Informed Options Trading prior to Takeover Announcements: Insider Trading?∗ Patrick Augustin† Menachem Brenner‡ Marti G. Subrahmanyam§ McGill University, Desautels New York University, Stern New York University, Stern August 26, 2016 Abstract Wequantifythepervasivenessofinformedtradingactivityintargetcompanies’equityoptions beforeM&Aannouncements. About25%oftakeovershavepositiveabnormalvolumes,whichare greater for short-dated out-of-the-money calls, consistent with bullish directional trading ahead of the announcement. Over half of this abnormal activity cannot be explained by speculation, newsandrumors,tradingofcorporateinsiders,leakageinthestockmarket,dealpredictability,or beneficial ownership filings by activist investors. Though the characteristics of a sample of illegal option trades prior to M&A announcements closely resembles the characteristics of abnormal option trades in our sample, the SEC litigates only about 8% of all deals in it. Hence, our findings flag abnormal options volume as a useful indicator for regulatory prosecution of insider trading. Keywords: Asymmetric Information, Civil Litigations, Insider Trading, Mergers and Acquisitions, Market Microstructure, Equity Options, SEC JEL Classification: C1, C4, G13, G14, G34, G38, K22, K41 ∗WethankKennethAhern,YakovAmihud,LaurentBarras,JustinBirru(discussant),RohitDeo,BenjaminGolez, John Griffin (discussant), Vic Khanna, Michael Neumann, Chayawat Ornthanalai (discussant), Sergei Sarkissian, Jan Schnitzler, Kenneth Singleton, Denis Schweizer (discussant), Anand Vijh (discussant), Ulf Von-Lilienfeld-Toal, Zvi Wiener,DavidYermack,XingZhou(discussant),FernandoZapatero,BohuiZhang,twoanonymousrefereesandsemi- narparticipantsatthe2013OptionMetricsResearchConference,theNYUSternCorporateGovernanceLuncheon,the Penn-NYUConferenceonLawandFinance,theCFA-JCF-ShulichConferenceonFinancialMarketMisconduct,McGill University, the Luxembourg School of Finance, the 2014 Jerusalem Finance Conference, the 2014 European Finance AssociationAnnualMeeting,theFinancialManagementAssociation,SingaporeManagementUniversity,QueenMary UniversityofLondon,theTCFASymposiumatFordhamUniversity,theColumbiaUniversity-BloombergWorkshopon MachineLearninginFinance,the2015WesternFinanceAssociation,the2015NorthernFinanceAssociation,theIFSID 4thConferenceonDerivatives,theFrankfurtSchoolofFinance&Management,theNYU/NASDAQ-OMXDerivatives Research Project, the University of Technology in Sydney, the 2016 International Risk Management Conference in Jerusalem, for helpful comments and suggestions. The support of the Investor Responsibility Research Centre Insti- tute,theChineseFinanceAssociation,andtheWhartonResearchDatabaseServices,isgreatlyappreciated. Wethank NERA Economic Consulting and Morrison-Foerster for sharing data and valuable discussions, and are also grateful to Yinglu Fu, Rodrigo Mayari, and Zach Kahn for outstanding research assistance. All errors remain our own. This projecthasbeensupportedbytheSocialSciences&HumanitiesResearchCouncilofCanada. Augustinacknowledges financial support from the Institute of Financial Mathematics of Montreal (IFM2). †McGill University - Desautels Faculty of Management, 1001 Sherbrooke St. West, Montreal, Quebec H3A 1G5, Canada. Email: [email protected]. ‡New York University - Leonard N. Stern School of Business, 44 West 4th St., NY 10012-1126 New York, USA. Email: [email protected]. §New York University - Leonard N. Stern School of Business, 44 West 4th St., NY 10012-1126 New York, USA. Email: [email protected]. 1 Introduction The U.S. Securities and Exchange Commission (SEC) alleged in 2013 that a brokerage account in Switzerland had been used for illegal insider trading the day prior to the leveraged buyout an- nouncementofH.J.HeinzInc. Althoughtheevidence,basedonapurchaseof2,533out-of-the-money (OTM) call options, was overwhelming, one can assume that there are many more cases that go un- detected, or where the evidence is not as clear-cut, in a legal/regulatory sense.1 The prior literature has documented evidence of informed options activity ahead of mergers and acquisitions (M&A) announcements. However, even though these studies provide evidence of informed trading, they are not instructive about the pervasiveness of informed trading in the economy. More importantly, there is little guidance in the literature about the sources of informed trading activity, and whether it can be explained by perfectly legal channels, or whether it could potentially be illegal. We explore these issues in considerable detail in this paper. Thefirstobjectiveofourstudyistoquantify thepervasivenessofinformedtradinginthecontext of M&A activity in the U.S. To this end, we conduct a forensic case-by-case analysis of the trading volume, implied volatility, and bid-ask spreads of equity options over the 30 days