker).2 As a consequence, un1 In 2005, according to its annual report, the German regulatory authmity Bundesanstalt for Finanzdienstleistungsaufsicht (BaFin) investigated 54 cases related to suspected insider trading. E.g., several managers at DaimlerChrysler were suspected to exploit inside information prior to the resignation of the former CEO Jiirgen Schrempp (Handelsblatt, August 29, 2005). However, the probably most prominent suspicion was about the former Co-CEO of the European Aeronautic Defence and Space Company (EADS), Noel Forgeard, who sold together with his children stocks and stock options for a seven digit profit just a few weeks before EADS disclosed severe difficulties in the production of the airplane A38o (Handelsblatt, June 21, 2006). Admittedly, this discussion highlights the disadvantages of insider trading exclusively and thus gives an incomplete picture. The reader should be aware that there exists a large body of 2 informed investors might refrain from trading on the capital market. Thus, a well developed capital market requires an effective insider regulation to protect uninformed investors. In order to analyze the effectiveness of insider trading regulations in Germany, our study basically addresses three questions. First, we analyze whether German corporate insiders earn abnormal profits while trading in their company's stock. Second, we use a distinct property of German law, i.e., the companies' obligation to reveal inside information through ad-hoc news disclosures, to examine whether profits realized by corporate insiders seem to be due to the exploitation of inside information or not. Finally, we explore which group of insiders seems to be most active in trading on inside information: the one which is best informed about a company's prospects (i.e., senior managers) or the one which is probably least closely watched by the regulator (i.e., family members of senior managers and directors). Today, insider literature which emphasizes the beneficial role of insider trading. E.g., Manove (1989) and Leland (1992) favor the permission of insider trading to increase informational efficiency of security prices. 188 BuR - Business Research Official Open~ Journal of VHB Ve<band der Hochschullehrer fur Betriebswirtschaft e.v. Volume 1 I Issue 2 I December 20081188·205 regulations prohibit the exploitation of inside information on capital markets in nearly all developed countries.3 In Germany, since 1994 § 14 WpHG (Security Trading Act) prohibits the exploitation and transmission of inside information. According to German law, inside information can be described as any specific information which is not subject to public knowledge and which, if it became publicly known, would likely have a significant effect on the stock price of the respective company (§ 13 WpHG). Moreover, to enhance market efficiency and to avoid information asymmetry § 15 WpHG requires an immediate public disclosure (ad-hoc announcement) of any inside information (as defined in § 13 WpHG) by the respective company. Additionally, as corporate insiders (i.e., senior managers, directors and their family members) may possess superior information about the company, since July 1, 2002 § 15a WpHG requires companies to report corporate insiders' transactions to the public as well as to the regulatory authority, the Bundesanstalt fiir Finanzdienstleistungsaufsicht (BaFin).4 Trading activities of corporate insiders have been subject to a large number of studies. One strand of literature focuses on the announcement day of insider transactions and explores if uninformed outsiders can benefit by mimicking insider transactions (e.g., 1988; Bettis, Vickrey and Vickrey 1997; and Fidrmuc, Goergen, and Renneboog 2006). Remarkably, the literature finds that even uninformed outsiders can earn abnormal profits using publicly available information, at least when transaction costs are ignored. Another strand of literature is motivated by the question whether corporate insiders earn abnormal profits by trading in company's stock and thus may use their foreknowledge about their firms' prospects (e.g., Lorie and Niederhoffer 1968; Jaffe 1974; Finnerty 1976; Seyhun 1986; Eckbo and Smith 1998; LakonJeng, Mebick, and Zeckhauser 2003; ishok and Lee 2001). The international literature documents that insiders earn high abnormal profits while trading in company's stocks.s While there 3 Bhattacharya and Daouk (2002) show that insider trading laws existed in 87 out of 103 countries with a capital market. 4 Section 2 of this paper discusses the definition of corporate insiders as well as the regulation and reporting requirements for insider trades in more detail. 5 A differing result is reported by Eckbo and Smith (1998). exist numerous studies focusing on insider trading in the US and the UK, until now not much research has been conducted on the German capital market. This may be due to the fact that until July 1, 2002 corporate insiders did not have to reveal their trades to the regulatory authority. 6 However, recent studies for Germany (see, e.g., Stotz 2006; Klinge, Seifert, and Stehle 2005; Betzer and Theis (...truncated)