Target insiders' preferences when trading before takeover announcements: Deal completion probability, premium and deal characteristics

• Published date: 01 January 2022
• Author: Jana P. Fidrmuc,Chunling Xia
• Date: 01 January 2022
• DOI: http://doi.org/10.1111/eufm.12308

Eur Financ Manag. 2022;28:162–207.wileyonlinelibrary.com/journal/eufm162

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© 2021 John Wiley & Sons Ltd.

DOI: 10.1111/eufm.12308

ORIGINAL ARTICLE

Target insiders' preferences when trading

before takeover announcements: Deal

completion probability, premium and deal

characteristics

Jana P. Fidrmuc

1

|Chunling Xia

2

1

Finance Group, Warwick Business

School, University of Warwick,

Coventry, UK

2

Department of Accounting and

Financial Management, School of

Business and Management, Queen Mary

University of London, London, UK

Correspondence

Chunling Xia, Department of Accounting

and Financial Management, School of

Business and Management, Queen Mary

University of London, London E1 4NS,

UK.

Email: c.xia@qmul.ac.uk

Abstract

We contribute to the M&A literature by characterizing

the information available to target insiders during the

pre‐public takeover negotiations. We analyze insider

trading in target firms in the US between 2005 and

2018. First, we show that signing confidentiality

agreements is an important information threshold.

Second, insiders have a good grasp of deal success.

They increase their net purchases only in deals with

higher completion probability. Third, insiders guess

the final offer price well, but their trading strategies

additionally reflect their knowledge of deal char-

acteristics. They prefer bidder‐initiated, cash, pri-

vately negotiated, and strategic deals. Insiders

combine several sources of information.

KEYWORDS

insider trading, mergers and acquisitions, target firms

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We would like to thank John A. Doukas (the Editor), an anonymous associate editor, an anonymous referee, and

participates of the Slovak Economic Association 2018 Annual Meeting in Bratislava and the European Financial

Management Association 2019 Annual Meeting in Ponta Delgada for helpful suggestions. We are also grateful to Allan

Hodgson and Sangho Lee for useful comments on an earlier draft of the paper. All errors are our own.

1|INTRODUCTION

The board of directors of a target (selling) firm has to make many important decisions from the

moment their firm is “in play”for a sale. On average, the pre‐public negotiation period takes

around 1 year from the moment a deal is initiated to its public announcement. The board is

concerned with optimally designing the pre‐public negotiation process to achieve shareholder

value maximization and fulfill its fiduciary duty. Many papers in the merger and acquisition

(M&A) literature address the question of whether firms should be sold in one‐to‐one nego-

tiations or rather in full‐scale auctions (Boone & Mulherin, 2007; Bullow & Klemperer, 2009;

Gentry & Stroup, 2019, to mention just a few). Liu and Officer (2019) focus inside the black box

of pre‐public negotiations and find frequent offer price revisions. In this paper, we contribute to

the literature by analyzing the information environment of the pre‐public selling process, by

focusing on patterns of passive insider trading in target companies before public announce-

ments of takeover deals. Our analysis highlights the signing of confidentiality agreements as an

important information threshold that helps to resolve many uncertainties in the pre‐public

selling period and markedly increases the chances of a deal going through. Furthermore, we

show that insiders' perception of the final offer price is quite accurate a considerable amount of

time before the deal announcement. Also, insiders are aware of the additional contribution of

deal characteristics, such as deal initiation, method of payment, selling method, and buyer type,

towards a higher takeover premium. Also, insiders have also a good perception of completion

probability.

The literature provides strong evidence that the restrictive insider trading regulation in the

United States (US) is effective in prohibiting insider buying before public announcements of

takeover deals (Agrawal & Jaffe, 1995; Agrawal & Nasser, 2012; Davis et al., 2020; Harlow &

Howe, 1993). Insiders possess material information, which is not in the public domain, and

therefore buying before investors become aware of the increased chances of takeover premium

is illegal. Despite a significant drop in insider buying, target insiders are still able to profit from

their private information. Agrawal and Nasser (2012) show that up to a year before the takeover

announcement insiders stop selling to such an extent that, despite a significant decrease in

their buying, their net purchases increase significantly. This passive insider trading strategy is

profitable but not necessarily illegal, as insiders' decrease in selling cannot be marked as trading

on material information. Davis et al. (2020) show that insiders increase their net purchases

already before deal rumor dates.

