Crackdown On Insider Trading Seems To Have Led To More Insider Trading

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Why does there seem to be more insider trading than there used to be? My assumption was always to the effect of "because now we look for it and have computers and stuff," but James Surowiecki has a column today saying in part "no, actually, there's more insider trading":

The S.E.C.’s enforcement actions have been on the rise as well, and the past three years saw more of them than any other three-year period in its history. Andrew Ceresney, the co-director of enforcement at the S.E.C., told me, “We’ve gotten better at detecting illegal activity, and at using technology that allows us to draw connections and see patterns.” But this isn’t just a case of vigilant policing giving the impression of a rise in crime; a number of studies of market-moving events have documented a boom in “suspicious activity” (that is, more trading than usual) around those events.

I determined to commit some pseudoscience about pre-merger insider trading and the result is this:

Loosely speaking what this tells you is:

  • A company's stock and call options tend to trade more actively just before it's acquired, and the stock price tends to go up;
  • The pre-merger-announcement trading volumes in the stock (blue lines) and call options (purple lines) are relatively more elevated than they were a decade ago; and
  • The stock price goes up a little more pre-merger-announcement than it did a decade ago though this is maybe squishier.

Down below you can read about how pseudosciency this is1 but still the lines go in Surowiecki's direction: there really does seem to be more abnormal trading just before mergers now than there used to be in the old, pre-Reg FD, pre-hounding-Steve-Cohen-to-the-ends-of-the-earth world. Certainly there's not less. This doesn't necessarily mean there's more illegal insider trading - maybe people have just gotten luckier or more skilled at predicting mergers using legal means - but it sort of hints at that, doesn't it?

Which is ... I don't know, it's just weird, that's really it. I throw it out there for your pseudo-empirical amusement; Surowiecki proposes some stories for why there's more insider trading generally, of which the main M&A-related one is that more deals are being done by multiple banks and multiple banks tends to mean multiple leaks. Also expert networks etc.

This all seems reasonable enough though you have to weigh the effect of bringing in a few more banks, all of which have signed confidentiality agreements and warned their employees about the horrors of insider trading, against other factors, like:

  • the SEC is really, really into catching insider trading;
  • they've got all sorts of gadgets now to do it, like quantitative performance analysis doohickeys and also wiretaps; and
  • insider traders keep going to jail for long (and predictable) periods.

You would think that insider trading, being a crime conducted mainly by people familiar with the concepts of risk and reward, would be the sort of crime that would be reduced straightforwardly by things like more effective enforcement and stricter punishments. You would be - I dunno, either you'd be wrong, and insider trading is up; or you'd be right, and the innocent thing that replicates insider trading - "buying lots of stock and call options right before a merger is announced" - is up anyway. That's almost worse.2

Surowiecki's proposed solution is to have more constant real-time disclosure, which sounds pretty exhausting and also doesn't really solve the issue of pre-merger insider trading, unless the idea is "disclose every informal conversation that might conceivably lead to a merger," which, can you imagine? I'm not sure that the SEC's highest and best purpose is to encourage a level playing field of pseudo-informed merger speculation.

On the other hand, there's not a lot of evidence that its highest and best purpose is to stop insider trading either. For one thing, we've talked before about the legal but still insidery access that prevents the stock market from being all that level a playing field regardless of how many Rajaratnams go to jail. For another, whatever is happening before mergers is, um, happening more than it used to. The SEC's much-heralded pivot to focus on accounting fraud3 suggests that the agency also feels it might have better things to do with its time.

Inside Tracks [New Yorker]
The S.E.C. Is ‘Bringin’ Sexy Back’ to Accounting Investigations [DealBook]

1.So mainly this is Bloomberg data on publicly listed U.S. merger targets. Then it's Bloomberg data on stock volume (PX_VOLUME), call option volume (VOLUME_TOTAL_CALL), and stock price (PX_LAST). The data series are meant to be more or less year-by-year unweighted averages of:

  • Ratio of stock volume in the 10 business days / 30 calendar days before a merger announcement, to the volume in the 6 months before the announcement - i.e. how elevated the volume is in the last 10/30 days, expressed as a multiple of the average volume.
  • Same, but with call option volume.
  • Stock price change over the same time periods, i.e. how much the stock moved in the short period before the merger.

Time period is like January 2001 - March 2013. There's no effort to calculate excess return or regress anything out so the raw numbers are not totally illuminating; i.e. pre-merger returns in '07/'08 are negative probably in part because of take-unders and stuff but also just, like, the market was down, man. Also each deal gets the same weight which I'm sure is distorting somehow.

More importantly there's a lot of missing data from just running Bloomberg fields which I've just ignored & averaged whatever data there was. This would probably trouble you if you were committing real science; e.g. only like 1/4 to 1/3 of deals in some years have call option volume data so that's worrisome. Whatever it's a ratio, etc. etc.

2.Is it? Perhaps that's just me, I dunno. But if everyone's correctly buying call options just before a merger is announced, I feel like the case for imprisoning some of them for insider trading is weaker.

3.Which, from that headline, I assume will proceed by training SEC enforcement agents to become sexually aroused at the sight of accounting fraud? I feel like that condition exists, actually.

Related

After The STOCK Act It Will Still Be Legal To Trade On Congressional Inside Information*

Here's a sort of touching monologue from David Einhorn's call with Punch: If you’ve done the analysis, and come to the conclusion that on it’s own, the company is not going to make it, it makes all of the sense in the world to raise equity at whatever the price is, so that you can know that the company, you know, is – is going to make it. Now, what that brings to my mind though is, you know, obviously we haven’t done your analysis, we haven’t done -- signed an NDA; I don’t know that we’re going to sign an NDA, because we prefer to just remain investors, but from my perspective, and I’ll be just straight up with you, is that gives a lot of signalling value. And the signalling value that comes from figuring out the company has figured out that it’s not going to make it on it’s own is that we’ve just grossly misassessed the -- you know what’s going on here. And -- and that, that will cause us to have to just reconsider what we’re doing, which is not the end of the world to you. You will continue on even if we don’t continue on with you. You could sort of see why the FSA read that to mean that he was insider trading. Like ... (1) You have told me something with signalling value. Sorry - "a lot of signalling value." (2) I will now act on that signal. (3) Don't be mad. "Signalling value" sure sounds like it means "material nonpublic information," doesn't it? Now as we've discussed before, trading on that information would not be enough to make Einhorn guilty of insider trading in the US, though maybe it wouldn't be exactly a great idea here either. Why? Because in our weird but sort of sensible insider trading laws, it's just not illegal to trade on material nonpublic information. It's only illegal to trade based on material nonpublic information that was obtained in violation of some sort of duty of confidence. Since Einhorn didn't sign an NDA, he had no duty of confidence. And since the Punch CEO and bankers weren't tipping him for nefarious purposes, but were instead sounding him out on the company's behalf as a shareholder and potential investor in a new capital raise, they weren't breaching their duty of confidence. You could quibble with the details of that but it's basically the law here. In England not so much. That also seems to be the law for our friends in Congress, who recently passed a law making it illegal for them to insider trade, which is worrying some people who make their living from trading on Congressional inside information: