Insider Trading and the Patent Application Process

Although prior research finds that insider trades generate abnormal returns, evidence on the nature of information that insiders use in their trading decisions is scant. Extant studies examining whether insider transactions are associated with significant future corporate events assume that insiders have foreknowledge of these events ex-ante when trading. The patent application process provides a powerful research setting since we can exploit knowing exactly when insiders receive private information about future grants of high impact patents. Arguing that insiders try to exploit the resulting information asymmetry, we predict and find that insiders in R&D intensive industries trade on this private information before the patent grant is publicly disclosed. We also investigate insider trading strategies after the official patent grant date, that is, after information asymmetry between insiders and outsiders is presumably dissolved. In case the stock market reacts favorably to the patent disclosure we expect insiders to sell shares subsequent to the grant in order to cash in on their equity holdings at a higher share price. In contrast, if the market underreacts to the patent grant, we expect insiders to buy shares after the grant in order to signal the value of the patent to the market. The results are consistent with both expectations. The results have implications for three distinct streams of the literature. First, we contribute to the discussion on the sources of insider trading profits by documenting that insiders trade on information asymmetries arising during the patent application process. Second, we complement studies which show that equity incentives motivate managers to invest in R&D by documenting that insiders cash in on their equity packages once R&D activities result in patentable inventions. Third, we contribute to a discussion on the uncertainties and information asymmetries that accompany the patent application process by showing that corporate insiders exploit these information asymmetries for their personal trading decisions.