Institutional Investors as Monitors: On the Impact of Insider Trading Legislation on Large Shareholder Activism

Abstract

This paper investigates the role of large institutional investors for monitoring the management of companies. The focus is on the fact that large shareholders face a conflict in the use of their information. They cannot trade on some information which is subject to insider trading legislation. As a precaution they do not acquire it in the first place in order to not jeopardize their trading strategy. As a result they stay less informed, thereby reducing their effectiveness as monitors. The paper investigates this dilemma and the efficiency implications of insider trading legislation in a simple information economy where the large shareholder is a mutual fund. The size of the fund is determined endogenously in equilibrium and is too small to provide optimal monitoring incentives. The main results are that appropriate insider trading legislation can increase efficiency through forcing disclosure of private information, and that the definition of inside information has to be sufficiently broad. The paper also shows that high market liquidity enhances monitoring activities.

JEL Classification: G34