Stock Price Run-up before M&A Announcements:
Evidence of Insider Trading or Market Anticipation?
Bachelor Thesis
29th June 2015
Student: Corina Gabriela Marin 10393870
Supervisor: dr. R. (Rafael) Perez Ribas
University of Amsterdam Faculty of Economics and Business BSc. in Economics and Finance 2014/ 2015
Statement of Originality
This document is written by Corina Gabriela Marin who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no
sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
This paper studies the pre-bid run-up in target stock prices before M&A announcements based on a sample of 1442 US deals from 2000-2014. Contrary to the efficient markets theory, the bid premium paid by acquirers is incorporated gradually in the returns starting prior to the official bid date. Two hypotheses have been proposed to account for this anomaly. The insider trading hypothesis assumes that informed investors illegally trade on confidential information, whereas the market anticipation hypothesis attributes abnormal returns to speculation in the media about prospective deals. The present paper uses the event study methodology and a measure of abnormal insider transactions to disentangle the effects of the two contrasting explanations. The results indicate the presence of statistically significant average abnormal returns lasting for five days before the announcement date. However, there appears to be no support for the insider trading hypothesis.
1 Introduction
Mergers and acquisitions (hereafter M&As) are among the largest and most easily observable types of corporate investments. The market for such activities has been increasing in
popularity in the past three decades, amounting to $4200 billion in worldwide transaction value in 2014 from less than $400 billion in 1985 (Institute of Mergers, Acquisitions and Alliances, 2015). As a result, M&As have naturally become the focus of extensive academic literature attempting to explain the process itself, issues of organizational and strategic fit and to quantify the effects on the parties involved.
The main appeal of takeovers is the creation of synergies that increase the value of both firms. Companies that pool their resources aim at achieving cost-savings and economies of scale, gaining access to new markets and diversifying or consolidating their core business. In spite of their staggering popularity and numerous benefits, M&As deliver mixed
performance to the wide range of stakeholders involved. Borg and Leeth (2000) find that the average premium accrued to the target shareholders reaches 16%, while bidders obtain neutral to negative returns.
Assuming efficient capital markets, the bid premium reflected in a positive return for the target should be incorporated instantaneously and completely in the stock price on the announcement of an M&A. However, several studies have found evidence of a gradual adjustment rather than a sudden increase in the stock price of the target in the months prior to the acquisition announcement1. Two competing hypotheses have been proposed to account for this anomaly. On the one hand, the pre-bid run-up might be accounted for by insiders trading on price-sensitive private information. Considering the significant profits that can be obtained from trading the target stock, insiders are highly incentivized to breach their
confidentiality agreements. Nonetheless, the run-up can also be caused by perceptive investors that anticipate the deal from mandatory disclosures or rumours. Acquirers purchasing a significant stake in the target prior to the bid or speculation in the media can produce signals that are traded upon by arbitrageurs.
A consensus regarding the validity of these two hypotheses has not been reached. Aspris, Foley and Frino (2014) support the view that M&As are public secrets and thus gradual adjustments reflect the actions of investors and speculators, while Banerjee and Eckard (2001) attribute abnormal returns to leakage of information about impending deals. Disentangling the contribution of each hypothesis to the run-up has serious implications for the integrity of financial markets considering that one explanation is based on legal
incorporation of publicly available information, whereas the other involves illegal use of proprietary information. Thus, the purpose of the present study is to assess the extent to which the presence of a stock price run-up for target firms involved in acquisitions is evidence of insider trading or investor anticipation. Most literature regarding insider trading in M&A deals in the US focuses on small samples of acquisitions dating from 1970-1990. The main departure from previous studies is the use of a unique and considerably larger dataset with mergers from 2000-2014 that are more relevant in today’s regulatory and business environment.
The event study methodology is used to calculate the daily average abnormal returns for a period starting sixty trading days before the announcement up to ten days after. The insider trading volume is analysed for two periods surrounding the announcement by constructing a measure of abnormal purchases and sales. Informed investors attempting to profit from private information about M&As should buy and sell shares at unusually high levels prior to and after the event, respectively. Based on a sample of 1442 exchange-listed US firms, the results indicate that the statistically significant abnormal returns last for five days before the event date. The magnitude of the effect is especially large on the official bid date and one day after, with returns of 13.65% and 5.43%, respectively. The daily average cumulative abnormal returns fluctuate randomly around zero for the period [-60, -25], but are significantly different from zero for the rest of the event window. However, aggregate insider purchases are abnormally high both before and after the announcement. These findings suggest that the run-up is not caused by illegal conduct, but by efficient market reactions to speculation.