preceding formal announcements of acquisitions, from January 1, 1996 through December 31, 2012. The second objective of our study is to assess the likelihood that the informed trading is illegal by ruling out plausible legal explanations. This forensic analysis provides novel insights on the sources of informed trading, and highlights “blind spots” that may be useful for regulators and prosecutors trying to detect insider trading activity. For target companies, we document that about a quarter of all deals in our sample, i.e., 25%, have abnormal volumes in equity options, over the 30 days preceding M&A announcements, that are statistically significant at the 5% level. The proportion of cases with abnormal volumes is relatively higher for call options than for put options. Stratifying the results by “moneyness,” we find that thereissignificantlyhigherabnormaltradingvolumeinOTMcalloptionscomparedtoat-the-money (ATM)andin-the-money(ITM)calls.2 Anexaminationofthecharacteristicsofcumulativeabnormal 1See, for example, “Options Activity Questioned Again” in the Wall Street Journal, February 18, 2013. 2We also find that ITM puts trade in abnormally larger volumes than ATM puts. This is evidence that informed traders may not only engage in OTM call transactions, but possibly also in ITM put transactions, or that the call trading generates arbitrage-based put trading activity. We explicitly consider synthetic options strategies and show in an Online Appendix (Section A-I) that a wide variety of strategies for exploiting private information about an acquisition result in the trading of OTM calls or ITM puts. 1 volume shows that informed trading is more pervasive for larger deals, those for which informed investors may potentially have less uncertainty about the final takeover price, and in cases of target firms receiving cash offers. We consider a plethora of robustness tests, in terms of volume, prices or liquidity, which overwhelmingly confirm the evidence of informed investors trading directionally in anticipation of a future price jump in the target company’s stock. Is this informed activity in options ahead of M&A announcements illegal? Our second objective is,toassessthislikelihood. Weexaminealargenumberofalternativeexplanationsandlegalchannels that could plausibly explain the abnormal trading volumes in options. In order to better distinguish informed from insider trading, we carefully differentiate between the legal status of informed and insider trading. We first show that the abnormal activity in options cannot be explained by specu- lation. We compare the options activity in the takeover sample to several control samples that are matched either on the activity in the underlying stock market, or on industry and firm characteris- tics. Similar findings of informed trading activity in options ahead of takeover announcements are absent from these control groups. This supports the conclusion that the run-up in options trading volume prior to the announcement cannot be explained by speculative trading activity in response to observable trading activity in the underlying shares and firm characteristics. In addition, our findings cannot be rationalized by news and rumors. We use RavenPack News Analytics, a database that is constructed from textual information in major newspaper outlets, public relation feeds, and over 19,000 other traditional and social media sites, to identify rumors and news about upcoming takeovers. We find no statistically significant difference in the average cumulative abnormal options trading volumes between the samples with and without news. We furthercheckwhethertheoptionstradesoriginatefromtheaccountsofcorporateinsiders. Corporate officers, directors, or large block-holders are legally required to disclose security transactions in their company’s options. A systematic analysis of the derivative transactions and holdings information in the Thomson Reuters insider filings reveals that not a single options transaction was executed by registered insiders within the thirty pre-announcement days. Thus, we conclude that the activity must originate from corporate outsiders. We also consider the possibility that astute options traders trade on information leakage in the stock market. However, past stock volume and return performance cannot explain the abnormal options activity. In addition, only 7% of all deals in our sample exhibit abnormal stock returns in 2 thepre-announcementperiod,whileabout44%ofalldealsexhibitexcessimpliedvolatility. Although 19% of all M&As have statistically significant abnormal stock volume, a frequency somewhat lower thanintheoptionsmarket, theeconomicmagnitudeissubstantiallysmaller. Next,weshowthatitis difficult to predict merger activity based on publicly observable information. The several predictive models we