For investors, regulators and public companies, two of the biggest hot-button issues are executive pay and insider trading.
Now a University of Pittsburgh professor and a colleague have found a connection between the two topics that is sure to enliven the debate.
David J. Denis and Purdue University’s Jin Xu say there is a correlation between executive pay levels in a country and that country’s attitude toward insider trading: The more restrictions that a country slaps on insider trading, the more an executive’s paycheck grows.
“Top executives are significantly more highly paid and hold more equity incentives in countries with stronger insider trading restrictions,” the two professors wrote in a paper published recently in the Journal of Accounting and Economics.
A country’s insider trading laws have “an impact on the managerial labour market in terms of what it is going to take to hire an executive to do the job,” Mr. Denis said.
Excutives are paid less in countries where insider trading is permittedand do not receive as many stock options or other equity incentives. Moreover, total pay and equity incentives increased significantly when restrictions on insider trading were imposed as well as after the first time the tougher laws are enforced, the researchers found.
Insider trading involves making investment decisions based on significant, confidential information that a company has not shared with all of its investors. Using the information can help insider traders make big profits as well as avoid losses. In the U.K., cases can be brought against those who trade on the information as well as those who provide it.
Mr. Denis and Ms. Xu discovered the relationship between pay and insider trading by analysing what the top executives at more than 1,800 U.S. firms and 400 non-U.S. firms were paid in 2006.
Compensation included salary, bonuses, equity incentives and other compensation. Equipped with the pay figures, they examined insider trading laws on a country-by-country basis.
One of the ways they did it was through a survey of executives that measured their perceptions of how restrictive the laws were. The researchers developed a numerical ranking for countries based on those perceptions and established a midway point for the scores of individual countries. Countries below the midway point of all the scores were perceived to have weaker laws while those above it were viewed as more restrictive.
What Mr. Denis and Ms. Xu found was that executives in countries in the bottom half received average pay of $300,000 while those in the top half received an average of $1.6 million.
The opportunity to capitalize on profits from insider trading does not account for all of the $1.3 million difference, Mr. Denis said, “but our evidence is showing it is a pretty important factor.”
He said the gap also contains a risk premium. If a greater percentage of an executive’s pay is based on incentives, companies have to pay them more because of the risk that executives will not be paid everything they are offered if the targets triggering the incentives are not met.
“As soon as you use equity incentives, you immediately have to pay the executives more because you’re exposing them to more risk,” Mr. Denis said.
From that standpoint, an argument could be made that it would be less expensive for companies if their executives were allowed to profit from insider trading. That would spare shareholders the expense of providing them with generous incentives that allow executives to make more than their counterparts in countries where insider trading is an accepted business practice.
However, critics of the practice say it is unfair to other investors to let those with a knowledge of inside information to profit from it.