The present study contributes to the existing M&A literature in several ways. First, the results regarding abnormal returns complement the numerous studies that document
run-ups in the target stock price prior to the official bid2. However, the present analysis indicates that the US stock market incorporates more efficiently M&A-related information than previously thought. The abnormal returns last for only five days before the formal announcement, in contrast to the findings of Aspris et al. (2014), which indicate unusual movements in the stock price for ten days prior to the announcement. Second, the short-lived build-up in the cumulative abnormal returns, combined with the insider purchases volume suggests that market anticipation is a more plausible determinant of the stock price run-up than illegal trading. Previous studies attributing abnormal returns to insiders may overstate the existence of illegal activities3.
The remainder of the paper is organized as follows. An overview of the literature regarding the insider trading and market anticipation hypotheses in M&A deals is presented in the next part. Sections 3 and 4 describe the empirical method and data collection,
respectively. Afterwards, the results and their interpretation will be discussed. Implications of the study, as well as limitations and suggestions for further research are presented in the final section.
2 Literature Review
The current section comprises three parts. The first one details the driving forces behind the large bid premium paid by acquirers. The second one describes the two competing
explanations for the gradual incorporation of the bid premium in the target stock price, whereas the third one presents the insider trading regulation and enforcement in the context of US M&As.
2.1 The Value of M&As
Even though the terms are often used interchangeably, acquisition refers to the process of buying a company and taking control of its assets, while merger refers to the creation of a third entity through the combination of two firms, in which case the original shareholders become joint owners4. The main rationale underlying such corporate investments is the creation of financial and operating synergies (Martynova and Renneboog, 2011). The former is derived from tax advantages and increased debt capacity, while the latter can emerge from economies of scale, reduced competition, higher market share and access to new markets.
2 See Andrade, Mitchell and Stafford (2001) and Keown and Pinkerton (1981)
3 Banerjee and Eckard (2001) compare the run-up in US mergers during 1897-1903 when insider trading was legal to the one in recent mergers with mandatory disclosure requirements. They conclude regulation has had little success in deterring trading on proprietary information.
Value can be created in several other ways as well, as highlighted by Seth, Song and Pettit (2002). Undervalued firms can be taken over by companies that identify the mispricing before the market adjusts its expectations, while poorly managed firms can attract corporate raiders aimed at replacing the management team in hopes that performance will mirror the changes.
Given these numerous sources of advantage, M&As are considered value-enhancing events. Andrade, Mitchell and Stafford (2001) find that the average abnormal returns around the event window for the target and acquirer combined equal 1.8%, suggesting that M&As indeed create value. However, the wealth generated is unevenly distributed between the shareholders of the two firms. Borg and Leeth (2000) observe that, on average, most returns are accrued to targets, leaving the acquirer with neutral to negative returns. Their conclusion is on par with Andrade et al. (2001), who find that the target share price increases by 16%, while the bidder stock experiences a 0.7% decline on the day of the announcement. In addition, Bruner (2004) summarizes the findings of 25 studies on target firm performance to conclude that the abnormal return can amount to 20%.
According to Eckbo and Thorburn (2000), a determinant of the significant acquisition premium is competitive bidding, a situation in which multiple prospective acquirers submit bids for the same target firm, thus driving its share price up. Moreover, target firm’s
shareholders have an incentive to keep their shares until the merger is finalized in order profit from takeover synergies. This situation forces the acquirer to increase the bid price until it fully incorporates the expected advantages from the takeover so as to induce the targets to accept the opposite part of the deal. The hubris theory as described by Brown and Sarma (2007) is another plausible explanation for the bid premium. Overconfidence might prompt CEOs to overstate their ability to identify suitable targets and consequently pay excessively for the acquisition. Additionally, Seth et al. (2002) argue that self-interested managers might pursue their own motives instead of maximizing shareholder value. Empire building
ambitions can prompt them to disregard financial considerations only to increase the size of the business under their management, which, in turn, boosts bonus payments and reputation. All these rationales justify the well-documented premium payment in M&A deals.
2.2 The Insider Trading versus Market Anticipation Hypothesis
The semi-strong form of the Efficient Market Theory states that stock prices incorporate immediately and fully all publicly available information (Fama, 1996). Malkiel (2003) concludes that there is no significant evidence against this category of efficient capital
markets hypothesis. Accordingly, at the moment of an M&A announcement, the stock price of the target should experience an immediate increase to a higher level and remain constant afterwards ceteris paribus, i.e. assuming no other information about the target is made available. However, several studies identify pre-announcement cumulative abnormal returns (hereafter run-up) between 12-15% for target firms5. Their results are inconsistent with the theory of market efficiency, which posits that it is impossible to persistently outperform the market by buying stock of prospective targets. Several explanations have been put forward in an attempt to explain this anomaly in target stock prices.
On the one hand, Aspris et al. (2014) state that investors can anticipate the
announcement of an M&A from signals such as toehold acquisitions or rumours in the media about impending deals. Toeholds are defined as a bidder’s purchase of a significant stake in the target, which might signal that a future change in ownership can be expected. The US market for corporate control is subject to mandatory disclosure requirements by the Securities and Exchange Commission (hereafter SEC). Firms must file a 13-D ownership report if they acquire more than 5% of the target firm’s common shares, a report that is observable by the public and might ignite takeover rumours (Bris, 2005). Holderness and Sheehan (1988) identify surges in the trading volume and price of the target stock following such disclosures, especially if the filer is a well-known corporate raider. Therefore, investors indeed follow and react to such filings.