consider all have low explanatory power ranging between 4% to 5%, with the average takeover propensity at 4%. Even if some individual investors may have superior skills in processing andconnectingdifferentpiecesofinformationtoinferthelikelihoodofoccurrence ofafuturetakeover, it is difficult to conceive how they would be able to infer the correct timing of the announcement. While we focus our analysis on the thirty days preceding the announcement dates, most of the informed activity arises just days before the information gets publicly released, which would be difficult to attribute to chance. Finally, we screen the 13D beneficial ownership reports, which need to be filed by registered active investment advisors no later than 10 days following the acquisition of beneficial ownership of more than 5% of any class of publicly traded securities. The trading by supposedly informed activist investors cannot fully explain the abnormal options activity, as only 17 of these deals have a filing in the 30 days prior to the announcement date. Have we proven evidence of illegal insider trading activity? Without supporting hard evidence by the Federal Bureau of Investigation, such as wire-taped phone conversations or other strong legal evidence, this is challenging to prove beyond reasonable doubt. Ultimately, only the jury will be able to judge the occurrence of trading on material non-public information and breach of fiduciary duty. However, this caveat does not prevent us from concluding that the abnormal options activity reported in this study raises a red flag and serious concerns about illicit activity in the options market. After all, out of the 467 deals with significant cumulative abnormal options volume, 236, or 13% of all deals, cannot be associated with any of the counterfactual legal explanations. Our third objective is to better understand the nature of the informed options trading activity based on studying the cases in which the SEC conducted an investigation into illegal insider trading aheadofM&Aannouncements. Wefilterthroughmorethan8,000litigationrecordsandhandcollect information on the size, timing and type of trades, information we supplement with criminal records from the U.S. Department of Justice (DoJ). We find that the SEC is likely to examine cases in which thetargetsarelargefirmsthatexperiencesubstantialabnormalreturnsaftertheannouncement, and in which the acquirers are headquartered outside the U.S. The characteristics of the illegal option 3 trades, i.e., short-datedOTMcalloptionsontargetcompaniesthatareinitiated, onaverage, 21days before the announcement, closely resemble the characteristics and timing of the abnormal options activity in a representative sample of takeover transactions. Yet, the SEC litigates about 8% of takeovers in our sample for insider trading in options or stocks, and only 43 deals out of the 467 that we associate with informed trading. Thus, the modest number of civil lawsuits for insider trading appears small in comparison to the pervasive statistical evidence we document. Why do we focus on M&As? Options trading around M&As offers a particularly attractive laboratory for the testing of hypotheses pertaining to insider trading, as M&A announcements are publicly unexpected events, in terms of their timing, and even their occurrence. Thus, on average, in the absence of unusual trading, we should not be able to distinguish options trading activity before an announcement from activity occurring on any randomly chosen date. Second, the nature of private information is clearly identified in the case of M&A announcements: a significant upward jump in the target’s stock price following the announcement in virtually all cases. This enables us to formulateclearhypothesesthatoneshouldfailtorejectifinformedtradingistrulypervasive. Third, the richness of our options data, with detailed information relating to a large number of underlying stocks for multiple strike prices and expiration dates, is especially useful for formulating hypotheses about informed trading across several dimensions. Fourth, theory suggests that option markets are the preferred avenue for informed investors ahead of major informational events. Thestructureofthepaperisasfollows. InSection2,weprovideareviewoftherelevantliterature. We describe the data selection process and summary statistics in Section 3. We examine abnormal options activity for targets in Section 4. Section 5 deals with the distinction between informed and insider trading. In Section 6, we provide an analysis of the SEC sample. We conclude in Section 7. 