A study of stock market trading in advance of large mergers done by market research firm Measuredmarkets, Inc. for the New York Times found that in a number of cases there was a significant increase in trading in the shares of the target company. New York Times, Sunday, August 27, 2006 at 1. This type of activity, the Times reported, is used by market regulators to “spot” insider trading. The head of the group that conducted the study for the newspaper concluded that “the aberrant activities most likely involved insider trading.” Id. The article supported this conclusion by noting that, while it is possible that increased trading resulted from new articles and similar items, in a number of instances studied by the market research firm, such events were not observed.
While there is not doubt that market regulators such as the SEC, NYSE and NASD examine pre-merger trading to detect suspicious trading patterns, those patterns do not support the conclusion reported by the Times that there is insider trading. Rather, the trend chronicled in the Times may well represent nothing more than a well-known economic phenomenon and efficient markets at work.
It is recognized among economists and market professionals that in advance of the announcement of a merger or takeover an increase in trading in the shares of the target company may be observed. In academic studies this increase is called “leakage.” Leakage results from the routine dynamics of the deal and the efficiency of the markets. Typically, as mergers talks progress an increasing number of professionals and consultants are brought “over the wall” – that is, they are informed about the deal because their services are required for the transaction to proceed. Once over the wall they are “temporary insiders” and bound by the insider trading laws.
As the deal moves forward the number of people who are over the wall can number hundreds or more depending on the complexity of the transaction. Market observers who study industries and companies frequently observe the increase in activity and, when combined with other data, may conclude that a significant transaction is coming. Since mergers frequently result in an significant increase in the share price, these investors may begin rapid buying. For example, the headquarters of the company may be in a small town. If suddenly hundreds of investment bankers, accountants, lawyers, public relations specialists and others fill hotels and offices near the company those studying the markets and that company may deduce from the increased activity that something is about to happen. This can and frequently does happen despite the best efforts of everyone to keep the deal secret. Piecing together this type of information along with other data and buying stock with the hope that there will be a deal and a big increase in share price is not insider trading. To the contrary, this is precisely the type of analysis of bits and pieces of information that aids market efficiency and is encouraged by the securities laws.
Leakage is a well-known phenomena and is reflected by the number of academic studies on the subject, including articles by a former SEC chief economist undertaken while he served on the staff of the Commission. See Gregg A. Jarrell & Annette B. Poulsen, Stock Trading before the Announcement of Tender Offers: Insider Trading or Market Anticipation?, Journal of Law, Economics and Organization, vol. 5(2), at 225-48 (1989); Gregg A. Jarrell & John Pound, Hostile Takeovers and the Regulatory Dilemma: Twenty-Five Years of Debate, The Midland Corporate Finance Journal, 5 (2) (Summer 1987). Unfortunately, the study done for the Times ignores this well-know fact and jumps to the conclusion that “suspicious” trading equals illegal trading. This is not true. Before accusations of illegal insider trading are made much more is required than an “up tick” in trading – even a dramatic one – or an absence of readily available new events, all of which may be explained by a well established economic theory acknowledged by a former SEC chief economist.