Our study, “Say on Pay Laws and Insider Trading,” published in The Accounting Review, examines whether the mandatory adoption of “say on pay” (SoP) laws—which require shareholder votes on executive compensation—leads executives to engage more in insider trading as a countermeasure to the increased compensation risk imposed by these regulations. This question is crucial because SoP laws, designed to enhance transparency and align executive compensation with performance, might inadvertently lead to increased insider trading activities, thus undermining their intended goals. Yet, the potential impact of SoP on implicit compensation, such as insider trading, has remained largely unexplored.

Over the past two decades, many countries have embraced SoP regimes. Previous studies, like those by Correa and Lel (2016), indicate that SoP boosts pay-for-performance sensitivity and slows the growth of pay rates, especially in firms with excessive pay and weak governance. Other single-country studies, including those by Ertimur, Ferri, and Oesch (2013) and Ferri and Maber (2013), show that SoP improves the quality of pay disclosures and prompts changes in pay practices following adverse votes. Collectively, the evidence suggests that SoP has had a direct impact on executive compensation. By increasing the performance sensitivity of top executive pay without a commensurate increase in levels, we argue that SoP increase executive pay risk.

Building on the premise that insider trading can serve as an implicit compensation mechanism, as suggested by Manne (1966), Roulstone (2003), and Denis and Xu (2013), we hypothesize that executives might ramp up insider trading activities to counterbalance the additional risk and potential loss in explicit compensation resulting from SoP laws. The implicit nature of insider trading makes it a subtle but powerful means for executives to secure their financial interests, potentially offsetting any regulatory efforts aimed at controlling explicit compensation.

Nevertheless, we acknowledge potential tensions in this hypothesis. Executives might refrain from increasing insider trading due to reputational concerns and the higher litigation risks associated with increased trading activity. Furthermore, heightened shareholder monitoring and increased scrutiny from boards and regulators could deter such activities. If shareholders monitor insider trading and consider it when casting SoP votes, executives might be dissuaded from seeking higher insider trading profits. Additionally, the very presence of SoP laws might signal an increase in overall executive activity monitoring by media, regulators, and governance agencies, resulting in higher reputation and litigation costs for engaging in insider trading. Hence, whether SoP affects insider trading remains an empirical question.

To address this question, we use a sample of over 90,000 observations drawn from 25 countries.  We compare firm-level insider trading profitability before and after SoP adoption, relative to firms from countries that have not adopted SoP or have not yet implemented it during the sample period. We find an increase in insider trading profitability following SoP adoption corresponding to an additional $100,000 of implicit annual compensation per executive or approximately 10% of the mean executive pay in the sample. This significant increase suggests that executives are leveraging insider trading as a means to mitigate the risks introduced by SoP laws.

Further analysis reveals that the increase in insider trading profitability is more pronounced in firms with higher levels of excess pay and weaker governance structures. This finding suggests that executives in such firms are more motivated to engage in insider trading to offset the effects of SoP. The correlation between weak governance and increased insider trading profitability highlights the importance of strong oversight mechanisms to counteract potential regulatory loopholes.

To further understand where the increase in insider trading profits comes from, we decompose insider trading profitability into trade informativeness (the ability to predict future stock returns), trade size, and trade frequency. The increase in profitability is primarily driven by more frequent and larger insider sales, consistent with executives’ efforts to reduce exposure to firm-specific risk. The tendency for executives to sell more frequently and in larger quantities suggests a strategic move to rebalance their portfolios in response to the heightened compensation risk imposed by SoP laws. Additionally, there is some evidence that insider sales become more predictive of future returns, especially over six-month periods, indicating that these sales are not random but rather based on informed decisions about future firm performance.

In sum, our study provides new insights into the unintended consequences of SoP laws on insider trading activities, thereby complementing existing research on executive compensation and insider trading. We add to the body of work on SoP by exploring its impact on implicit compensation, such as insider trading profits, highlighting the broader implications for evaluating SoP effectiveness. Additionally, our findings align with research indicating that boards view insider trading profits as part of total compensation, revealing how executives adjust their behavior in response to compensation reforms. Finally, we extend the understanding of regulatory impacts by showing how compensation-related reforms can lead to increased insider trading, emphasizing the importance of considering both explicit and implicit pay in regulatory design and assessment.

The results have implications for practitioners such as investors, proxy advisors, and regulators, emphasizing the need for enhanced monitoring and controls on insider trading alongside SoP reforms. Investors and proxy advisors should be vigilant about potential increases in insider trading activities when evaluating executive compensation packages and casting votes or issuing recommendations on SoP proposals. By addressing both explicit and implicit forms of compensation, regulators and policymakers can create a more balanced and effective framework for executive compensation.

The complete paper is available for download here.