Leaks and Takeovers

When firms are takeover targets, they often experience a rise – or run-up – in the price of their stock even before the takeover is publicly announced. The common wisdom about run-ups is that information about the impending takeover is leaked to the market, which causes the stock price to increase. Some of these leaks are unintentional. Opportunistic outsiders overhear conversations or documents land in the wrong hands. Some leaks are driven by greed. Insiders trade on their privileged information to enrich themselves or pass their information on to friends and relatives. But what if information leaks have a strategic purpose? Could participants in the takeover process leak information to influence its outcome?

In the paper “Leaks and Takeovers,” I develop a theoretical model to answer these questions. Leaking information is valuable for a takeover target when it attracts additional acquirers and thereby increases the competitiveness of the takeover process. The leak also causes a run-up once the information of the impending takeover is incorporated into prices.

In the model, a takeover target is initially approached by an acquirer. The target’s management has inside information about the value of takeover synergies and aims to maximize takeover revenue. Generally, the revenue is higher when there are more bidders. If there is only one, the target’s management has to accept a relatively low price, which arises from a one-on-one negotiation. There are other potential acquirers interested in taking over the target, but only when they learn that the value of synergies is sufficiently large. Researching a target and preparing an offer is costly, after all. By leaking favorable information to the market, the target can thus lead a potential, second acquirer to submit a bid as well and ensure that it is sold in an auction.

Leaking information is not free, however. The SEC investigates allegations of insider trading and prosecutes them in civil court. Those leaking privileged information are often prosecuted along with those who profit from it. The target management’s propensity to leak information is thus constrained by the SEC’s enforcement efforts. More effective enforcement lowers the likelihood of leaks and thereby reduces run-ups before takeover announcements.

Enforcement also renders the market for takeovers more efficient. This is because the threat of information leaks may deter profitable takeovers. The intuition is simple. Preparing a takeover offer is costly, both in terms of management’s time and in terms of actual expenses. If an acquirer anticipates that the target is likely to leak information and to attract an additional bidder, going through with the initial offer may not be profitable. Thus, the market for takeovers may break down. By discouraging leaks, SEC enforcement plays a crucial role in ensuring that efficient takeovers take place. This justification for enforcement differs starkly from traditional doctrine, which focuses on the insider’s breach of fiduciary duty and the unfairness of trading shares on privileged information.

Besides preventing market breakdowns, SEC enforcement may also render the takeover process more competitive. In takeovers, preemptive bidding occurs when an acquirer submits a high initial bid in order to discourage other bidders from participating. The relation between enforcement and preemptive bidding is subtle. When enforcement is strong, only targets with relatively high synergies leak information and attract additional bidders. But when bidders know that the value of synergies is large, preemptive bidding becomes less effective. Intuitively, even if the preemptive bid is high, other bidders are still willing to participate in an auction, since they anticipate a large profit from taking over the target. Thus, with preemptive bidding, enforcement serves a dual purpose: Reducing the incidence of leaks ensures that the takeover process is competitive even if leaks occur.

Information leaks also change our understanding of traditional takeover defenses. Many companies have in place defenses that lower the post-takeover value from a hostile acquisition, such as staggered boards (which prevent the acquirer from changing the target’s strategy immediately after the takeover) or poison pills (which dilute the acquirer’s shares and make the acquisition more costly). These defenses, however, come with a downside: They reduce the target’s incentive to leak information. Intuitively, the potential gain from attracting an additional bidder is lower, while the regulatory costs of leaking information remain the same. Firms with stronger takeover defenses are therefore less likely to leak information and more likely to be taken over by a single acquirer, which results in lower takeover revenues. In this sense, takeover defenses may backfire. If they do not prevent takeovers altogether, they may lead to worse outcomes for targets.

Acquirers, on the other hand, often employ toeholds to facilitate takeovers. Common explanations for this practice range from “flying under the radar,” i.e. acquiring an initial stake without triggering reporting requirements, to increasing the acquirer’s willingness to bid in a subsequent auction, which deters potential competitors. My model provides a new channel: Toeholds are valuable, because they discourage the target from leaking information. When the acquirer already holds a fraction of shares, the target’s value from attracting an additional bidder is lower, which reduces the target’s propensity to leak information. Intuitively, by discouraging leaks, toeholds reduce the competitiveness of the takeover process, which benefits the acquirer that established the toehold.

In sum, I analyze a formal model of information leaks in takeovers, and I show how targets may strategically leak information to attract additional bidders. The paper’s findings suggest concrete implications for takeover strategy and enforcement: Traditional takeover defenses may lead to worse outcomes for targets, and enforcement of insider trading is crucial, not just for the secondary market for shares, but also for the primary market in which takeovers occur.

This post comes to us from Professor Martin Szydlowski at the University of Minnesota’s Carlson School of Management. It is based on his recent paper, “Leaks and Takeovers,” available here.