By: Andrew Ross Sorkin
June 17, 2014
There is often a tip.
Before many big mergers and acquisitions, word leaks out to select investors who seek to covertly trade on the information. Stocks and options move in unusual ways that aren’t immediately clear. Then news of the deals crosses the ticker, surprising everyone except for those already in the know. Sometimes the investor is found out and is prosecuted, sometimes not.
That’s what everyone suspects, though until now the evidence has been largely anecdotal.
Now, a groundbreaking new study finally puts what we’ve instinctively thought into hard numbers — and the truth is worse than we imagined.
A quarter of all public company deals may involve some kind of insider trading, according to the study by two professors at the Stern School of Business at New York University and one professor from McGill University. The study, perhaps the most detailed and exhaustive of its kind, examined hundreds of transactions from 1996 through the end of 2012.
The professors examined stock option movements — when an investor buys an option to acquire a stock in the future at a set price — as a way of determining whether unusual activity took place in the 30 days before a deal’s announcement.
The results are persuasive and disturbing, suggesting that law enforcement is woefully behind — or perhaps is so overwhelmed that it simply looks for the most egregious examples of insider trading, or for prominent targets who can attract headlines.
The professors are so confident in their findings of pervasive insider trading that they determined statistically that the odds of the trading “arising out of chance” were “about three in a trillion.” (It’s easier, in other words, to hit the lottery.)
But, the professors conclude, the Securities and Exchange Commission litigated only “about 4.7 percent of the 1,859 M.&A. deals included in our sample.”
The S.E.C. and the Justice Department have publicly made prosecuting insider trading a priority. Judging from the headlines about traders at Steven A. Cohen’s hedge fund or the hedge fund manager Raj Rajaratnam or the investigation involving the activist investor Carl C. Icahn, they do appear to be focused on it. The S.E.C. recently hired Palantir Technologies, a firm that has helped the government analyze data to find terrorists, to help it uncover illegal trading activity. And with the mini-merger boom — the first quarter of merger activity this year was the most active since 2007, according to Mergermarket — there should be fresh evidence of more insider trading.
Yet if history is any guide, based on the results of the study over 16 years, the government has a lot of catching up to do.
The professors found that “it takes the S.E.C., on average, 756 days to publicly announce its ﬁrst litigation action in a given case. Thus, assuming that the litigation releases coincide approximately with the actual initiations of investigations, it takes the S.E.C. a bit more than two years, on average, to prosecute a rogue trade.” The average “rogue trade” the professors found, was worth about $1.6 million.
A spokeswoman for the S.E.C. had no immediate comment.
The professors — Menachem Brenner and Marti G. Subrahmanyam at N.Y.U. and Patrick Augustin at McGill — began their study, which won the Investor Responsibility Research Center Institute’s annual investor research competition, two years ago.
“We became intrigued by reports of a number of illegal insider trading cases in options ahead of takeover announcements, in particular, the leveraged buyout of Heinz by Warren Buffett and 3G Capital,” Professor Augustin said in a statement. In that case, two Brazilian brothers were caught using inside information on that deal to trade options ahead of the announcement through a Swiss Goldman Sachs brokerage account owned by an entity based in the Cayman Islands. The men were fined $5 million.
“The statistical evidence we present is consistent with informed trading strategies, and is too strong to be dismissed as just random speculation,” Professor Augustin said.
The study found that “informed trading is more pervasive in cases of target ﬁrms receiving cash offers.” The professors surmise that is because cash deals are more definitive and stock deals are harder to bet on.
The professors found that the bigger the deal and the more trading volume in the stock of the target company, the more likely there will be insider trading. “Over all, our interpretation of the evidence is that informed traders are more likely to trade on their private information when the anticipated abnormal stock price performance upon announcement is larger and when they have the opportunity to hide their trades due to greater liquidly of the target companies.”
The study also found, perhaps surprisingly, that there weren’t more leaks to investors based on the number of advisers — bankers and lawyers — involved in the deal. The professors had expected to find a correlation, and other studies have shown that there can be more leaks to the media when more advisers are involved. But the data, the professors said, was “not statistically signiﬁcant.”
Of the deals the S.E.C. pursued, the professors found that the agency usually investigated cases of insider trading when deals had been completed and often missed those in transactions that later collapsed.
“Completed deals are strong predictors of options litigation, as a withdrawn or rumored deal is about 22 times less likely to be investigated,” the professors found.
“The S.E.C., being resource-constrained, pursues larger-sized cases that provide the biggest ‘bang for the buck’ from a regulatory perspective.”
Perhaps oddly, the professors say that the S.E.C. is more inclined to pursue cases involving a foreign buyer than a domestic one.
The professors also suggested that the S.E.C. may be looking in the wrong place when it comes to insider trading.
The S.E.C., according to the study’s findings, found “102 unique cases involving insider trading in options ahead of M.&A.’s from January 1990 to December 2013, with an average of about four cases per year.” The study found that the S.E.C., though, is more focused strictly on stock trading, not options: “We ﬁnd 207 M.&A. transactions investigated in civil litigations because of insider trading in stock only.”
The professors concluded, “The large number of investigations for stock trades relative to option trades stands in contrast to our ﬁnding of pervasive abnormal call option trading volumes that are relatively greater than the abnormal stock volumes.”
While we all may have suspected that insider trading was going on, who knew it was this pervasive?
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