Speculation arising from press releases or independent research of business
professionals about a possible M&A deal is also not uncommon. The daily column “Heard on the Streets” of The Wall Street Journal is a prime example of the channel through which rumours might surface and reach investors. By examining the occurrence of published
rumours, Pound and Zeckhauser (1990) find that markets react efficiently to such information and incorporate it in the share price. Another legitimate source of information comes from professionals that specialize in following closely the corporate developments of a few firms and are thus better informed than regular investors (Aspris et al., 2014). Investment banks place clients that request M&A advisory services on restricted lists to prevent conflicts of interest, which can signal that a corporate event is approaching. Jabbour, Jalilvand and Switzer (2000) conclude that arbitrageurs might trade on the information derived from publicly available news to gain short-term abnormal profits and thus drive the pre-announcement stock price increase. Lin and Howe (1990) find that insiders cannot
consistently outperform the market, thus lending further support to this alternative explanation for the abnormal returns.
On the other hand, Agrawal and Nasser (2012) attribute abnormal returns to insiders that illegally trade on private information. Insiders are defined as individuals that have a duty to shareholders, usually managers and members of the board of directors (Fidrmuc, Goergen and Renneboog, 2006). As indicated by Keown and Pinkerton (1981), M&As are defined by two characteristics that render them particularly attractive for inside trading. First, they involve information that is available to many participants in a deal such as accountants, investment bankers, executives of the two firms and other intermediaries. As a result, a large number of individuals can either trade on non-public knowledge on their own or leak it to acquaintances that are not classified as insiders and are exempt from reporting their dealings to the SEC.
Second, acquisitions are major value-impacting events and affect stock prices
significantly. The high mark-up of 20% provides a powerful incentive to trade on confidential knowledge of an impending deal despite the fact that insider trading is banned in most
countries. Meulbroek (1992) shows that before the announcement of a major corporate event, daily returns are positively correlated with the volume of illegal insider trading as identified from successful SEC prosecutions. According to her, more than half of the pre-bid run-up occurs on days when insiders traded. Using a similar approach based on the number of shares exchanged, Banerjee and Eckard (2001) find that up to 50% of the cumulative abnormal returns prior to the announcement can be attributed to the usage of private information. Further support for this hypothesis is provided by Bhattacharya et al. (2000), who analyse various corporate events in Mexico, a country where insider trading regulation was adopted, but not enforced. Since major firm-specific events appear to have no effect on stock prices, they conclude that gains must be completely accrued to insiders prior to the announcements.
2.3 Insider Trading in the US
The US has accounted for almost half of the world market for M&As each year by the
number of deals and transaction value since the 1970s (Institute of Mergers, Acquisitions and Alliances, 2015). Considering the high profitability of trading on proprietary information about prospective M&As, the need for a regulatory framework in the market for corporate control has surfaced very early on in the US (Bris, 2005). Insider regulation aims at impeding the transfer of wealth from regular investors to individuals classified as insiders, which possess superior information about the true value of the firm. In the context of an M&A,
profits can be obtained by buying the undervalued stock from uniformed shareholders before the merger information is fully incorporated and selling it after the announcement. Therefore, insiders involved in illegal trading on private information are expected to acquire stakes in the target a few weeks prior to the official news release and dispose of them afterwards. This process can affect trust and participation in the financial markets and hinder outsiders’ ability to participate fairly in value-increasing events, thus decreasing overall market efficiency (Banerjee and Eckard, 2001). In addition, such information asymmetries can decrease liquidity in securities markets and create adverse selection problems (Bris, 2005).
Under the assumption that insider trading disadvantages far outweigh its benefits, Section 10(b) of the Securities and Exchange Act of 1934 requires insiders to either disclose the private material information they possess or abstain from trading altogether (Agrawal and Nasser, 2012). According to Rule 14-e3, the definition of insiders is relatively broad,
including corporate insiders such as directors, officers and other individuals who own more than 10% of any equity class (Bris, 2005). Material information refers to information that a reasonable investor would likely consider important in his investment decisions. Fidrmuc et al. (2006) provide an overview of this specific regulatory framework. According to them, insiders must report all their dealings under Rule 10b-5, which imposes disclosure
requirements regarding transaction-specific and personal data. The regulation is more lax with respect to the timing of the disclosure by allowing the insider to report within the first ten days of the month following the month of the transaction. The files are published in SEC’s Insider Trading Report, and subsequently taken over by the Wall Street Journal and other news outlets. This process can take up to forty days to reach market participants, a significant delay that implies trades executed by outsiders in the meantime are based on stale information. Moreover, in contrast to UK regulations, the US system does not impose any trading bans on insiders before major corporate events.
