Corporate Insiders, Toehold Acquisitions, And Information Leakage: Do Insiders Tip Their Hands?
In the search for competitive advantages, investors have for many years attempted to ape the actions of those believed to possess nonpublic information. The efficacy of this approach has been borne out by several academic studies published in the last two decades that are virtually unanimous in documenting the excess returns earned by corporate insiders--primarily corporate officers and board members--on their own transactions and, to a lesser degree, by those who follow their lead.(1) One problem with this strategy for the individual investor, however, is that he rarely knows on what basis the insider is making his decisions; thus, he must place a good deal of faith in the insider's acumen.
One case in which the future direction of stock prices can be readily predicted is that of the takeover bid. The finance literature is replete with studies documenting the dramatic increase in the prices of target firms in takeover bids of various types. (This literature is surveyed in Jensen and Ruback and, more recently, Jarrell, Brickley, and Netter.)
In recent years, researchers have begun to study an event that is frequently a precursor to a takeover bid--the "toehold acquisition." This may be defined as the purchase by a would-be acquirer of a relatively small proportion (often less than 10 percent) of the shares of a target firm for the ultimate purpose of launching a proxy contest, tender offer, or some other bid for control.
Toehold acquisitions are typified by repeated small open-market share purchases by potential acquirers who, under the Williams Act, must report their transactions to the Securities and Exchange Commission by the filing of form 13D (1) when the amount of shares held by the acquirer exceeds 5 percent, and (2) when additional holdings of 2 percent or more are amassed. Because these filings become available for public inspection shortly thereafter, it is possible for those outside of the firms involved to "confirm" the hitherto unknown information on which insiders have based their purchases.
Empirical research by Madden, Holderness and Sheehan, and Mikkelson and Ruback have shown that the stock prices of target firms tend to rise significantly around the announcement of toehold acquisitions by "corporate raiders."(2) This suggests that a profitable investment strategy may be to purchase the shares of a firm in which (1) corporate insiders have been buying heavily and (2) corporate raiders have been amassing shares. This study examines the efficacy of such a strategy. In doing so, two questions are addressed. First, do the open-market transactions of corporate insiders and corporate raiders provide signals that the average investor can use to increase his or her chances of success? Second, are the transactions of some categories of corporate insiders better "signals" than others?
If, as is widely believed, corporate insiders are able to systematically exploit their access to nonpublic information, they should be observed to be engaged in more and/or larger trades than normal around the occurrence of events that are expected to have significant effects on the prices of their firms' shares. Given that a toehold acquisition is often an early indication that a takeover target is "in play," which typically leads to subsequent increases in the price of the target firm's stock, we would expect the volume of purchases by corporate insiders in the target firms to be greater in periods of potential acquisitions than in other periods.(3)
The pattern of insider purchases should reflect the level of information and, therefore, the degree of certainty the insider attaches to rumors of an impending takeover bid. Consider the following scenario. At the very early rumor stage, the insider may, if he attaches any credibility to the rumor at all, make a few small share purchases that can be easily sold off later. …