Insider trading restrictions and top executive compensation

https://doi.org/10.1016/j.jacceco.2013.04.003Get rights and content

Highlights

  • The use of equity incentives is significantly greater in countries with stronger insider trading restrictions.

  • These higher incentives are associated with higher total pay.

  • Both the level of pay and the use of incentives increase following enforcement of insider trading laws.

Abstract

The use of equity incentives is significantly greater in countries with stronger insider trading restrictions, and these higher incentives are associated with higher total pay. These findings are robust to alternative definitions of insider trading restrictions and enforcement, and to panel regressions with country fixed effects. We also find significant increases in top executive pay and the use of equity-based incentives in the period immediately following the initial enforcement of insider trading laws. We conclude that insider trading laws are one channel through which cross-country differences in pay practices can be explained.

Introduction

Recent studies document substantial cross-country variation in both the level of executive compensation and the use of equity-based incentives for top executives (see, e.g., Murphy, 1999, Murphy,). However, the underlying factors contributing to these observed differences remain the topic of active investigation. For example, although Conyon et al. (2011) find that higher levels of pay for U.S. CEOs relative to their U.K. and E.U. counterparts can be explained (at least in part) by their higher stock and option incentives, their findings leave open the question of why incentives are so much higher for U.S. CEOs. Indeed, Conyon et al. suggest that “researchers should shift their efforts toward better understanding the reason for differences in incentives between CEOs in the U.S. and CEOs in the U.K. and other parts of the world”.

We analyze whether country-level restrictions in insider trading contribute to cross-country differences in top executive compensation. Specifically, we analyze several (not mutually exclusive) channels through which compensation and insider trading restrictions might be related. One possibility is that insider trading represents a form of compensation for top executives. Thus, when insider trading laws are restrictive, equilibrium in the labor market forces firms to increase the level of top executive compensation. A second possibility is that the strength of insider trading laws affects the optimal use of equity incentives. If insider trading represents a form of equity incentives (e.g., Manne, 1966), restricting such trading might lead firms to substitute other types of equity incentives in the executive compensation contract. Similarly, when insider trading laws are weaker, firms might choose to use relatively fewer incentives in pay packages so as to avoid trading-related agency conflicts (see, for example, Baiman and Verrecchia, 1995). Because greater equity incentives expose top executives to greater risk, the increased use of equity incentives when insider trading is restricted also leads to higher levels of compensation. A third possibility is that insider trading laws are themselves a response to cross-country differences in pay practices. Specifically, in countries in which firms use greater equity incentives, stronger insider trading laws are required to mitigate trading-related agency conflicts with executives.

To provide evidence on these hypotheses, we analyze both levels of top executive compensation and the use of equity-based incentives for a broad set of executives in 41 different countries. Our primary sample consists of 468 non-U.S. firms with American Depository Receipts (ADRs) and 1852 U.S. firms in 2006. The primary virtue of analyzing compensation in foreign firms with ADRs is that such firms are required to file Form 20-F with the SEC. Thus, we are able to obtain complete, standardized compensation data at the firm level for all of our sample firms. By contrast, most prior cross-country compensation studies have been forced to rely upon survey-based and country-aggregate compensation data.1 We recognize that a possible limitation of our data is that firms with ADRs are not representative of the population of firms in that country and later address this potential limitation.

We measure insider trading restrictions in two ways. First, following Du and Wei (2004), we use an insider trading restriction (ITR) index that is based on global executive opinion surveys about the extent of insider trading restrictions in individual countries. Second, we use an insider trading law (ITL) index from Beny (2006) that captures differences in the strength of insider trading laws. Importantly, for our purposes, both ITR and ITL exhibit substantial cross-country variation.

Our baseline analysis indicates that equity incentives are positively related to insider trading restrictions. These findings are robust to the inclusion of a variety of firm-level and country-level control variables, such as firm size, leverage, R&D, growth opportunities, board structure, shareholder protection, and country GDP. Moreover, the implied impact of insider trading restrictions on equity incentives is also economically important. A one-unit increase in the ITR index (approximately one standard deviation) is associated with an increase in overall equity incentives of over 200%, and an increase in the percentage of equity-based pay (i.e., the incremental flow of incentives) of about 22 percentage points. We also find that the level of top executive total pay is positively associated with insider trading restrictions. However, we cannot reject that this finding is driven by the greater use of equity incentives (and, therefore, higher risk premium) in countries with stronger insider trading restrictions.

These baseline findings are consistent with all three hypothesized channels for the association between insider trading restrictions and compensation. In addition, a fourth possibility is that there is no causal connection between insider trading restrictions and top executive pay/incentives. Under this explanation, the association between the two is a spurious byproduct of the fact that our regressions omit potentially important factors that are correlated with both insider trading restrictions and executive pay.

To further discriminate among these alternative explanations, therefore, we conduct several additional tests. First, we exploit time-series variation in insider trading restrictions to estimate panel regressions with country and year fixed effects. The results from these tests indicate that greater restrictions on insider trading are associated with significant increases in the use of incentive compensation.

Second, we analyze changes in compensation around the dates of initial enforcement of insider trading laws. After controlling for time trends and fixed country effects, we find that both the level of total executive compensation and the use of equity-based incentives increase significantly following the initial enforcement of insider trading laws.

Third, we analyze whether the observed link between executive compensation and insider trading restrictions is associated with the level of insider ownership. Because higher insider ownership diminishes the need for additional incentives at the margin, this should weaken the link between insider trading restrictions and the use of equity incentives if the direction of causation runs from trading restrictions to executive pay. Consistent with this argument, the results from these tests indicate that higher inside ownership weakens the link between insider trading restrictions and both overall equity incentives and the level of pay.

