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 in Montreal. 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 3 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 professors – Menachem Brenner and Marti G. Subrahmanyam at NYU 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,” 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,” 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 suggested that the SEC may be looking in the wrong place when it comes to insider trading.
The SEC, according to the study’s findings, found “102 unique cases involving insider trading in options ahead of M&As from January 1990 to December 2013, with an average of about four cases per year.” The study found that the SEC, 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?