Lukomnik praises studies of insider trading and hostile takeover impediments for real-world relevance
The Investor Responsibility Research Center Institute(IRRCi) has awarded its prize to two groundbreaking studies that expose troubling empirical realities. Both studies involve mergers and acquisitions. One offers strong evidence of insider trading in the target’s shares, and the other demonstrates that managers at troubled companies engaged in personally beneficial, shareholder-detrimental acquisitions as soon as their jobs gained protection from hostile takeovers.
‘The purpose of the award is to remind investors, directors and corporate officers that corporate investments exist in the real world,’ says IRRCi executive director Jon Lukomnik. ‘I hope investors, corporate officers and directors read these papers and understand the issues they raise.’
The insider trading study, Informed options trading prior to M&A announcements: Insider trading? looked at trading in options in both the target and acquiring companies in the days preceding the announcement of the deals. The analysis showed ‘pervasive directional options activity, consistent with strategies that would yield abnormal returns to investors with private information.’ While effects were noted in a variety of trades, they were ‘stronger for out-of-the-money (OTM) call options and subsamples of cash orders for large target firms, which typically have higher abnormal announcement returns.’
This analysis showed that the SEC’s insider trading cases also involved situations with similarly unusual trading, although the SEC prosecuted only a handful of the possible cases. Indeed, the authors noted, ‘Our analysis of the trading volume and implied volatility over the 30 days preceding formal takeover announcements suggests that informed trading is more pervasive than would be expected based on the actual number of prosecuted cases.’
The other prize winner was Playing it Safe? Managerial Preferences, Risk, and Agency Conflicts, which looked at management decision-making after the state in which the company is incorporated adopted a business combination law that imposed additional hurdles for hostile takeovers. By making hostile takeovers more difficult, the laws gave existing management much greater job security. The authors noted that the managers at troubled companies seemed to act differently as a result of newfound job security: they suddenly acquired ‘cash-cow’ targets and started stockpiling cash, regardless of whether an acquisition made strategic sense. The newly entrenched managers apparently made these acquisitions to reduce the risk of the firm’s failure.
While preventing firm failure through these acquisitions might sound like pro-investor behavior instead of the agency conflict of interest the authors deem it to be, these acquisition announcements correlated with negative average announcement returns. In other words, the market judged the acquisitions to be bad business decisions. In addition, co-author Professor Todd Gormley points out that if the acquisition made good sense from a shareholder’s perspective, why did the passage of the management-entrenching law trigger the deal? Why not do the deal before getting the protection from hostile takeovers?
Although the study was dated, using data from the 1980s and 1990s when the business combination laws were arguably important blockers of hostile takeovers, Gormley explains the ongoing relevance is based on its applicability to the effect of takeover protections more generally. ‘Our paper and others find there’s evidence [takeover protections] are not benefiting shareholders,’ he acknowledges. ‘However, a few papers make reasonable arguments that in some circumstances these protections can help shareholders.’ Nonetheless, he adds, ‘major investors do care a lot about management’s ability to entrench itself. For example, Vanguard opposes poison pills.’
Beyond praising the two papers that received the IRRCi prize on their own terms, Lukomnik stresses the significance of each paper’s relevance in the real world. ‘Too often we get papers that treat securities as if they existed in a hermetically sealed theoretical world. But those pieces of paper or electronics--those securities-- represent something in the real world and have real world effects,’ he says.
