Secondary markets and the power of the enforcement of insider trading laws

To facilitate small and high growth firms in need of finance, the London Stock Exchange (LSE) introduced a secondary market, the Alternative Investment Market (AIM), in 1995. The AIM is a lightly regulated market, with minimum eligibility criteria and ongoing obligations, which was initially considered to be a stepping-stone to the traditionally regulated Main Market (MM) of the UK. However, it rapidly started to attract firms from all over the world gaining its own identity and reputation. This success made secondary markets increasingly popular, with more and more countries introducing secondary markets with similar regulatory regimes to the AIM. Examples of countries that have introduced secondary markets include Belgium, France, Japan, Portugal, Spain, and the Nordic countries. The idea of secondary markets also gained traction in the US. Specifically, in 2012 the US introduced the Jumpstart Our Business Startups (JOBS) Act that exempts small firms from the Sarbanes-Oxley (SOX) Act of 2002, effectively reducing barriers for small firms seeking capital. Another indicator of secondary markets’ popularity is that the number of firms listed in the most prevalent secondary markets increased from 121 in 1995 to over 2,000 in 2018. The total market capitalization of secondary markets also increased from approximately $4 billion in 1995 to over $145 billion in 2018. Still, the AIM is one of the most popular, rapidly growing, and successful secondary markets in the world.

However, secondary markets, and particularly the AIM, have attracted criticism as low-quality markets, susceptible to abusive behaviors and fraud. Rejecting these claims, Marcus Stuttard, head of the AIM, argues that if AIM was a casino it wouldn’t have its 20 years of longevity and maturity.

Our recent study “Price run-ups and insider trading laws under different regulatory environments” explores whether the lightly regulated AIM offers a comparable investment environment with respect to informed trading, compared to the traditional regulated MM. In particular, it examines the impact of exchange regulations on the price run-ups prior to the announcement of takeovers – a major corporate event, notorious for information leaks and illegal trading. Our study further explores how the introduction and enforcement of stricter insider trading laws affect the two markets.

The empirical tests of our study are as follows. First, we examine the price run-up patterns for target firms listed in the AIM and in the MM. Due to the different regulatory nature of these two markets, and in line with the common view that secondary markets are of lower quality, we examine whether the AIM target firms experience higher levels of abnormal stock returns prior to their takeover announcement, compared to their MM counterparts. Second, we examine whether such patterns change following the introduction of stricter insider trading laws. To that end, we use the price run-up patterns around the enactment of the Financial Services & Markets Act (FSMA) in 2001. This Act established the Financial Conduct Authority (FCA) as the single regulator for both markets, with the scope of preventing market abuse and promoting investor protection. However, even though the FSMA introduced stricter laws, it has received criticism for poor enforcement. Thus, this event provides an exogenous shock of stricter regulation with low enforcement. Third, we explore whether the increase in regulatory enforcement in the form of criminal convictions in the UK since 2009 has changed the perception of potentially informed investors regarding the likelihood of being caught across the two markets. The first criminal conviction on insider trading in the UK took place on March 2009, followed by numerous convictions. Since criminal convictions are characterized as the strongest form of penalty, we use the first criminal sanctions related to insider trading as an exogenous shock that may influence the price run-ups prior to the announcements of takeovers.

The differences between the two UK markets

The AIM and the MM differ substantially on firms’ eligibility criteria and ongoing obligations. First, the admission criteria for the AIM are less stringent compared to those of the MM. Specifically, the listing criteria for admission to the AIM mandate (1) no minimum percentage of float; (2) no requirement of audited financial statements in the years prior to the listing (nonetheless there is a requirement for a minimum of three years of audited financial statements for the companies that have been trading in other exchanges) and; (3) no minimum market capitalization. In contrast, the admission to the MM requires: (1) a minimum 25% of float; (2) a minimum of three years of audited financial statements before the admission; and (3) a minimum market capitalization of £700,000. 

Second, the two exchanges differ in the annual and compliance costs. Specifically, the AIM is regarded as a less expensive market according to its principles of facilitating small firms in need of finance. 

Third, firms listed in the AIM should have a Nominated Advisor (Nomad) for the whole duration they are in the exchange, including the time of their listing. No such requirement holds for the firms listed in the MM. The Nomads, which are typically accounting firms, investment banks, or financial firms, oversee and guide the AIM firms. Specifically, they advise and prepare firms for their listing as well as maintain regular contact and guide them throughout their existence in the exchange. In addition, the Nomads are responsible for regulating the AIM firms and ensuring that they comprehend and adhere to the “AIM rules for companies.” Moreover, and in direct relevance to our study, the Nomads are responsible for monitoring the stock prices of the firms they oversee, especially ahead of important corporate events, while they are expected to prepare draft public announcements before important corporate events to be used in case there is a leakage of sensitive information. 

