Shareholder Litigation and Insider Trading: Evidence from Derivative Litigation

Abstract

We examine whether shareholder litigation deters informed insider trading, utilizing the staggered adoptions of Universal Demand (UD) laws by different states. The UD laws substantially raise the hurdle for shareholders to file derivative litigation. We find that corporate insiders significantly increase opportunistic trades, including both insider purchases and sales, after the passage of UD laws, suggesting derivative litigation serves a disciplinary role in curbing insider trading. The deterrence effect of derivative litigation complements that of federal securities litigation, as it is effective in constraining informed insider trading activities unaccompanied by investor losses such as insider purchases. The deterrence effect on insider trading is more pronounced for firms with limited media coverage and firms with block-holders who have the resources and incentives to initiate shareholder litigation. Overall, our evidence suggests that shareholder litigation in the form of derivative litigation plays a unique governance role.