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Are all insiders rogue traders?

Insider trading is a topic of intense public debate these days, but this debate must be framed in the context of a clear, objective definition of informed versus insider trading.

Registered insiders — corporate directors or officers, their advisers, or stakeholders who hold a significant fraction of a company's stock — are allowed to trade in their company's stock, or options written on it, but they are bound by mandatory disclosure rules, and timing. Thus, their trades may be of a legal or illegal nature, depending on the circumstances of trading and disclosure.

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But there are also other informed traders, who are not directly connected with the company, who may make educated guesses or have superior forecasting ability. Alternatively, others may enter into illicit trades if such trades are based on material non-public information, and if they are in breach of their fiduciary duty.

Thus, the devil lies in the details and rogue trades are hard to disguise, if analyzed thoroughly. Are all informed or insider investors rogues? The answer is a clear "no!"

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In the aftermath of the global financial crisis, the Securities and Exchange Commission (SEC) in the U.S. has redoubled its efforts to pursue and prosecute illicit trading activity. While illicit trading is mostly prosecuted in individual stocks, trading stock options is another method that unscrupulous individuals may employ to exploit private information for personal gain, for example, by trading stock options.

While substantial gains can be made by such individuals by buying an M&A target's stock ahead of a takeover announcement, the same dollar investment can result in much larger gains by buying stock options, due to the leverage these options provide. In addition, trading in options may avoid the scrutiny of the regulators, due to the complexity of certain trading strategies using such instruments.

In our recent study of options trading, we found that approximately 26 percent of all M&A deals in a sample of 1856 cases displayed abnormal options trading volumes during the thirty pre-announcement days. This sample covers M&A announcements over a 17-year period from 1996 to 2012. We further document that the chances of this activity being purely random are rather slim.

This raises the important policy question: Is all such unusual activity based on inside information, which is illegal, or is most of it due to actions by informed traders, who use their superior analytical skills? Is it possible that some sophisticated traders can make reasonable predictions based on publicly available information, and may analyze trends in the industry, follow statements made by management, etc.?

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Though our statistical analysis is rather robust and covers many angles, it is certainly possible that some of the cases we document could be considered perfectly legal, and not necessarily based on inside information. However, it is important to emphasize that such a determination requires a case-by-case detailed inquiry by the regulators.

What seems surprising, at first glance, is that the statistical patterns we present in our research are quite pervasive and overwhelmingly strong, compared with the limited number of cases that have been litigated by the SEC.

In defense of the SEC, we may offer the following explanations for this discrepancy. For one thing, the publicly available litigation reports from the SEC used in our study include only civil litigations, and do not necessarily account for any criminal ones, especially those that are under litigation. For another, given that litigation can be costly, especially given how difficult it is to prove breach of fiduciary duty beyond a reasonable doubt, the SEC may be cautious about initiating action unless they unearth concrete evidence. Thus, it may not be cost effective to initiate litigation if the prospects of prosecution are not bright.

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Such executive choices by the regulator may very well be efficient in the presence of their own resource constraints. A conscious decision not to publicly disclose litigation may be desirable, if a whistleblower protection program needs to be arranged.

We believe that trading based on inside information has negative externalities for the market as a whole and should be illegal, as it is, in many countries. Our study raises a red flag regarding activity in one area of the market, and hence, it may be worth paying more attention to the activity in the options market ahead of important corporate announcements. Does this evidence suggest that the U.S. stock markets are rigged? We do not believe so. There is possibly some rogue trading, but it does not necessarily have a major impact on M&A activity, and certainly not on the market as a whole.

Commentary by Patrick Augustin, Menachem Brenner and Marti G. Subrahmanyam, the authors of a recent study that showed insider trading is worse than initially thought. Patrick Augustin is assistant professor of finance at the Desautels Faculty of Management at McGill University. Menachem Brenner is research professor of finance at the Leonard N. Stern School of Business at New York University. Marti G. Subrahmanyam is the Charles E Merrill professor of finance, economics and international business at the Leonard N Stern School of Business at New York University.

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