2 Literature Review and Contributions Wecomplementandextendtheliteratureoninformedtradingalongthethreekeydimensionsdetailed in the introduction. While previous research has highlighted the existence of abnormal options activity ahead of M&A announcements, we explicitly quantify the prevalence of informed trading in the economy and document that the informed options activity is driven by a quarter of all deals. Second, in a major distinction from previous work, we examine the sources of informed trading in 4 the options market and show that at least 13% of all deals cannot be associated with any other legal explanation. We rule out that the abnormal pre-announcement option volumes are explained by trading initiated by stock market activity, high-level insiders, public rumors, or quantitative speculators who may predict takeovers based on publicly observable information. Third, a unique feature of our research is that we examine all SEC-prosecuted cases related to insider trading in options prior to M&A announcements during the period of our study. Thus, we can compare the characteristics of abnormal options activity to illegal options trades and compare it with the SEC’s litigation record related to options trading around takeover announcements. Since our objective is to identify the sources of informed trading in the options market prior to takeover announcements, we relate our work to the prior empirical literature associated with illegal insidertrading. Inthisspirit,Poteshman(2006)concludesthatinformedinvestorstradedputoptions ahead of the 9/11 terrorist attack. Keown and Pinkerton (1981) confirm the leakage of information and excess stock returns earned through insider trading in the presence of merger announcements, but they do not investigate equity option activity. Meulbroek (1992) studies the characteristics of a sampleofillegalinsidertradingcasesprosecutedbytheSECfrom1980to1989,butdoesnotfocuson options trading either. Similarly, Guercio, Odders-White, and Ready (2015) study SEC prosecutions and argue that illegal insider trading has decreased in response to more aggressive enforcement. Also Ahern (2015) examines civil and criminal prosecutions made by the SEC and the DoJ, but he studiesinsidertradingnetworksanddoesnotexaminesecuritytransactions. CornellandSirri(1992) provide a case study examination of illegal insider trading in stocks ahead of the 1982 takeover of Campbell Taggart by Anheuser-Busch, while Fishe and Robe (2004) find that trading by brokers, who illegally had advance access to information from the analysis in a newspaper column, covering a sample of 116 stocks, negatively impacted market depth. Acharya and Johnson (2010) show that a larger number of equity participants in leveraged buyout syndicates is associated with greater levels of suspicious stock and options activity. Wang (2013) shows that unusual options volume and price activity ahead of M&As predicts SEC litigation, while Frino, Satchell, Wong, and Zheng (2013) use SEC litigation reports to study the determinants of illegal insider trading, focusing on stocks, but not options.3 Some of our research revisits previous work that documents unusual options volume and price ac- 3See Bhattacharya (2014) for a comprehensive literature review. 5 tivityaheadofM&Aannouncements. Cao, Chen,andGriffin(2005)findevidencethat,forthetarget companiesinM&Atransactions,theoptionsmarketdisplacesthestockmarketforinformation-based trading during the periods immediately preceding takeover announcements, but not in normal times. Focusing on the acquirer firms, Chan, Ge, and Lin (2015) provide evidence that the one-day pre- event implied volatility spread (the implied volatility skew), a proxy for informed option trading, is positively (negatively) associated with acquirer cumulative abnormal returns.4 Examining deals case by case and focusing on target companies, we emphasize how and where insiders trade in the options market, as they engage in directional strategies for targets, which are reflected in more pronounced abnormal activity in OTM calls and cash-financed takeovers. In our analysis, we explicitly consider syntheticoptionstrategiesthatleadtolongbullishorshortbearishexposuresfortargets. Examining earlier evidence in greater detail is useful since the results presented in the literature are inconsistent across studies.5 As we are particularly interested in informed trading that may be generated by those who are outside the firm, our focus clearly differs from the large body of literature that attempts to decode informed trading by corporate insiders in stocks. For example, Cohen, Malloy, and Pomorski (2012) show that only opportunistic, but not routine, transactions have predictive content for stock prices. AgrawalandNasser(2012)argueinfavorofwidespread“passive”insidertradingontargets,whereby registered insiders increase their net exposure by selling less stock ahead of the announcements. In general,thesestudiesfocusonstocktradesonly,andprovidenoevidenceonoptionactivity. Whether informed trading by corporate outsiders is illegal is impossible to answer without corroborative evidence on all trades, as we can only confirm evidence of statistical anomalies, rather than the legality of the transactions. We cannot rule out either that abnormal activity is the result of insider tips that have percolated down from corporate executives, as suggested by Ahern (2015). A parallel literature has developed in the legal field, which discusses the fine line between legal and illegal insider trading (see Crimmins (2013)). 