Information Transfers and Insider Trading in Stock Substitutes: Evidence from Economically Linked Firms in the Supply Chain

The Securities Exchange Act of 1934 prohibits insiders from using privileged information to trade the stocks of their own firms. However, insiders could still exploit confidential inside information by trading the stocks of their firm’s supply chain partners. This form of insider trading is referred to as trading in stock substitutes in the supply chain. Using a sample of merger and acquisition (M&A) deals, we test hypotheses about insider trading in stock substitutes by interlocked insiders who are simultaneously affiliated with the merging firms (acquirer or target firms) and their supply chain partner firms (supplier or customer firms). We find that these interlocked insiders trade the stocks of merging firms’ supply chain partner firms using the private information before M&A announcements. Specifically, our results show that interlocked insiders’ net purchases of these supply chain partners’ shares are positively associated with these partner firms’ 5-day abnormal returns around M&A announcements. Furthermore, in our subgroup analysis, we find that insider trading in stock substitutes is more evident in the merging firms’ suppliers than in their customers. Finally, as expected, we find that insider trading in stock substitutes is more prevalent in the presence of lower litigation risk and greater information asymmetry of the partner firms. Our findings provide the first empirical evidence of insider trading in stock substitutes.