Furthermore, regulation does not deter illegal transactions unless it is strictly
enforced. In response to violations of existing rules, the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) of 1988 increased punishment to a maximum of 10 years of imprisonment and $1 million in fines (Bettis, Coles and Lemmon, 2000). In 2000, the SEC adopted Rules 10b5-1 and 10b5-2 aimed at broadening the definition of insider trading to include activities of acquaintances of registered insiders. Intentionally breaching the duty owed to the source of information, not necessarily the shareholders of the stock traded, constitutes a violation of these rules. However, detection and prosecution of such cases can be very difficult, as highlighted by Fidrmuc et al. (2006). First of all, it is difficult to prove
intent to misuse private information when cases are mostly built on circumstantial evidence and the defendants can claim that their trades are based on superior abilities to uncover profitable opportunities. Second, acquaintances are not obliged to report their dealings to the SEC. Finally, enforcement is further undermined by the inadequate funding the regulatory authorities receive from the government, which often renders them unable to retain legal and financial experts or to acquire new detection technologies.
2.4 Hypotheses
Current literature has been unable to provide a reconciliation of the two divergent hypotheses, which have serious implications for the regulatory oversight and the integrity of securities markets. If the apparent run-up in target returns is due to illegal conduct, stronger
enforcement of the existing regulation and more efficient detection of such cases are required. If, in contrast, the anomaly can be explained by investor anticipation, the run-up implies that stock prices are aligned with their fundamental values, thus promoting an efficient allocation of capital (Jarrel and Poulsen, 1989).
The first hypothesis concerns the run-up in target stock prices. If the daily abnormal returns fluctuate randomly around zero on all days apart from the formal announcement date, there is no evidence of a gradual increase in the stock price and capital markets are efficient. However, given the theoretical foundation upon which this study is based, statistically significant daily excess returns in the days prior to the announcement can be expected. If the results indicate the presence of a stock price run-up, either insider trading or market
anticipation can provide an explanation. Knowing that the target stock price will increase significantly on the day of the announcement, an informed investor would buy shares before the news becomes public and sell it afterwards. Thus, the hypothesis regarding insider trading is supported if insiders are overall net buyers and sellers pre- and post-bid, respectively. Otherwise, market anticipation remains the only possible explanation for the abnormal returns.
3 Empirical Method
The current section contains two parts corresponding to each of the tested hypotheses.
3.1 The Abnormal Returns Hypothesis
As long as stock prices reflect the present value of all future cash flows of a firm, any stock market reaction to company-specific news acts as a measure of expected profits or losses
caused by new information. Assuming an efficient stock market, the effect of an event on share prices can be quantified by calculating abnormal returns from actual and expected returns in the absence of the event (Andrade et al., 2001).
Based on Fama and French (1996) and Carhart (1997), a multi-index model can be used to predict the returns for each firm had the M&A not occurred. They improve the explanatory power of the Capital Asset Pricing Model by adding three more factors next to market risk as determinants of securities’ returns. Small Minus Big (𝑆𝑀𝐵) captures the tendency of small stocks to outperform large stocks, where size is represented by the market capitalization of the firm. High Minus Low (𝐻𝑀𝐿) measures the difference in returns between firms with high versus low market-to-book ratios. Momentum (𝑀𝑂𝑀) captures the extrapolation of recent trends, i.e. the tendency of good or bad performance to persist for a few months.
The specification of the four-factor asset pricing model estimated is:
𝑅𝑖,𝑡 = 𝛼𝑖+ 𝛽𝑖,𝑀𝑅𝑀,𝑡+ 𝛽𝑖,𝑆𝑀𝐵𝑆𝑀𝐵𝑡+ 𝛽𝑖,𝐻𝑀𝐿𝐻𝑀𝐿𝑡+ 𝛽𝑖,𝑀𝑂𝑀𝑀𝑂𝑀𝑡+ 𝜀𝑖,𝑡 (1) where 𝑅𝑖,𝑡 and 𝑅𝑀,𝑡 are the returns of the security i and the market benchmark on day t and 𝑆𝑀𝐵, 𝐻𝑀𝐿 and 𝑀𝑂𝑀 are the factors that account for risk differentials between different classes of stocks. The residual 𝜀𝑖,𝑡 defines the abnormal return for firm i on day t, while 𝛼𝑖 and 𝛽𝑖 are OLS estimates for firm i’s parameters.
The parameters of the model are estimated for each firm over 240 trading days, starting 300 days prior to the M&A news. Based on Borg and Leeth (2000), the event
window considered is [-60, +10] in order to capture the effects on returns before and after the announcement date, which is defined as t = 0. The event date is identified as the official announcement day rather than the actual takeover date because changes in the expected value of the target should be instantly reflected in the stock price. The estimation and event window should not overlap so as to isolate properly the effect of the event on returns and avoid bias in the estimates of 𝛼𝑖 and 𝛽𝑖.
