Shadow Trading and Corporate Investments

Corporate insiders engage in shadow trading when they use private information pertaining to their own firm to trade in the shares of economically connected companies. We develop a model to analyze the consequences of shadow trading on corporate investment choices and derive four main findings. First, when a firm permits shadow trading it can externalize on shareholders of connected companies part of the cost of its insiders' compensation. Second, shadow trading can give insiders and shareholders incentives to prefer greater corporate risk-taking. Third, under certain conditions the prospect of shadow trading profits can lead both insiders and shareholders to prefer negative-expected-value projects over positive-expected-value ones. Fourth, when shareholders are unaware of the manager's engagement in shadow trading, the manager's strategic project choice can be inefficient for the firm and can increase stock price volatility. We then discuss the policy implications of our findings