Fourth, the MM firms are subject to the UK Corporate Governance Code which stipulates a “comply or explain” approach to its provisions. The AIM firms are not subject to the Code; however, they are expected to adhere to a recognized corporate governance code which, most often, is the Quoted Companies Alliance, a governance code for small and medium firms. Finally, the MM firms are required to produce an insider list that includes details of all individuals with access to inside information.

Does the AIM offer a comparable investment environment to the MM with respect to informed trading?

We find abnormal stock returns 40 trading days prior to takeover announcements in both the AIM and the MM. The abnormal stock returns persist after controlling for firms that have a high probability of being taken over. This pattern is indicative of information leakage related to the forthcoming takeover prior to its public announcement. Interestingly, although the AIM has been criticized as a market susceptible to fraud, we find that the returns are 9% higher in the MM compared to those of the AIM. This difference is robust after controlling for a range of market and deal anticipation proxies. This is contradictive to the criticism AIM has received and shows that it can provide a comparable investment environment to the MM with regards to informed trading. We further find that the difference in the price run-ups reported in the two markets also has an impact on the premium paid by the bidders. We find that the bidders incur part of the cost of information leakage that occurs prior to the announcement by paying higher premiums in the MM but not in the AIM. 

We interpret these findings as follows. Even though the AIM is a lightly regulated market, all firms listed in the AIM are scrutinized by the Nomads who are responsible for supervising the stock prices of the firms they oversee and tracking any abnormal behaviors. We argue that this framework of close supervision by the Nomads provides better monitoring on informed trading compared to the structure of traditionally regulated markets. Another possible interpretation is that large hedge funds typically trade in the MM to pursue larger deals with higher impact on returns. These large funds have recourses to spend on expert networks which provide specialized information about firms. However, although expert networks provide sophisticated advice, they have occasionally been accused of providing confidential price sensitive information. Meanwhile, large funds may also afford to spend resources to track companies in order to gain information edge.

What is the impact of introduction and enforcement of stricter insider trading laws on the two markets? 

We find that the stricter regulations implemented in 2001 by the FSMA did not lead to a reduction in abnormal stock returns prior to takeover deals in any of the two markets. However, we find support that the underlying mechanism that reduces the pre-announcement price run-ups is the enforcement of the law. This is in line with the view that for insider trading laws to work, they must be enforced. Otherwise, if laws are poorly enforced it may be better to have no laws at all. Specifically, we find that the manifestation of regulatory enforcement in the form of criminal sanctions in 2009 has a significantly negative effect on the price run-ups for target firms in the MM, but not in the AIM. A possible explanation is that the focus of the enforcement is in the MM. In particular, only 11.1% of the prison sentences given to individuals are due to trading in AIM firms, compared to 75.3% due to trading in MM firms and the remaining 13.6% due to trading in non-UK firms. Moreover, we find that the number of criminal convictions and the severity of the conviction penalties further assist in reducing the pre-announcement abnormal stock returns. These findings highlight the importance of criminal convictions in limiting price run-ups prior to takeovers. They also show that regulatory focus is of importance within the same country.

Conclusion

Our study extends the literature on price run-ups prior to takeovers by providing first-hand evidence in the unexplored but important setting of two differently regulated markets within the same legal and economic environment. This dimension is critical due to the lack of comparative evidence on price run-up levels between main and secondary markets. This examination is important given the increase in popularity of secondary markets around the world and the volume of takeovers in these markets. For example, the value of takeovers in the AIM has reached a total of over $2.5 billion with more than 200 successful deals between 1995 and 2018. Second, we add to the debate around the influence of insider trading regulations and regulatory enforcement on stock prices by assessing their impact on price run-ups in two different regulatory exchanges within the same country. We highlight the significance of criminal convictions and further add the important dimension of the regulatory focus within the same country in battling the leakage of information. 

Our findings and related discussion have important implications for companies and their managers, policy makers, and investors in two ways. First, we show that, in contrast to the general view and press critiques, the AIM could be a comparable investment environment to the MM, with regards to informed trading. Second, we provide insights on the role of regulatory changes, regulatory focus, and criminal sanctions in battling informed trading.

Styliani Panetsidou is a Lecturer (Assistant Professor) in Finance at Coventry University

Angelos Synapis is a Lecturer (Assistant Professor) in Finance at Coventry University

Ioannis Tsalavoutas is a Professor of Accounting and Finance at the University of Glasgow.

This post is adapted from their paper, “Price run-ups and insider trading laws under different regulatory environments” available on SSRN and forthcoming in the Review of Quantitative Finance and Accounting.

The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.

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