DO INSIDERS PRACTICE WHAT THEY PREACH? INFORMED OPTION EXERCISES AROUND MERGERS AND ACQUISITIONS

• Author: Brandon N. Cline,Daniel Bradley,Qin Lian
• Date: 01 September 2012
• DOI: http://doi.org/10.1111/j.1475-6803.2012.01319.x
• Published date: 01 September 2012

The Journal of Financial Research •Vol. XXXV, No. 3 •Pages 317–342 •Fall 2012

DO INSIDERS PRACTICE WHAT THEY PREACH? INFORMED OPTION

EXERCISES AROUND MERGERS AND ACQUISITIONS

Daniel Bradley

University of South Florida

Brandon N. Cline

Mississippi State University

Qin Lian

Louisiana Tech University

Abstract

Weexamine executive stock option exercises around a sample of merger and acquisition

announcements between 1996 and 2006, focusing on a subset we identify as potentially

informed. For stock-financed acquisitions, we find a surge in informed exercises by

acquirer insiders in the year leading up to the acquisition announcement, but target

insiders display no similar increase. Wefind the market reaction upon the announcement

for acquirers is negatively related to extreme early exercises and find some evidence of

long-run underperformance. Overall, our evidence indicates that insiders knowingly bid

for firms when they personally believe their own firm is overvalued.

JEL Classification: G11, G14, G32, G34, G39, M52

I. Introduction

The extant literature on mergers and acquisitions suggests that, on average, target share-

holders receive large premiums whena deal is announced, while acquiring firms generally

experience zero or negative short-run abnormal returns. Likewise, support leans toward

negative postacquisition long-run returns for acquirers, particularly for those financing

the deal with stock. If the collective evidence indicates that acquisitions, at best, do not

lead to increased shareholder wealth, why do so many firms engage in them?

Roll’s (1986) hubris hypothesis suggests that managers irrationally overestimate

the value of the target firm. Rau and Vermaelen (1998) find some support for this

Weare very grateful to our referee, Jie Cai, for his insightful feedback through the review process. Wealso thank

seminar participants at the University of Connecticut, the Universityof Kentucky, Mississippi State University,West

Virginia University, Georgia State University, the 2009 ISCTE Business School (IBS) Mergers and Acquisitions

Conference, 2009 Eastern Finance Association, 2008 Financial Management Association, and the 2008 Southern

Finance Association meetings for useful comments and suggestions. We also appreciate the comments of Leonce

Bargeron, Ivan Brick, Don Chance, Qinglei Dai, Kristine Hankins, Ann Marie Hibbert, Michael Highfield, Brad

Jordan, Jayant Kale, Alexander Kurov, Greg Nagel, Ken Roskelley, Harvey Ryan, Costanza Meneghetti, Omesh

Kini, Jason Smith, Katsiaryna Salavei, Mike Stegemoller, Ninon Sutton, and Adam Yore.

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C2012 The Southern Finance Association and the Southwestern Finance Association

318 The Journal of Financial Research

conjecture in that growth or “glamour” stocks are more likely to be influenced by hubris

compared to value firms whose management is more cautious in their acquisition be-

havior. Malmendier and Tate (2008) study overconfidence by examining chief executive

officer (CEO) overinvestment in their firm and how the popular press depicts each CEO.

They argue that overconfidence by CEOs leads to poor merger decisions.

Unlike the hubris hypothesis, which relies on poor management decisions,

Shleifer and Vishny (2003, pp. 296–97) argue that shifts in investor sentiment cause

management to take advantage of misvaluation opportunities. In fact, they argue that their

“theory is in a way the opposite of Roll’s(1986) hubris hypothesis of corporate takeovers.”

In their model, managers use their overvalued stock as a currency to buy real assets.

Chemmanur, Paeglis, and Simonyan (2009) examinethe medium of exchange used when

both acquirers and targets possess private information and find that acquirers choos-

ing stock are often overvalued and those choosing cash are valued correctly. Rhodes-

Kropf and Viswanathan (2004) suggest that during periods of high valuations, rational

targets with incomplete information accept stock bids from overvalued firms because

they misjudge synergistic gains. Cai and Vijh (2007) argue that target executives with

high liquidity restrictions accept lower premiums presumably to release them of such

restrictions.

In this article, we examine these theories focusing on the motives of acquiring

firms’ insiders by investigating their executive stock option (ESO) exercise behavior

around the acquisition announcement. If managers believe that their stock is overvalued,

then consistent with the prediction in Shleifer and Vishny’s (2003) model, we would

expect to see an increase in their exercise behavior around the announcement of a stock-

financed acquisition. On the other hand, if managers are undertaking acquisitions because

they are overconfident in their abilities, then the hubris hypothesis would predict either

no change or a decrease in option exercises.1,2

Though we examine all types of exercises, we focus on exercises that we identify

as being potentially informed exercises, relying on a key fundamental principle in the

options literature—early option exercise. Early stock option exercise of exchange-traded

options is clearly irrational because one gives up the time value component of the option

1Somewhere in between these two theories lies the managerial discretion hypothesis. Bargeron et al. (2008)

find private equity firms bid much less than public acquirers for target firms, but the difference falls as managerial

ownership in the acquiring firm increases. They suggest this is consistent with the view that managers with little

stake in the firm gain at the expense of shareholders by engaging in empire building. That is, managing a larger

firm as a result of a merger brings more prestige and power and more pay for the executive decision makers,

and it mitigates the takeover threat. Consistent with this view, Harford and Li (2007) find in a sample of mergers

between 1993 and 2000 where shareholders are worse off ex post, 75% of the time CEOs of bidding firms are

better off. While we believe that this theory would predict no systematic changes in option exercise activity, it is

not entirely clear.These managers may (or may not) be influenced by hubris and may (or may not) believe the stock

is overvalued.

2Wealso recognize that the f irst prediction in Malmendier and Tate(2008) suggests that overconfident CEOs

are likely to do more acquisitions, conditional on havingsuff icient access to internally generated funds. Thus, in this

framework, overconfident CEOs using cash would not be expectedto increase their exercise of options. Likewise,

the overvaluation story suggests that managers engaging in stock-financed acquisitions are more likely to increase

their option exercises, but when using cash as a method of payment, they maynot increase their selling. Thus, at

least in the case of cash-financed deals, both hypotheses have similar predictions and therefore are not necessarily

mutually exclusive. We thank the referee for pointing this out.