4The literature is too voluminous to be fully summarized here. Other important related references are Jayaraman, Mandelker, and Shastri (1991), Jayaraman, Frye, and Sabherwal (2001), Arnold, Erwin, Nail, and Nixon (2006), Spyrou, Tsekrekos, and Siougle (2011), Barraclough, Robinson, Smith, and Whaley (2013), Podolski, Truong, and Veeraraghavan (2013), Kedia and Zhou (2014), Chesney, Crameri, and Mancini (2015), Ordu and Schweizer (2015), Liu, Lung, and Lallemand (2015). 5For instance, Cao, Chen, and Griffin (2005) document greater abnormal options activity of OTM options, while Chesney, Crameri, and Mancini (2015) argue that there is more informed trading in put options. Wang (2013) argues that there is higher abnormal volume for ATM call options. 6 3 Data Selection and M&A Deal Characteristics The data for our study come from three primary sources: the Thomson Reuters Securities Data Company Platinum Database (SDC), the Center for Research in Securities Prices (CRSP) Database and the OptionMetrics Database. We start our sample selection with the full domestic M&A dataset for U.S. targets from SDC Platinum over the time period from January 1996, the starting date for available option information in OptionMetrics, through December 2012. Our final sample consists of 1,859 transactions for which we were able to identify matching stock and option information for the target. These deals were undertaken by 1,279 unique acquirers on 1,669 unique targets.6 Starting from an initial sample of 185,419 transactions, we restrict the study to deals aimed at affectingachangeofcontrol,wheretheacquirerownedlessthan50%ofthetarget’sstockbefore,and wasseekingtoownmorethan50%ofitafterthetransaction. Hence,oursampleincludesonlyM&As of majority interest, excluding all deals that were acquisitions of remaining or partial interest (mi- nority stake purchases), acquisitions of assets, recapitalizations, buybacks/repurchases/self-tender and exchange offers. In addition, we exclude deals with pending or unknown status, i.e., we only include completed, tentative or withdrawn deals. These restrictions reduce the sample size to 34,350 deals. Next, we require information to be available on the deal value, and eliminate deals with a transaction value below 1 million USD, which leads to a sample of 19,064 transactions. Finally, we match the information from SDC with price and volume information in both CRSP and Option- Metrics. We require a minimum of 90 days of valid stock and option price and volume information on the target prior to, and including, the announcement date, which results in the final sample of 1,859 takeover announcements. All matches between SDC and CRSP/OptionMetrics are manually checked for consistency based on the company name. Panel A in Table 1 reports the basic deal characteristics for the full sample. Pure cash offers make up 48.6% of the sample, followed by hybrid financing offers with 22.3%, and share offers with 21.7%. 82.9% of all transactions are completed, and mergers are mostly within the same industry, with53.4%ofalldealsbeingundertakenwithacompanyinthesameindustrybasedonthetwo-digit SIC code. 90.2% of all deals are considered to be friendly and only 3.4% are hostile, while 11.6% of all transactions are challenged. For only 6.5% of the sample do the contracts contain a collar 6Thus, 190 of the targets were involved in an unsuccessful merger or acquisition that was ultimately withdrawn. However, we include these cases in our sample, since the withdrawal occurred after the takeover announcement. 7 structure, 76.5% of all deals involve a termination fee, and in only 3.5% of the transactions does the bidder already have a toehold in the target company. Panel B shows that the average deal size is 3.8 billion USD, with cash-only deals being, on average, smaller (2.2 billion USD) than stock-only transactions (5.4 billion USD). The average one-day offer premium, defined as the excess of the offer price relative to the target’s closing stock price, one day before the announcement date, is 31%. 