Academic journal article Financial Management

Bidder Incentives for Informed Trading before Hostile Tender Offer Announcements

Academic journal article Financial Management

Bidder Incentives for Informed Trading before Hostile Tender Offer Announcements

Article excerpt

In these circumstances, the bidding firm has an incentive to tip arbitrageurs, so that shareholders with the lowest private tendering costs own the shares necessary for the bidder to obtain a controlling interest. Inside information creates the opportunity for arbitrageurs to offer uninformed shareholders a price sufficient to induce them to sell. The low private tendering costs of arbitrageurs reduce the minimum successful bid price if the arbitrageurs buy the pivotal share that grants a controlling interest. If, however, arbitrageurs do not purchase the pivotal share, the minimum successful bid price is once again determined by the reservation price of the original pivotal shareholder. In that case, tipping does not lower the cost of the acquisition for the bidder.

Target firm management has similar incentives to exploit the differences in shareholders' valuations of the shares arising from private tendering costs. Bagwell (1991) shows that the cost of a takeover to a potential acquirer is increased if the target firm repurchases shares because shareholders with the lowest reservation prices tender first. Thus, a share repurchase leaves the target firm in the hands of shareholders with higher reservation prices, increasing the cost of acquiring the controlling share to subsequent bidders. Tipping arbitrageurs and others with low private tendering costs works in a similar way, but to the advantage of the bidder. If arbitrageurs buy the pivotal share, the bidder's cost of acquiring a controlling interest decreases.

We present a model of a bidding firm's incentive to tip arbitrageurs when there are constraints on the acquisition of shares prior to disclosing information about a bid. The Williams Act amendments to the Securities Exchange Act of 1934 impose just such a constraint. As shown below, the incentive for the bidding firm to leak information prior to announcement depends on 1) the amount of dilution the bidder anticipates (the back-end price imposed by the legal system), 2) the degree to which the back-end price of the offer embeds any stock price increase arising from the additional trading by arbitrageurs prior to announcement, 3) the private tendering costs of the pivotal share, and 4) the size of the bidder's toehold.

The model suggests that the incentive for pre-announcement tipping is negatively related to the degree of expropriation allowed by the legal system. If the legal system allows the bidder to expropriate all of the improvement due to the takeover from minority shareholders, the bidder will not tip because arbitrageurs will be unwilling to purchase a controlling interest. The bidder's incentive to tip is also negatively related to the degree to which the back-end price embeds any pre-announcement run-up because this increases the Cost of the bid. Because the bidder cannot control the amount of informed trading once information is released,(1) if the bidder knows that pre-announcement trading will cause the back-end price to rise sufficiently that the deal becomes unprofitable, it will not tip arbitrageurs. In general, a bidder has more incentive to tip prior to announcement the higher the private tendering costs of the pivotal shareholder and the smaller the bidder's toehold in the target firm's shares.

Since arbitrageurs, who are likely to have lower tendering costs, will tender at a lower price than shareholders with higher private tendering costs, some

value-increasing bids that would otherwise fail succeed in the presence of informed trading. As a result, informed trading enables more value-increasing bids to occur. This benefit has led some to argue that definitions of illegal insider trading should exclude the tipping of arbitrageurs prior to tender offers (Jensen (1986)). In addition, informed trading prior to announcement does not enable value-decreasing bids to occur because arbitrageurs will not buy shares in anticipation of a bid if the bid price will be less than the current market price of the share. …

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