Ernst Maug
Duke University, Durham, NC 27708
ABSTRACT
This paper investigates the role of large institutional investors for monitoring the management of companies. The focus is on the fact that large shareholders face a conflict in the use of their information. They cannot trade on some information which is subject to insider trading legislation. As a precaution they do not acquire it in the first place in order not to jeopardize their trading strategy. As a result they stay less informed, thereby reducing their effectiveness as monitors of companies in which they hold large stakes. The paper investigates this decision making problem and the efficiency implications of insider legislation in a simple information economy where the large shareholder is a mutual fund which forms endogenously. The main result is that appropriate insider trading legislation can increase efficiency since it enforces an implicit transaction tax on small investors which reduces their incentive to free ride on the improvements of the mutual fund.