Using the estimated coefficients obtained from the four-factor model, the
corresponding market movement and Fama-French factors in the event window, the expected returns for each firm (𝐸(𝑅)) in the absence of an event can be calculated. Daily abnormal returns (𝐴𝑅s) for the interval [-60, +10] are obtained as the difference between the actual and expected return of the stock:
Since there might be information leakages or slow market adjustments to M&A news, the overall effect of the merger on firm value is captured by the cumulative abnormal return (𝐶𝐴𝑅), an aggregation of daily abnormal returns over a total of 70 days surrounding the announcement. Under the assumption that the returns of the underlying securities are
normally and independently distributed, the average abnormal returns (𝐴𝐴𝑅s) and cumulative abnormal returns (𝐶𝐴𝐴𝑅s) across the N securities can be computed.
𝐴𝐴𝑅(𝑇1,𝑇2) = 1 𝑁∑ 𝐴𝑅(𝑇1,𝑇2) 𝑁 𝑖=1 (3) 𝑅𝑢𝑛 − 𝑢𝑝𝑖 = 𝐶𝐴𝑅𝑖,(𝑇1,𝑇2) = ∑ 𝐴𝑅𝑖,𝑡 𝑇2 𝑡=𝑇1 (4) 𝐶𝐴𝐴𝑅(𝑇1,𝑇2) = 1 𝑁∑ 𝐶𝐴𝑅(𝑇1,𝑇2) 𝑁 𝑖=1 (5)
If there are no unusual movements in the target return, the 𝐴𝐴𝑅s and 𝐶𝐴𝐴𝑅s should fluctuate randomly around zero. However, a gradual increase in the stock price prior to the announcement should be reflected in positive daily average abnormal returns and a
corresponding build-up in 𝐶𝐴𝐴𝑅s as t approaches zero. To test the null hypotheses that the average abnormal and cumulative abnormal returns are equal to zero, two-tailed t-tests for significance levels 10%, 5% and 1% are employed.
3.2 The Insider Trading Hypothesis
To test the second hypothesis of abnormal insider purchases and sales prior to and after the M&A, I follow the model proposed by Giammarino et al. (2004). First, let 𝐵̅ be the average daily insider trading purchases, averaged over 300 days prior to and after the announcement. 𝐵𝑡 represents the average daily purchases, averaged over a particular period t. 𝑆𝑡 and 𝑆̅ are constructed in a similar manner for insider sales. Insider trading intensity (𝛥𝑡) is derived from abnormal purchases (𝑏𝑡) and sales (𝑠𝑡) as follows:
𝑏𝑡= 𝐵𝑡 𝐵̅ , 𝑠𝑡 = 𝑆𝑡 𝑆̅ (6) 𝛥𝑡= 𝑏𝑡− 𝑠𝑡 (7)
The variables are calculated for the main periods [-60, -1] and [+1, +60]. In order to check the robustness of the results, the pre-announcement intervals [-30, -1] and [-90, -1] and the post-announcement intervals [+1, +30] and [+1, +90] are checked as well. If in period t insiders buy at their typical pace, 𝑏𝑡 should equal one. A 𝑏𝑡 higher (lower) than one implies insiders buy more (less) shares than normal. Similar explanations apply to 𝑠𝑡 from a selling perspective. 𝛥𝑡 is higher (lower) than zero if there are abnormal acquisitions (dispositions) of shares, while 𝛥𝑡 equals zero if there is no net abnormal trading activity.
Since the stock price of the target increases on the day of the event, individuals that possess private information can acquire the shares at a lower price to sell them for a profit post-event. According to the insider trading hypothesis, this pattern is translated into a 𝛥𝑡 higher than zero before the M&A news and lower afterwards.
4 Data
Data on M&A deals between 1st of January 2000 – 31st of December 2014 is retrieved from Thomson ONE, previously known as SDC Platinum, and it includes the official
announcement date and the CUSIP codes of the targets. Multiple selection criteria are applied to obtain the final sample. The acquirer and target must both be US firms listed on the NYSE, NASDAQ or AMEX, that completed a deal worth more than $1 million. In addition,
companies from financial, utilities and governmental industries are excluded. This process results in 2631 M&As. 573 observations are omitted because the target was involved in partial acquisitions or resold after its initial purchase by the acquirer, thus incorporating the mixed effect of multiple events in its stock price.
Second, daily returns without dividends are retrieved from the Center for Research in Security Prices (CRSP). Daily instead of monthly observations are used because the latter obscure the short-term effects of corporate events on returns. The sample is further restricted to 1442 occurrences of M&As after accounting for incomplete coverage in the database. The daily Fama-French factors and market return are obtained from Wharton Research Databases Services (WRDS). The S&P500 index is used as the market benchmark because it provides a good representation of the US equity market. The index mainly tracks the performance of companies with high market capitalization and thus captures the systematic risk determined by macroeconomic factors with minimum noise from other types of risks.