Given the restrictive regulatory environment with private material information, and

Agrawal and Nasse r (2012) indicating that insiders are still able to execute profitable trading

strategies, we contribute to the M&A literature by answering the question of what kind of

information insiders use to trade profitably. Does insider trading vary with realized takeover

premium? Or do insiders instead trade on their knowledge of deal characteristics that are

correlated with the final offer price, without being directly aware of the future takeover

premium? Do they start trading immediately after the deal is initiated or wait until they have

more precise information concerning the deal characteristics and deal success—that is, do

they wait until confidentiality agreements with interested bidders are signed? Do insiders

trade more for deals with higher expected completion probability? Answers to all these

questions are important as they provide evidence on the information environment of pre‐

public merger negotiations and reveal how much insiders know during the negotiation

process.

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Members of the board of directors and key company managers learn about their firm being

“in play”no later than around the initiation date, be it a target‐or bidder‐initiated deal.

1

The

target insiders may then adjust their trading in the company stock depending on their own

expectation concerning the current takeover premium, which is the difference between the

insiders' expected final offer price and the stock price at that moment. The expected takeover

premium is, however, uncertain and subjective. The insiders' expected takeover premium is

most likely affected by their guesses of the future offer price and deal characteristics, but also by

their guess of the probability of deal completion. We conjecture that insiders take into account

their guesses concerning completion probability and takeover premium when trading in the

stock of their own firms. It is also likely that they consider their information on deal char-

acteristics. We further conjecture that signing of confidentiality agreements is an important

event because it represents a commitment for the transaction on both the seller and buyer sides.

Once confidentiality agreements are signed, insiders are surer about the deal outcomes. They

also have more precise information concerning the bidders' identities and bidder competition.

Thus, we hypothesize that insiders trade more once bidders start signing confidentiality

agreements.

Our paper is closely related to Agrawal and Nasser (2012) who are the first to highlight the

passive insider trading strategies in M&A target firms before the public announcement. Our

analysis focusing on the information environment during the pre‐announcement negotiation

period differs from Agrawal and Nasser (2012) in three important aspects. First, their analysis

focuses on a fixed period of 1 year (or 6 months) before deal public announcements across all

deals and emphasizes the deal initiation as the important information dissemination point. In

contrast, we carefully code the initiation date and the date of signing the first confidentiality

agreement across all deals, and we therefore capture the exact timing of when insiders get

access to more precise information concerning the deal. The fact that the pre‐public negotiation

process is relatively lengthy and varies widely across deals highlights the importance of mea-

suring insider trading from the initiation date when trading on the expected takeover premium

becomes an option or from the confidentiality agreement signing date when the information

concerning negotiation outcomes becomes more reliable. Agrawal and Nasser (2012) show that

profitable insider trading is concentrated within 6 months just before the deal announcement,

but note that “this finding is consistent with [their] expectation that most takeovers talks begin

within the six months before public announcement of a deal”(p. 614). Our analysis reveals that

insiders possess more precise information concerning the expected premium once con-

fidentiality agreements are signed. Special robustness tests show that insiders increase their net

buying only after signing confidentiality agreements, rather than over the 6‐month period

before the public announcements.

Second, even though Agrawal and Nasser (2012) formulate the hypothesis of stronger

passive insider buying in firms with less uncertainty about takeover completion, their empirical

evidence is relatively weak and indirect. They only show that insider net purchases significantly

increase in friendly deals, deals without post‐announcement competition, domestic acquirer,

and less regulated target and assign these patterns to higher deal completion probability. We

use a more precise and direct measure of deal completion probability and show more con-

vincingly that deal completion probability matters for insider trading strategies. Third, we

1

The three examples in Appendix I.A in the Supporting Information Appendix illustrate this and show that all board members and senior managers are

involved in the decision making during the pre‐public selling negotiations since the initiation. Boone and Mulherin (2007) provide a more general description

of the process.

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