Shadow Trading and Corporate Investments

Yoon Ho Alex Lee, Lawrence Liu, Alessandro Romano*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

Abstract

Corporate insiders engage in shadow trading when they use private information pertaining to their own firm to trade in the shares of economically connected companies. We develop a model to analyze the consequences of shadow trading on corporate investment choices and derive four main findings. First, when a firm permits shadow trading it can externalize on shareholders of connected companies part of the cost of its insiders' compensation. Second, shadow trading can give insiders and shareholders incentives to prefer greater corporate risk-taking. Third, under certain conditions the prospect of shadow trading profits can lead both insiders and shareholders to prefer negative-expected-value projects over positive-expected-value ones. Fourth, when shareholders are unaware of the manager's engagement in shadow trading, the manager's strategic project choice can be inefficient for the firm and can increase stock price volatility. We then discuss the policy implications of our findings.

Original languageEnglish (US)
Pages (from-to)191-227
Number of pages37
JournalJournal of Law, Finance, and Accounting
Volume7
Issue number2
DOIs
StatePublished - 2023

Funding

The authors wish to thank Daniel Aobdia, Ian Ayres, Bernard Black, Luca Enriques, Ezra Friedman, Jeffrey Gordon, Henry Hansmann, Erik Hovenkamp, Alvin Klevorick, Aneil Kovvali, Jon Macey, John Morley, Roberta Romano, Stefano Rossi, Julien Sauvagnat, Alan Schwartz, Nadav Shoked, Holger Spamann, Alireza Tahbaz-Salehi, and the participants at the 2020 Labex-NYU-SAFE/LawFin Law & Banking/Finance Conference, Oxford Business Law Workshop, the Bocconi Faculty Workshop, the Harvard Law School workshop organized by the Italian Law Students Association, the Third Conference in Law and Macroeconomics at Yale Law School, the 2021 Seoul National University Trans-Pacific Business Law Dialogue, and the 2022 Annual Meeting of the American Law and Economics Association for their helpful comments and suggestions. We thank excellent research assistance by Karolina Bartosik. All errors are ours.

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Law

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