Information about insider trading is retrieved from Thomson Reuters. The file
contains dealings as reported by insiders under Section 16(b) of the Securities and Exchange Act of 1934 and includes the transaction date, CUSIP of the firm to which the insider is linked, the type of transaction (acquisition or disposition of shares) and the number of shares exchanged. 18.7% of the transactions are eliminated because data regarding the type of transaction was unavailable, thus making it impossible to determine the net trading volume. A short description of all the variables is provided in the Appendix and summary statistics are presented in Table 1 below.
Table 1. Summary Measures of Returns and Insider Trading
[-300, 0] [0, +300]
Variables Mean Std. Dev. Min/ Max Mean Std. Dev. Min/ Max A. Returns Firm 0.11 4.67 -83.8/ 275 0.19 4.26 -91.34/ 275 Market 0.02 1.28 -8.95/ 11.35 0.03 1.27 -8.95/ 11.35 SMB 0.02 0.57 -4.62/ 4.29 0.02 0.56 -3.79/ 4.29 HML 0.03 0.61 -4.86/ 3.95 0.02 0.54 -3.34/ 3.95 MOM 0.02 1.00 -8.3/ 7.04 0.01 0.97 -8.3/ 7.04 B. Insider Trading Acquisition 5.05 584.98 0/ 9 21.89 1686.91 0/ 16.34 Disposition 7.95 560.21 0/ 8.85 45.45 2379.16 0/ 15.77
Descriptive statistics for the returns and insider transactions are expressed in percentages and thousands of shares, respectively. Firm and Market refer to the returns of the targets and the S&P500 index, while SMB, HML and MOM capture return differentials between firms with different characteristics. Acquisition and Disposition refer to the shares bought and sold by insides.
5 Results
The daily abnormal returns averaged across all firms, as well as the corresponding 95% confidence intervals for the mean 𝐴𝑅s are provided in Figure 1 below.
Figure 1. Daily Average Abnormal Returns (𝐴𝐴𝑅s)
The daily average abnormal returns (𝐴𝐴𝑅s) for the period [-60, +10] surrounding the announcement date are presented. The vertical bars represent 95% confidence intervals for the mean returns. Starting six days before the announcement until one day afterwards, the abnormal returns are significantly different from 0.
-1% 1% 3% 5% 7% 9% 11% 13% -60 -50 -40 -30 -20 -10 0 10 Return
The abnormal return accrued to the target firm on the day of the announcement is 13.65% on average. This finding is consistent with an acquisition premium paid by the bidder as indicated by Andrade et al. (2001) and Bruner (2004). During a short period surrounding the announcement date, the abnormal returns exhibit unusual characteristics. Starting six trading days before the official news until one day afterwards, the average excess returns take on values significantly different from zero at the 5% significance level, which complements the results of Keown and Pinkerton (1981). Even though there is support for the presence of a run-up, its magnitude is greatly reduced and its start date is closer to the announcement. The daily average abnormal returns are positive in 27 out of the 30 days before the bid and are significantly different from zero at the 1% significance level on 4 out of the 6 final days prior to the announcement. The magnitude of the effect is particularly large on the event date, but the rest of the statistically significant abnormal returns in the period [-6, 0] vary between 0.31% and 0.65%. Considering that the daily return averaged over one year surrounding the bid date is 0.11%, the run-up is not particularly large. In the interval [+2, +10], the daily 𝐴𝑅s are not significantly different from zero, which is in line with the idea that stock prices incorporate rapidly new information. However, one day after the announcement there is an abnormal return of 5.43% that signals the presence of a short-lived, but significant post-event drift. For the interval [-60, -30], the 𝐴𝑅s do not present any particular characteristics.
Figure 2 depicts the daily cumulative abnormal returns averaged across all firms and 95% confidence intervals for the mean 𝐶𝐴𝑅s.
Figure 2. Daily Average Cumulative Abnormal Returns (𝐶𝐴𝐴𝑅s)
The daily average cumulative abnormal returns (𝐶𝐴𝐴𝑅s) for the period [-60, +10] surrounding the
announcement date are presented. The vertical bars represent 95% confidence intervals for the mean return. The 𝐶𝐴𝐴𝑅s are statistically significant in the interval [-24, +10].
