More Corporate Actions, More Insider Trading?

The following post comes to us from Patrick Augustin of the Finance Area at McGill University; Jianfeng Hu of the Finance Area at Singapore Management University; and Menachem Brenner and Marti Subrahmanyam, both of the Finance Department at New York University.

According to Preet Bharara, the U.S. Attorney of the Southern District of New York, insider trading is “rampant” in U.S. securities markets, and his actions in the past few years indicate concrete action by his office to combat such activity. In a similar vein, the Securities and Exchange Commission (SEC) has stepped up efforts to chase down high profile insider traders, and has made it its key priority in pursuing errant behavior. Academic studies, including our own, have previously documented empirical evidence of informed trading ahead of major corporate events such as earnings announcements, mergers and acquisitions (M&A) and corporate bankruptcies.

There has been no research, however, that documents such evidence around another major event, the announcements of corporate divestitures or spinoffs (SP), although these are fairly common events that are largely unexpected and move asset prices. The parent company’s stock typically experiences a significant price jump at the time of the SP deal announcement, which suggests that errant traders could potentially gain from trading on private information about future SPs. It is, therefore, surprising that there is hardly any documented evidence of insider trading ahead of SPs litigated by the SEC, save for two cases: the well-publicized incident of Galleon hedge fund manager Raj Rajaratnam, who purchased 3.25 million shares of AMD Inc. prior to the divestiture of its manufacturing business back in 2008; and a dated case from 1996, in which a psychiatrist misappropriated information from a patient about an upcoming spinoff and violated fiduciary duty by illegally trading based on this private information. Both cases involved insider trading in the parent company’s stock, although equity options would likely have provided a bigger “bang for the buck.” Given the striking lack of evidence of informed trading ahead of corporate SP announcements, despite displaying characteristics that make them prone to insider trading, we set out to examine the evidence.

In our paper, Are Corporate Spin-offs Prone to Insider Trading?, which was recently made publicly available on SSRN, we use a large sample of 446 such announcements to present evidence of average abnormal stock announcement returns of approximately 2%, around the date of the announcement. These abnormal returns are greater for cross-industry spinoffs, deals that reflect a greater fraction of a parent’s market capitalization, and cases where the subsidiary is incorporated in the same state. Moreover, the positive jump in the parent company’s stock is typically associated with a downward jump in the prices of the parent company’s bonds, which is likely due to a wealth transfer from creditors to shareholders: a sale of assets reduces the hard capital that creditors can seize in case of bankruptcy. These opposing price movements in stocks and bonds suggest that informed investors may even engage in profitable capital structure arbitrage if they trade based on private information. We, therefore, examined informed trading activity in stocks, equity options, corporate bonds and credit default swaps (CDS), prior to the announcement of corporate SPs for a sample of 280 US parents, over the time period January 1996 to December 2013.

We document pervasive trading activity in options, but not in stocks, consistent with strategies that could yield high (leveraged) abnormal returns to investors with private information. This is evidenced by positive abnormal trading volumes and excess implied volatility for options prior to SP announcements. We confirm this evidence using high-frequency data, by showing that there are abnormally more option transactions initiated by customers in the direction that would benefit from the subsequent price movement. These effects are stronger for call options than for put options. Surprisingly, we find no evidence of abnormal volumes or returns for stocks, corporate bonds or CDS. Despite a plethora of robustness checks, we find that abnormal options volume is the only measure of informed trading that positively and robustly predicts abnormal announcement returns. Quantitatively, about 13%—roughly one out of eight—of all deals in our sample exhibit statistically significant abnormal options volume in the pre-announcement period. The odds of abnormal options volume being greater in a propensity-matched control sample, i.e., a sample of firms with similar company characteristics and a high likelihood of being divested, are approximately one in 4,000.

While in the case of M&As, informed traders use stocks and options, in the case of SP the equity options market is the preferred venue because the rise in the parent’s stock price is typically less pronounced than that of a target’s stock price in a tender offer. This suggests that an informed investor will benefit substantially more from a levered strategy, which he can more easily implement in the equity options market. At the same time, he is constrained by transactions costs, which can be prohibitively high in the bond and CDS markets, for equal amounts of leverage.

What is the take-away from this research? For one thing, it suggests that regulators may benefit from keeping a closer eye on the activity in the options market around corporate announcements. For another, it suggests that we may have a corporate governance problem that needs to be addressed, because it seems that in light of more corporate actions, we will witness more and more evidence of unusual trading activity, which could be related to leakage of information from insiders or insider trading itself. The corporate board and senior management should put in place mechanisms to trigger an alarm when unusual activity is detected in the firm’s securities.

The full paper is available for download here.

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