Academic journal article Financial Management

Insider Trading after Repurchase Tender Offer Announcements: Timing versus Informed Trading

Academic journal article Financial Management

Insider Trading after Repurchase Tender Offer Announcements: Timing versus Informed Trading

Article excerpt

Abnormally high net insider selling is commonly observed after repurchase tender offer (RTO) announcements although, on average, firms experience positive abnormal returns in the years after the repurchases. We explore two potential explanations: liquidity trade timing and informed trading. Consistent with the notion that fixed price RTOs are more likely than Dutch-auction RTOs to signal undervaluation, the results suggest that insider selling after fixed price RTO announcements are driven largely by insiders who time their trades with the repurchase announcements. In contrast, selling after Dutch-auction RTOs seems to be driven primarily by informed traders who exploit mispricing associated with the repurchase announcements.

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The last two decades have seen a proliferation of stock repurchases. Stefan Selig, Vice-Chairman of Bank of America Securities, observes that "repurchasing stock is one of the most frequently discussed corporate finance topics in boardrooms today" (Henry, 2004). (1) Although firms repurchase shares for various reasons, the most commonly cited explanation in the academic literature is signaling (Bhattacharya, 1979; Dann, 1981; Vermaelen, 1981, 1984; Asquith and Mullins, 1986; Ofer and Thakor, 1987; Constantinides and Grundy, 1989; Lane, Sarker, and Wansley, 1989; Lakonishok and Vermaelen, 1990; Comment and Jarrell, 1991; Dann, Masulis, and Mayers, 1991; Hausch and Seward, 1993; Persons, 1997; D'Mello and Shroff, 2000). (2) Consistent with the signaling hypothesis, firms engaging in repurchase tender offers (RTOs) experience, on average, very positive repurchase announcement abnormal returns (Dann, 1981; Comment and Jarrell, 1991) and post-repurchase announcement long-term abnormal returns (Peyer and Vermaelen, 2008). Given the large average post-repurchase long-term abnormal returns, it is puzzling that insiders engage in abnormally high selling activities in the quarter after the RTO announcements (Pettit, Ma, and He, 1996). The purpose of this paper is to test two alternative hypotheses for this somewhat counterintuitive trading pattern. Under the first hypothesis, insiders trading for liquidity reasons time their selling activities with the repurchase announcement to minimize potential undervaluation, thereby maximizing their selling price. Under the second hypothesis, insiders trading on their private information sell shares in response to overpricing due to market misinterpretation of the degree to which certain repurchase announcements act as signals of undervaluation.

As Fried (2001) suggests, managers planning to sell shares for nonspeculative reasons might time their trades with repurchases in an effort to maximize the selling price of their shares. The idea is that repurchases are generally undertaken when firms are undervalued (Brav et al., 2005). Accordingly, the announcement of an RTO is, on average, associated with a substantial increase in price. As such, insiders, through the repurchase announcement, are able to mitigate the effects of undervaluation before they sell.

RTOs provide managers with an additional opportunity to benefit from insider trading. As Fried (2000) points out, an RTO is a unique setting to examine insider trading in that it allows insiders to be somewhat sheltered from litigation since the "materiality" threshold for information disclosure is not as strong. (3) As such, RTOs can provide incentives for insiders to take advantage of their private information. For example, if investors misinterpret nonsignaling repurchases as signals of managerial optimism, the unsubstantiated increase in price would allow insiders to exploit the mispricing with less risk of punishment.

Consistent with Pettit, Ma, and He (1996), we find that managers sell substantial amounts of shares after RTO announcements. (4) In the quarter immediately after the announcements, the net amount of shares sold by insiders is, on average, 1.96% of the shares outstanding as compared to quarterly averages of 0. …

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