Insider Trading and the Effectiveness of Chinese Walls in Securities Firms
![handle is hein.journals/jecoplcy4 and id is 373 raw text is: 2008]
INSIDER TRADING AND THE EFFECTIVENESS OF
CHINESE WALLS IN SECURITIES FIRMS
H. Nejat Seyhun*
ABSTRACT
This study investigates the profitability of insider trading around the
time when investment bankers appoint their representatives to the board of
directors. If Chinese Walls at security firms are somewhat porous, then the
presence of investment bankers on a board will increase the information
efficiency of the clients' stocks and reduce the profitability of insider trad-
ing. Consistent with expectations, appointment of investment bankers to
the board of directors eliminates the profitability of insider trading and re-
duces both the bid-ask spreads and volatility. These effects are temporary
and are reversed when the representatives depart. The finding that Chinese
Walls are porous has a number of important economic, legal, and regulatory
implications.
1. INTRODUCTION
This study comprises an indirect test of the effectiveness of Chinese
Walls, defined as policies and procedures that are designed to stop the
passage of information, especially price-sensitive information, operating
between departments within a firm or a financial group.' The concept of
* Professor Nejat Seyhun is a Jerome B. & Eilene M. York Professor of Business Administration
and Professor of Finance at the University of Michigan School of Business. Dr. Seyhun's current re-
search activity focuses on backdating of executive options, risk-return trade-off in asset prices, intra-day
impact of insider trading, long-run performance of IPOs, managerial overconfidence, Chinese walls and
conflicts of interests in securities firms, option pricing, and conflicts between information efficiency and
rewards to information gathering.
Acknowledgments: I thank Jonathan Paul Carmel, Serdar Dinc, Kathleen Fuller, Ross Levine,
Henry Manne, Raghu Rajan, Anjan Thakor and participants at the Journal of Law, Economics, and
Policy's Insider Trading Symposium at George Mason University School of Law and the University of
Michigan faculty workshop for helpful comments. I thank Lisa Kincius and Pam Russell for editorial
assistance. Sophie Shive provided excellent research assistance.
1 The Securities and Exchange Act of 1934 requires every broker-dealer to establish, maintain,
and enforce written policies to prevent the misuse of material, nonpublic information. 15 U.S.C. §
780(0 (2006); see also McVea (1993). There are numerous financial press accounts of porous Chinese
Walls and attendant conflicts of interests. In a highly publicized case, Mr. Martin Siegel, a managing
director at Kidder, Peabody, Inc., was running both the risk-arbitrage and mergers and acquisitions
desks (Rosen, The American Banker, July 19, 1987). Ron Suskind describes an entertaining account of](ViewImageLocal?handle=hein.journals/jecoplcy4&div=24&collection=&method=preview&ext=.png&size=3)
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Insider Trading and the Effectiveness of Chinese Walls in Securities Firms
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