What Do Outside Directors Know? Evidence From Outsider Trading

Sarbanes-Oxley and other regulatory reform have advocated to put more outsiders on the board. The rationale of this measure is that outsiders are more independent, while a potential drawback is that they might not know enough about the firm to be effective monitors. Having information about the firm is a necassary condition to be an effective monitor. This paper investigates whether outside directors have information about the firm and its conditions. Using a comprehensive sample of executives' and board of directors' transactions from 1986 to 2003 in U.S. companies, we compare the trading profits of three types of individuals: (i) insiders (executives of the firm), (ii) non executive directors who are large blockholders, and (iii) directors who are neither employees of the firm, nor large blockholders (outside directors). Insiders and outside directors earn higher abnormal returns than the market. Insiders generally perform better than outsiders in purchases transactions. These results suggest that outside directors do have substantial inside information about the firm, even though they know less than the executives. We also find that in better governed firms the difference in performance between outsiders' and insiders' returns is lower, suggesting that firms with better governance structure may have better mechanism in place that allows outsiders to receive more information