4 Informed Options Activity prior to Takeovers Our first objective is to quantify the prevalence of informed trading using options volume, after which we will assess the likelihood of this informed trading being illegal in Section 5. If informed trading is present, but there is no leakage of information, informed traders should benefit relatively more from strategies that use options, due to the leverage they can obtain from them, if they are capital-constrained.7 A takeover announcement is generally associated with a stock price increase for the target, usually a significant one (Andrade, Mitchell, and Stafford, 2001); the average one-day offer premium is about 31% in our sample. An informed trader who intends to trade is likely, given his capital constraints, to engage at least partly in leveraged trading strategies that will maximize his profits. The obvious venue for such activity is the options market, where we would expect to see significant abnormal trading volumes in options for the target firms in anticipation of major corporate takeover announcements. We emphasize that an informed trader would pursue directional strategies for the target, as the stock price almost always goes up after an announcement. We thus state the first hypothesis. • H1: There is evidence of positive abnormal trading volume in the equity options of target firms prior to M&A announcements. Inthepresenceofsuperiorinformation,atradingstrategyinvolvingthepurchaseofOTMcalloptions shouldgenerateasignificantlyhigherabnormalreturn,asaconsequenceofthehigherleverage(“more 7The underlying assumption for all hypotheses is that informed traders are capital-constrained and would like to ensure that their private information is not revealed to the market prior to the trades, to minimize market impact. Theinformedtraderfacesthetrade-offbetweentransactinginthemoreliquidstock,wherehistradesarelesslikelyto bediscovered, or inthe options market that providesmore leverage, but wherethe chance of aprice impactis greater duetotherelativelylowerliquidity. Aslongascapitalconstraintsarebinding,informedinvestorswill,atleastpartly, migratetotheoptionsmarket(John,Koticha,Narayanan,andSubrahmanyam,2003). CaoandOu-Yang(2009)argue thatspeculativetradingwilloccurintheoptionsmarketmainlyaroundmajorinformationaleventsifinvestorsdisagree aboutthefuturevaluesofstockprices. Informedagentsmayalsochoosetotradeintheoptionsmarketinthepresence of asymmetric information (Easley, O’Hara, and Srinivas, 1998) or short-sale constraints (Johnson and So, 2012). 8 bang for the buck”). Hence, we expect a larger increase in abnormal trading volume for OTM calls relative to ATM and ITM calls. Moreover, an informed investor, taking advantage of his privileged knowledge of the future direction of the target’s stock price evolution, is also likely to increase the tradingvolumethroughthesaleofITMputs,whichwillbecomelessvaluableoncetheannouncement has been made, followed by an upward move in the stock price of the target. An alternative strategy, arising from put-call parity, would be to buy ITM puts coupled with the underlying stock, financed by borrowing (mimicking the strategy of buying OTM calls; though the strategy mimics a call, it assumes that there is no constraint on borrowing). A possible reason for engaging in such a strategy rather than the more obvious one of buying OTM calls could be the lack of liquidity in OTM calls. Thus, an abnormally high volume in ITM puts may result from either the strategy of mimicking the purchase of OTM calls or the strategy of taking a synthetic long position in the stock (buying a call and selling a put with the same strike price). An informed trader may possibly engage in more complicated trading strategies to hide his intentions. Irrespective of which alternative strategy is applied, we should observe abnormal trading volume in OTM call and/or ITM put options. Given the importance of leverage, we can sharpen the first hypothesis in Hypothesis H2. • H2: The ratios of the abnormal trading volumes in (a) OTM call options to ATM and ITM call options, and (b) ITM put options to ATM and OTM put options, written on the target firms, are higher prior to M&A announcements. In order to address Hypotheses H1 and H2, we conduct a forensic analysis of the trading volume in equity options written on target firms during the 30 days preceding M&A announcements. In a nutshell, we find that approximately 25% of all deals in our sample exhibit statistically significant abnormal options activity (at the 5% level) in the pre-announcement period. The magnitude of abnormal volume is greater for OTM call options than for ATM and ITM calls, and we show that the odds of abnormal volumes being greater in a sample with randomized announcement dates are at most one in a million (three in a trillion if we consider the most egregious cases). 4.1 Identifying Abnormal Trading Volumes Hypothesis H1 asserts that there is positive abnormal trading volume in equity options written on the target prior to a public M&A announcement. We test this formally by applying the classical 9