-5% 0% 5% 10% 15% 20% 25% 30% -60 -50 -40 -30 -20 -10 0 10 Return
As expected, the daily average cumulative abnormal returns fluctuate randomly around zero for the period [-60, -25], but are statistically different from zero for the rest of the event window. However, in contrast to Banerjee and Eckard (2001), who found that half of the total cumulative effect occurs prior to t = 0, these results indicate that approximately one fifth (4.79%) of the total increase (23.96%) in average 𝐶𝐴𝑅s occurs pre-announcement. Given the fact that their sample contains 56 M&As completed before 1990, these differences in findings can be attributed to several factors related to the date of the takeovers. First, following repeated violations of existing laws, punishments for illegal insider trading have been increased in 1988. The maximum financial penalty has been increased to $1 million and prison sentences have been lengthened to a maximum of 10 years, which might have deterred insiders from engaging in illegal activities. Second, the introduction of stronger regulation against the illegal use of confidential information in 2000 might have further decreased the incidence of insider trading. Rules 10b5-1 and 10b5-2 have extended the definition of insider trading and covered previous legal gaps. In addition, a different way in which insider activity can be restricted is through company-level regulations. Firms often impose short-term trading bans on key employees to protect themselves against the loss of reputation, higher bid-ask spreads and lower liquidity for the company’s shares derived from being associated with illegal activities (Bettis et al., 2000). All these explanations can account for the decrease in the magnitude and duration of the abnormal return compared to earlier studies.
As far as the second hypothesis is concerned, the expected pattern of trading did not materialize. Table 2 presents the values of average and abnormal daily insider purchases and sales and abnormal insider trading intensity for the three periods surrounding the event date.
Table 2. Insider trading variables
Period relative to the
announcement date Bt St bt st Δt A. [-30, -1] 12037 12263 1.132 0.490 0.642 [+1, +30] 18212 24237 1.713 0.969 0.744 B. [-60, -1] 6972 7381 0.656 0.295 0.361 [+1, +60] 45632 84176 4.293 3.365 0.928 C. [-90, -1] 8492 6212 0.799 0.248 0.551 [+1, +90] 35424 73968 3.332 2.956 0.376
Insider trading variables are calculated for three periods surrounding the announcement day. 𝐵𝑡 and 𝑆𝑡refer to
insider purchases and sales averaged over the respective periods, 𝑏𝑡 and 𝑠𝑡 refer to the abnormal purchases and
Of the twelve values of 𝑏𝑡 and 𝑠𝑡 reported, six are higher than one, so insiders are buying and selling at a faster rate than usual. Even though prior to the announcement, insiders were overall net buyers as predicted (𝛥𝑡 > 0), their net purchases intensified or decreased slightly in the months following the M&A news. Contrary to the insider trading hypothesis, both before and after the announcement date insiders are actively buying shares of the target firm. A possible explanation lies in the uncertainty surrounding M&As. Although the
acquirer makes public its intentions to buy another firm, at the moment of the announcement there is still speculation in the market regarding the completion of the acquisition. If the insiders believe there will be a significant post-announcement drift in the stock price caused by slow market adjustment, they may continue to buy shares.
Another interesting result is the tenfold increase in the number of shares exchanged by insiders after the acquisition during the main interval under consideration. The insider trading volume increased drastically in the period following the announcement as shown by abnormal purchases (𝑏𝑡), which increased from 0.656 to 4.293 and abnormal sales (𝑠𝑡), which increased from 0.295 to 3.365. The findings are robust with respect to the chosen time
interval. This puzzling trading intensity can be attributed to post-announcement market volatility. Given the uncertainty surrounding the merger completion, insiders may start trading significantly more to profit from major price movements. Since they do not possess private information about the M&A anymore, informed investors can trade if they believe there will be large price swings without breaching any confidentiality contracts.
While these findings cannot be used to validate the market anticipation hypothesis, they do provide an insight into the probable cause of the target stock price run-up. The build-up in cumulative abnormal return is short-lived and starts only six days prior to the official bid. In addition, the calculated insider trading variables do not correspond to the pattern of trading expected in the presence of illegal activities. Thus, there is reason to believe that market anticipation is a more probable cause than insider trading for the pre-bid run-up in target stock prices. This conclusion is not surprising if the harsher insider trading laws and multiple avenues for market anticipation are taken into consideration. Stronger regulation and enforcement in recent years might have prevented illegal conduct from insiders. At the same time, many sources of rumours can bring new information to the markets. Business
professionals that follow a few specific firms may be able to identify major events concerning those companies such as M&As. Additionally, toehold purchases and rumours in the media provide signals that changes in ownership can be expected. As explained by Aspris et al.
(2014), the markets can disseminate this information quickly and thus drive the five-day abnormal returns prior to the announcement.
6 Conclusion
The purpose of this study was to assess if the presence of a pre-bid run-up in target stock prices is due to insider trading or investor anticipation. The standard event study
methodology is applied to a sample of 1442 exchange-listed US firms that were engaged in M&As. The analysis shows that target firms gain statistically significant abnormal returns starting six trading days before the official announcement until one day after. Almost one fifth of the total cumulative abnormal returns occur before the M&A is announced and the abnormal return one day after the announcement amounts to 5.43%. These results conflict with the theory of efficient capital markets, which asserts that there should be no pre-announcement run-up or post-pre-announcement drift in the context of corporate events. In line with previous research, the findings of the present paper reveal that the
abnormal return gained by the target on the day of the event is 13.65%. Given the fact that the bid premium in M&As is a well-known phenomenon and that insiders know the acquisition plans in advance, informed investors can buy target shares at a lower price before the announcement and sell them afterwards for a profit. However, the results indicate that insiders buy an abnormally high number of shares both before and after the announcement. This unexpected trading pattern does not support the insider trading hypothesis. In addition, the increase in abnormal purchases in paralleled by a tenfold increase in the insider trading volume in the two months following the event. A plausible reason is that even after the announcement, there is uncertainty in the market regarding the completion of the merger. Insiders who believe that the stock price of the target will rise further from
post-announcement drifts or that the market did not incorporate all the expected benefits of the merger may still want to acquire stakes in the target.
