In our paper forthcoming in the Journal of Financial Economics, we raise a question: can a firm looking for a takeover target use a target firm’s net insider buying as a signal of the potential worthiness of this acquisition? Prior studies have not examined the implication of insider trading for the outcomes of corporate mergers and acquisitions (M&As), possibly due to target insiders’ uncertain foreknowledge about acquisition outcomes and the stringent insider trading regulations prior to M&As. Our study fills this void by investigating whether target firm insider trading helps to reduce the “lemons” problem in the M&A market.

Corporate insiders’ trading activities are often used as a way to sign various potential firm-level events (e.g., dividend policy changes, seasoned equity offerings, open market share repurchases, corporate disclosures, etc.) as good or bad. However, it is not ex ante clear whether target insider trading can be used to infer the success of future M&As because the informational implications of target insider trading for acquisition outcomes are quite different from those of insider trading for the outcomes of other corporate events. In particular, prior to M&As, (1) target insiders are often uncertain about the bidder’s synergy potential, sometimes even lacking the knowledge of a potential acquisition, and (2) the Short Swing rule (i.e., SEC rule Section 16b), which requires any profits earned by insiders on round trip trades within any six-month period to be paid back to the firm, curbs target insiders’ trading prior to takeovers more severely than insider trading prior to other corporate events because takeover completion forces the sale of the target stock. (Facing any upcoming corporate events other than M&As, however, insiders can avoid the violation of the Short Swing rule simply by holding the stock over six months. If the limited target insider trading prior to M&As is unlikely to reflect target insiders’ private information, it would not be informative of M&A outcomes.) Due to these dissimilarities in the information structure and the regulatory environment of insider trading between M&As and other firm-level events, it is a discrete and important empirical issue to test whether target firm insider trading helps to reduce the adverse selection problem in the M&A setting.

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