Did regulation fair disclosure diminish institutional investors' ability to mimic profitable insider trades?

Abstract

This study investigates whether Regulation Fair Disclosure (hereafter Reg FD) was successful in leveling the playing field between institutional (large) and individual (small) investors in terms of their ability to profit by mimicking insider trading patterns. I identify trades made by large versus small investors and examine their relative ability to distinguish profitable insider trades from unprofitable trades. I argue that, prior to Reg FD, large institutional investors had superior access to management which enabled them to obtain material information before it was publicly announced. Such managerial access could have helped large investors to identify and mimic information-driven insider trades that were more likely to be profitable. Consistent with my expectation, I find that, in the pre-Reg FD period, large investors exhibit higher abnormal trading volume around insider trades that are ex post profitable; in contrast, small investors do not exhibit such a pattern. My main finding is that, after the passage of Reg FD, the abnormal trading volume around profitable insider trades observed for large investors disappears. The analysis of directional trading behavior of investors suggests that Reg FD was successful in mitigating large investors' ability to mimic profitable insider sales. On the other hand, in relation to insider purchases, I find that large investors' mimicking ability persists after the passage of Reg FD. While their superior mimicking ability post Reg FD may be due to their own expertise in information collection and processing, superior information access cannot be ruled out as an explanation. Overall, my findings suggest that the restrictions on private information disclosure instituted by Reg FD were largely effective in blocking management's selective communication channel and reducing the information advantage enjoyed by large investors.