Based on the results of these additional tests, we conclude that the evidence appears most consistent with a causal link that runs from insider trading restrictions to compensation incentives. Such a link is consistent with both (i) insider trading serving as an implicit form of compensation, and (ii) firms optimally choosing to use greater (fewer) equity incentives when insider trading restrictions are strong (weak). Because (i) depends on insider trading restrictions leading to reduced trading profits for executives whereas (ii) does not, distinguishing between these two explanations requires observation of whether stronger insider trading restrictions actually do reduce executive trading profits.

Unfortunately, we are unaware of systematic data on the profitability of insider trading outside of the U.S. Therefore, we conduct an indirect test by analyzing the run-up in stock prices prior to acquisition announcements in each of our sample countries. Prior studies document both the existence of abnormal insider trading by executives prior to takeover announcements (Agrawal and Nasser, 2012) and an association between pre-announcement run-ups and informed trading (Arshadi and Eyssell, 1991). We thus test whether cross-country differences in stock price run-ups are associated with the strength of insider trading laws. Consistent with reduced informed trading in countries with tighter restrictions on insider trading, we find a significant negative association between pre-acquisition stock price run-ups and the strength of insider trading restrictions. However, we note an important caveat with interpreting this finding as evidence of reduced insider profits for executives in countries with stronger insider trading restrictions. Although the study by Arshadi and Eyssell (1991) finds that there is a reduction in net insider purchases prior to tender offer announcements after the passage of a new insider trading law in the U.S., they report that the largest effect is on trading by beneficial owners of the target's shares. Thus, our finding of lower run-ups in countries with stronger insider trading restrictions can be viewed as evidence of reduced trading profits for executives only if the trades of those executives are correlated with those of other beneficial owners. Unfortunately, we lack direct evidence on that issue.

By identifying insider trading restrictions as an important channel through which differences in cross-country compensation and incentives can be explained, our findings contribute to the growing international executive compensation literature.2 Our findings also complement and extend those of Roulstone (2003), who finds that self-imposed insider trading restrictions in U.S. firms are related to higher executive compensation and a greater level of incentive compensation.

The remainder of the paper is organized as follows. In Section 2, we provide background on the literature that hypothesizes a link between insider trading and compensation. Section 3 describes our sample selection process and describes our primary data. Section 4 reports the results of our cross-sectional regressions. In Section 5, we report the results from a series of additional tests that explore alternative explanations for our findings. Section 6 reports the results from our analysis of stock price run-ups prior to acquisition announcements and Section 7 concludes.

Section snippets

Insider trading, equity incentives and top executive compensation

In this section, we discuss several channels through which insider trading restrictions might be associated with compensation levels and equity incentives. These channels differ in the extent to which they rely on a substitution between insider trading profits and compensation, and the direction of causation in the hypothesized association between insider trading restrictions and compensation.

Sample selection and data description

In this section, we describe the executive compensation data that we use in our empirical analysis as well as our primary measures of insider trading restrictions. We then report summary statistics for the sample.

The association between insider trading restrictions and executive compensation

In this section, we report our base analyses of the empirical association between insider trading restrictions and executive compensation using our sample of U.S. and ADR firms in 2006. We begin in Section 4.1 with the univariate association, and then estimate multivariate regressions of the association between insider trading restrictions and both compensation levels and incentives in Section 4.2.

Additional tests

Our findings to this point indicate that equity incentives are positively related to insider trading restrictions. We also find that the level of top executive total pay is positively associated with insider trading restrictions. However, we cannot reject that this finding is driven by the greater use of equity incentives (and, therefore, higher risk premium) in countries with stronger insider trading restrictions.

These findings are consistent with several potential explanations. Compensation

Do insider trading restrictions reduce the insider trading profits of executives?

To this point, our results support a causal link that runs from insider trading restrictions to equity incentives. Such a causal link might be due to either a substitution between insider trading profits and direct executive compensation or to the existence of stronger insider trading laws allowing firms to optimally use more incentives. The former assumes that insider trading restrictions are correlated with actual reductions in trading profits for executives, while the latter does not. Thus,

Summary and conclusions

We exploit variation in insider trading restrictions across countries to investigate the link between such restrictions and top executive compensation and incentives. Our results indicate that top executives are significantly more highly paid and hold more equity incentives in countries with stronger insider trading restrictions. These findings are robust to the inclusion of possible country-level and firm-level omitted variables, to panel data specifications, to alternative definitions of

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  • Cited by (0)

    We thank an anonymous referee, Leonce Bargeron, John Core (the editor), Melanie Cao, Martijn Cremers, Diane Denis, Mara Faccio, Steve Kaplan, Seoyoung Kim, Ken Lehn, David Lesmond, Tim Loughran, Henry Manne, John McConnell, Darren Roulstone, Shawn Thomas, and Mark Walker for helpful discussions and comments. In addition, the paper has benefited from comments from workshop participants at Carnegie Mellon University, Hong Kong University of Science and Technology, Michigan State University, Nanyang Technological University, National University of Singapore, Penn State University, Singapore Management University, Temple University, Tulane University, University of Toronto, the 2009 Northern Finance Association meetings, the 2009 State of Indiana Finance Conference and the 2010 American Finance Association meetings for their helpful comments. Xu acknowledges the financial support from the Purdue University Center for International Business Education and Research. Special thanks are due to Luis Marques for part of the data used in the paper. Clarke Bjarnason provided able research assistance.

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