The effect of insider trading and compensation incentives on disclosure quality

This study tests whether managers\u27 incentives for insider trading profits influence the managers\u27 disclosure behavior. This study further tests whether the adverse effect of insider trading on disclosure quality will be mitigated if firms offer higher levels of compensation or if firms place less weight on stock-based compensation (including stock options and restricted stocks). Baiman and Verrecchia (1996) show that the expected decrease (or increase) in abnormal insider trading profits resulting from the increased (or decreased) disclosure level as a factor enters managers\u27 disclosure decisions. However, if firms offer higher levels of compensation, managers will perceive less need to get compensated through insider trading; alternatively, if firms place less weight on stock-based compensation (including stock options and restricted stocks), managers will be awarded fewer shares of firm equity and have fewer opportunities to trade. In both occasions, the decrease in the trading incentives of the managers may mitigate the adverse impact of insider trading incentives on disclosure quality. The empirical proxy for disclosure quality is obtained from the Corporate Information Committee Report (CICR) compiled by the Financial Analysts Federation (FAF). A simultaneous equation modeling approach is used to allow for endogeneity of both disclosure quality and insider trading. The OLS procedure, rank regression, and the regression using the original values (as opposed to the industry-year-adjusted values) of the observations are also performed. The empirical results from rank regression and the regression where the original values are used provide support for the second hypothesis (H2), i.e., a higher compensation level is conducive in mitigating the negative effect of insider trading incentives on disclosure quality. However, the tests for the direct negative impact of insider trading on disclosure quality (H1) and for the indirect negative impact of stock-based compensation on disclosure quality (H3) are not statistically significant in the current study