In our paper, Insider Trading in Takeover Targets, forthcoming in the Journal of Corporate Finance, we provide systematic evidence on the level, pattern and prevalence of trading by registered insiders before announcements of takeovers during modern times. We examine insider trading in about 3,700 targets of takeovers announced during 1988-2006 and in a control sample of non-targets, both during an ‘informed’ and a control period. We analyze open-market stock transactions of five groups of corporate insiders: top management, top financial officers, all corporate officers, board members, and large blockholders. We separately examine their purchases, sales and net purchases in target and control firms during the one year period prior to takeover announcement (informed period) and the preceding one year (control) period, using a difference in differences (DID) approach. Using several measures of the level of insider trading, we estimate cross-sectional regressions that control for other determinants of the level of insider trading.
We find an interesting and subtle pattern in the average trading behavior of target insiders over the one year period before takeover announcement. We find no evidence that insiders increase their purchases before takeover announcements; instead, they decrease them. But while insiders reduce their purchases below normal levels, they reduce their sales even more, thus increasing their net purchases. This pattern of passive insider trading is confined to the six-month period before takeover announcement, when insiders are more likely to be informed about an upcoming takeover; it holds for each insider group, and for all three measures of net purchases that we examine. The economic magnitude of this effect is quite substantial. Over the six-month pre-announcement period, our DID estimates indicate an increase of about 50% in the dollar value of net purchases of targets’ officers and directors, relative to their usual net purchase levels. These effects are even stronger in certain sub-samples with less uncertainty about takeover completion, such as friendly deals, and deals with a single bidder, domestic acquirer, or less regulated target. As with all prior studies analyzing trades of registered insiders, we assume that insiders comply with the law to report all their trades to the SEC and do not trade via third parties.
Our findings suggest that target insiders engage in profitable passive insider trading before takeover announcement. This trading pattern appears to reflect insiders’ attempts at capitalizing on their information advantage during takeover negotiations, while avoiding running afoul of SEC rules on insider trading. As such, this finding suggests the limits of insider trading regulation, an issue that has been extensively debated by law and economics scholars (see, e.g., Manne (1985), Salbu (1993), and Fried (2003)).
We find that registered insiders of target firms forego large potential gains from increasing their purchases before news of a takeover is publicly disclosed. While insiders reduce their pre-announcement purchases before all three types of takeovers that we examine (mergers, tender-offers and LBOs), the reduction is statistically significant only in mergers. These findings suggest that insider trading regulations are somewhat effective at deterring registered insiders from trading actively before takeovers, especially mergers. This finding contrasts with prior findings, discussed in the introduction, of profitable active trading by registered insiders before many other corporate events such as bankruptcies, stock repurchases, earnings announcements, and earnings restatements.
Why do registered insiders shy away from active, profitable trading before mergers, but not before other major corporate events? The answer may lie in the enforcement mechanism used for different insider trading laws. As Agrawal and Jaffe (1995) discuss, the reduction in pre-announcement purchases by target insiders in mergers appears to be an unintended consequence of the ban on short-swing trading (section 16b), which is enforced by private attorneys, rather than by the SEC. The main regulation against insider trading, rule 10b-5, which can only be enforced by the SEC, appears to be largely ineffective against the type of insider trades for which it might be the easiest to enforce, namely trades reported to the SEC by registered corporate insiders. Whether this apparent non-enforcement (or under-enforcement) of rule 10b-5 against registered corporate insiders is by choice (e.g., optimal non-enforcement, as argued by Carlton and Fischel (1983)) or due to the difficulty of proving a violation under rule 10b-5, remains an open question for future research.
More broadly, how do our findings that registered insiders engage in profitable passive, but not active, trading tie up with other indications (e.g., stock price run-ups and SEC actions) of widespread insider trading in takeover targets in general? Well, a takeover deal directly involves at least two firms, involves several intermediaries (such as investment bankers, lawyers and auditors), and affects most of the stakeholders (employees, investors, customers, suppliers, etc.) in the firms. So information can leak from a variety of sources. Our findings suggest that the overall level of insider trading in target firms might be even higher absent the deterrent effects of insider trading laws and their enforcement. The international evidence in Bhattacharya and Daouk (2002) is consistent with this conjecture.
The full paper is available for download here.