Insider trading before big mergers and acquisitions may be more pervasive than previously suspected, a new study suggests.

McGill professor Patrick Augustin worked with New York University professors Menachem Brenner and Marti G. Subrahmanyam to study patterns of call and put options for equities ahead of hundreds of mergers and acquisitions that took place from 1996 to the end of 2012.

They concluded as many as 26 per cent of mergers or buyouts were accompanied by evidence of insider trading, based on the abnormal volume and movement of stock options of both target companies and acquiring companies.

Insider trading is when someone with inside knowledge of a deal buys stock in advance so they can benefit from a run-up in stock prices when the deal goes through.

SEC doesn't detect most cases

By contrast, the U.S. Securities and Exchange Commission investigates about four cases a year of insider trading out of the average 109 merger  and acquisition deals a year. The researchers estimate that is about 4.7 per cent of all merger activities getting investigated, while more than one quarter involve some kind of illegal insider trading. 

The SEC is more likely to turn its sights on deals with a foreign component or a big ticket price and more likely to investigate insider trading involving stocks, rather than more sophisticated instruments such as options, the study says.

The regulator is also years behind. “It takes the SEC, on average, 756 days to publicly announce its first litigation action in a given case. Thus, assuming that the litigation releases coincide approximately with the actual initiations of investigations, it takes the SEC. a bit more than two years, on average, to prosecute a rogue trade,” the study says.  The average “rogue trade” was worth about $1.6 million, it found.

Among the red flags the researchers noticed for insider trading were all-cash deals, where the anticipated lift in stock price because of a merger offer was large. The more parties involved in the deal – investment banks, brokers, merger partners – the more likely that someone could  not resist taking a position that would earn them a bundle.

Nexen, Heinz insider trading

The options trades, either puts or calls, took place in the month before the deal, with the average about 16 days before the public announcement.

The study mentions some prominent cases of insider trading, including Berkshire Hathaway’s leveraged buyout of H.G. Heinz, which resulted in the SEC charges of insider trading against two Brazilian investors from 3G Capital, a private investment firm with an interest in the deal.  

Also on their radar, the CNOOC takeover of Nexen, which resulted in an $11 million fine to two Hong Kong asset management firms will pay $11 million US in settlement for insider trading ahead of the deal.

While earlier studies of insider trading have looked at movements in options, this is first to do such sophisticated analysis over a long period. The professors are so confident in their findings of pervasive insider trading that they determined statistically that the odds of the trading “arising out of chance” were “about three in a trillion.”