While these findings do not prove unequivocally that market anticipation is the cause of the build-up in daily cumulative abnormal returns, they do cast doubt on the insider trading hypothesis. In effect, Section 10(b) of the Securities and Exchange act of 1934 and its
amendments might have proved useful in deterring insiders from illegal practices. There are multiple legitimate ways in which anticipation can drive the pre-announcement abnormal returns. First, speculation in the media about prospective deals occurs frequently. Second, acquirers may buy a significant stake in the target before launching an official bid, which can
generate suspicions that an ownership change will follow. Third, business professionals might identify patterns that lead them to believe an M&A will occur.
Coupled with the results, these rationales lead to the conclusion that market anticipation provides a more suitable explanation for target return run-up in today’s regulatory and market environment. However, there are several reasons why the findings must be interpreted cautiously. First of all, the insider trading data collected from Thomson ONE only contains self-reported trades by investors as required by SEC regulation. Since the data only includes trades as declared by registered insiders under Rule 10b, an implicit assumption of the analysis is that insiders report truthfully the number of shares exchanged and the transaction date. Through adverse selection, those trying to profit from confidential information are the most likely to omit reporting certain dealings for fear of prosecution. In addition, insider transactions could be channelled through third-parties in order to circumvent the law. Thus, even though trading on private information is illegal, only activities as
reported by registered insiders could be examined. A second problem arises from the fact that rumours in the media could also be caused by insiders. Informed investors might intentionally leak information to newspapers in order to provide a solid justification for their
acquaintances’ trades in case they are detected and prosecuted. Another limitation stems from the fact that 18.7% of the insider transactions have been excluded from the sample due to incomplete information, which might have further influenced the results. Future research could address these problems by creating a more comprehensive sample with data collected from past SEC prosecutions of illegal trades.
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Appendix A
Variable Notation Definition Source
1. Variables retrieved from databases
Firm Return 𝑅𝑖 Holding period return without dividends CRSP
Market Return 𝑅𝑀
Return on the S&P500 index (based on the largest 500 companies listed on the NYSE or NASDAQ)
WRDS
Small Minus Big 𝑆𝑀𝐵
Average return on three portfolios of small stocks minus the average return on three portfolios of big stocks
WRDS
High Minus Low 𝐻𝑀𝐿
Average return on two value portfolios minus the average return on two growth portfolios
WRDS
Momentum 𝑀𝑂𝑀 Return derived from the extrapolation of
recent trends WRDS
Acquisition and
Disposition -
Number of shares bought and sold by insiders Thomson Reuters 2. Constructed variables Daily Abnormal Return 𝐴𝑅
Realized daily return minus expected daily return for each firm
Average Daily
Abnormal Return 𝐴𝐴𝑅
Daily abnormal returns averaged across the N firms
Cumulative Daily
Abnormal Return 𝐶𝐴𝑅
Daily abnormal returns cumulated over the event period
Average
Cumulative Daily Abnormal Return
𝐶𝐴𝐴𝑅 Daily cumulative abnormal returns averaged across the N firms
Overall Average Daily Purchases and Sales
𝐵̅ and 𝑆̅ Daily purchases and sales averaged over the entire estimation period [-300, +300] Average Daily
Purchases and Sales
𝐵𝑡 and 𝑆𝑡
Daily purchases and sales averaged over several periods: 90, -1] and [+1, +90], [-60, -1] and [+1, +60], [-30, -1] and [+1, +30] Abnormal Purchases and Sales 𝑏𝑡 and 𝑠𝑡
Average daily purchases and sales over a particular period divided by the Overall Average daily purchases and sales
Variable Notation Definition Source 2. Constructed variables
Delta 𝛥𝑡 Abnormal purchases minus Abnormal sales
Daily Abnormal
Return 𝐴𝑅
Realized daily return minus expected daily return for each firm
Average Daily
Abnormal Return 𝐴𝐴𝑅
Daily abnormal returns averaged across the N firms
Cumulative Daily
Abnormal Return 𝐶𝐴𝑅
Daily abnormal returns cumulated over the event period
Average
Cumulative Daily Abnormal Return
𝐶𝐴𝐴𝑅 Daily cumulative abnormal returns averaged across the N firms
