IMPACT OF THE GALLEON CASE ON INFORMED TRADING BEFORE MERGER ANNOUNCEMENTS

• Date: 01 September 2013
• Author: Inga Chira,Jeff Madura
• Published date: 01 September 2013
• DOI: http://doi.org/10.1111/j.1475-6803.2013.12013.x

IMPACT OF THE GALLEON CASE ON INFORMED TRADING

BEFORE MERGER ANNOUNCEMENTS

Inga Chira and Jeff Madura

Florida Atlantic University

Abstract

On October 16, 2009, the U.S. government charged Galleon hedge fund founder Raj

Rajaratnam and five others with insider trading, in what was described by a key

prosecutor overseeing the case as a “wake‐up call to Wall Street and to every hedge fund

manager.”We find that the mean abnormal stock price runup of targets (a measure of

informed trading) during the 26 months since the inception of the Galleon case declined

from 5.12% to 2.84%. The early evidence strongly suggests that the Galleon case has sent

a clear signal to the traders, and that the traders are listening.

JEL Classification: G34

I. Introduction

The abnormal stock price movements in target firms before merger announcements may

be caused by adept traders who use public information to anticipate which targets will be

acquired in the near future or by traders who possess inside information and engage in

insider trading activity. Because target firms tend to experience a large jump in stock price

on the day a planned merger is announced, traders with inside information about

the merger can benefit from taking a long position in the target’s shares before the

announcement. Insider trading (which we define to reflect the illegal use of inside

information) may discourage trading in financial markets because it allows some traders

to have a comparative advantage over others (see Leland 1992).

1

Studies by Bhattacharya and Daouk (2002) and Chen and Hao (2011) suggest

that insider trading reduces the informational efficiency in a stock market. In addition,

bidder firms may incur a higher cost when purchasing targets, because their control

premium is applied to a higher market price when insider trading causes an abnormal

stock price runup in target firms (see Schwert 1996; Betton, Eckbo, and Thorburn 2008).

Studies have documented the impact of increased enforcement against insider

trading across countries. Bhattacharya and Daouk (2002) find that the first prosecution of

insider trading in a country reduces the cost of equity. Bushman, Piotroski, and Smith

(2005) find that the initial enforcement of insider trading laws increases the analyst

We would like to thank the executive editors of the JFR, an anonymous associate editor of the JFR, and Sridhar

Sundaram (reviewer).

1

Some other studies refer to insider trading to represent trading by insiders (mangers or directors). See

Tanimura and Wehrly (2012) for a review of regulations imposed on trading by insiders.

The Journal of Financial Research Vol. XXXVI, No. 3 Pages 325–346 Fall 2013

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© 2013 The Southern Finance Association and the Southwestern Finance Association

following of stocks. Chen and Hao (2011) find that the enforcement of insider trading

laws reduces the gross spreads of American Depositary Receipts (ADR) initial public

offerings. Jayaraman (2012) finds that the increased enforcement of insider trading laws

in countries results in higher quality financial reporting. We build on these studies by

assessing whether recent efforts by the U.S. government to increase enforcement have

reduced the level of insider trading in the United States. To the extent that regulation can

prevent insider trading, it ensures informational efficiency and reduces the costs in the

market for corporate control.

Before 2009, the number of illegal insider trading cases pursued by the U.S.

government was limited when considering the massive volume of trading in U.S. stock

markets. In addition, the penalties to guilty parties resulting from prosecuted cases were

generally minor. One possible inference from these results is that existing laws in the

United States before 2009 effectively discouraged illegal insider trading activity, which

would explain the limited number of cases. An alternative inference is that the U.S.

government did not have the resources to detect insider trading or power to enforce the

laws, which allowed insider trading to occur.

On October 16, 2009, the U.S. government sent a powerful signal to the U.S.

market when it filed charges against the founder of a large hedge fund and five others, and

announced its dedication to detect and prosecute insider trading. Its ability to enforce laws

was strengthened by the Dodd–Frank Act. Our goal is to determine whether the

government’s increased efforts, power, and publicity had an impact on the level of insider

trading activity before merger announcements.

We find that the market‐adjusted abnormal stock price runup of the target over

days 42 to 1 relative to the merger announcement over the 84 months before the

Galleon case was 5.12% (14.80% of takeover premium measured from days 42 through

þ1) and runup over days 30 to 1 was 4.58% or 13.49% of the takeover premium. By

comparison, the mean abnormal stock price runup of the target for mergers over the

26 months following the inception of the Galleon case is 2.84% (or 7.90% of the total

takeover premium) for the 42 days preceding the merger and 2.46% (or 6.91% of the

takeover premium) for the 30 days before the merger announcement.

2

The reduction in the

abnormal stock price runup since the inception of the Galleon case is statistically

significant using both parametric and nonparametric tests.

In recognition that the change in the target’s mean abnormal stock price runup in

the period since the inception of the Galleon case could be attributed to factors other than

the government efforts or ability to enforce insider trading laws, we apply a multivariate

analysis that controls for other factors. Overall, we find that while controlling for other

factors, the mean abnormal stock price runup of target firms is significantly lower since

the inception of the Galleon case. We believe that the increase in government efforts,

tougher insider trading laws (attributed to the Dodd–Frank Act), and the publicity

2

Using the market model, the 42‐day runup before the Galleon case was 5.35% and the 30‐day runup was

4.84%. After Galleon, the runup was 0.25% and 0.71%, respectively, with the same significance as the market‐

adjusted model. For the Fama–French model, the runup was 5.10% and 4.63% before Galleon (same significance)

and 0.36% and 0.81% after Galleon (significant at the 10% significance level). From this point forward, we will use

the market‐adjusted model only to report results unless significant differences are observed between the models.

326 The Journal of Financial Research