MIT Sloan Professor Finds Evidence of Significant Front-Running

CAMBRIDGE, Mass., July 15, 2008 — In the wake of allegations of front-running on Wall Street and an SEC investigation, evidence of significant front-running has been found by MIT Sloan School of Management Professor Mozaffar Khan.

In a recent paper, “Do Short Sellers Front-Run Insider Sales?”, Khan and coauthor Hai Lu of the Rotman School of Management at the University of Toronto found significant increases in short sales immediately prior to large sales by corporate insiders such as CEOs, consistent with front-running based on leaked information about an upcoming insider sale.

Front-running, which is trading in advance of a large trade in order to profit from the price movement that usually follows the large trade, can happen when people are tipped off about an impending large sale. A brokerage employee might tip off a favored client like a large hedge fund or a brokerage might trade on its own prior to executing a client's large trade. Both scenarios are illegal, as the trades are not based on public information.

In their paper, the authors document an increasing trend of daily short sales in the days leading up to a large insider sale and peaking sharply on the day of the large insider sale. They found that for large insider sales, short sales are significantly higher starting seven days before the insider sale.

They did not find evidence that short sellers anticipate insider sales based on publicly available information. Rather, their evidence suggests the front-running is made possible by information that is privately leaked.

Khan, an MIT Sloan professor of economics, finance and accounting, said, “It seems like this is driven by leaked information. We don't have data to say who is leaking the information and who it is being leaked to, but this is an issue that should be addressed by the exchanges and the SEC.”

He explained that front-running based on leaked information hurts ordinary investors who expect the stock market to provide fair gains. “If some people illegally acquire private information, then they are going to have an unfair advantage over those without that information. This might deter people from investing in the stock market. If a lot of people don't participate in the stock market, then companies — even good companies with great products — can't raise money, leading to inefficient capital allocation. It distorts the entire playing field.”

Khan added, “If there is leakage, then we need enforcement by the SEC of existing regulations and they need to investigate who is doing the leaking to stop it.” He added that the other way to stop the leakage is to increase the frequency of disclosure of short sales required by exchanges from monthly to perhaps daily.

“If others participating in the market can observe from daily disclosures that short sales have increased, they will rationally infer the presence of some private information and adjust the stock price accordingly. In this way the private information gets impounded in the stock price sooner rather than later, and therefore reduces the front-runners' unfair advantage over the rest of the public,” he said, noting that there is a cost to collecting and disclosing the information which has to be balanced with the need for more frequent disclosures.

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