The stock prices of takeover targets typically increase substantially prior to merger announcements This increase attracts considerable public attention because it is usually perceived to be associated with the leaking of inside information. Hence, the numerous Securities and Exchange Commission (SEC) cases against individuals and entities accused of trading on inside information about upcoming mergers and acquisitions.
These cases typically involve suspected leaks of confidential information through social connections. Senior executives or board members often initiate the leaks, which spread among the social networks that are either directly or indirectly linked to them. For example, in a case filed on April 22, 2013, the SEC alleged that Mark D. Begelman traded ahead of the announcement of BFC Financial Corporation’s acquisition of Bluegreen Corporation for nearly $15,000 in illicit profits. Begelman obtained the confidential information from a member of the World Presidents’ Organization (WPO), which is a global professional group of current or former executives at major companies. In another case filed on September 20, 2012, the SEC alleged that a former board member of the Mercer Insurance Group leaked confidential information about Mercer’s negotiations regarding the company’s acquisition by United Fire. To find out whether this social-connection effect exists generally in M&A, we study how a target’s social connections affect its stock return prior to the merger announcement (“target run-up”).
We conjecture that the targets with more socially connected executives and directors experience higher target stock price run-ups prior to merger announcements. A bidder typically pays a substantial premium for its target.Thus, some executives and board directors may have an incentive to leak the valuable information of an upcoming merger to their social peers. The information could be direct information about the upcoming merger, such as the possibility or the synergy of the merger. It could also be indirect information helpful for estimating the probability or the synergy of the merger. By leaking the information, executives or board members can, on one hand, enhance their social ties and benefit from future reciprocal interactions with their social peers. On the other hand, if their leak is detected, they could be charged with insider trading. Executives and board directors would balance between the cost and the benefit in determining whether to leak information. When the perceived benefit of doing favors outweighs the expected litigation risk, leaks could occur from executives and board directors to their social peers. With leaked information, social peers could buy the target’s stock prior to the merger announcement, in anticipation of an increase in the target’s stock price once the merger is announced. This pre-announcement increase in stock purchases leads to a pre-announcement run-up in the target’s stock price.
To test this hypothesis, we measure work, school, or other social ties (such as country club memberships and participation in nonprofit organizations) for each target’s senior executives and board directors. Our empirical findings are consistent with our hypothesis. They show that a target’s stock price run-up prior to its merger announcement is significantly higher if the target’s top executives and board members are more socially connected. For example, according to our results based on sorted portfolios, when the degree of those social connections increases from the bottom quintile to the top quintile, cumulative abnormal returns of the target’s stock increase 4.59 percent in window [-6, -2] (i.e., a one-week trading-day window from the sixth to the second trading day prior to the merger announcement). In sum, we find that a target whose executives and directors have more social connections experiences a higher pre-announcement target stock price run-up.
The above result holds after we address the endogeneity concern by using deaths of connected board members and senior executives as exogenous shocks. We also find that the target social-connection effect on target stock run-up does not exist during the merger announcement, after the announcement, or before the merger negotiation is initiated. These findings suggest that it is the private information related to the upcoming merger driving the target social-connection effect.
Overall, our results present evidence that the social network of a target’s executives and directors can transmit leaked private information on an upcoming merger prior to the announcement and that this phenomenon contributes to the target’s stock price run-up.
 See, for example, Asquith (1983), Asquith, Bruner, and Mullins (1983), Dennis and McConnell (1986), Dodd (1980), and Keown and Pinkerton (1981).
 For the first case, see SEC press release 2013-66 “SEC Charges Former Executive with Insider Trading On Nonpublic Information Obtained as Part of Professional Group” at www.sec.gov. For the second case, see SEC press release “SEC Charges Three in North Carolina with Insider Trading.”
 Schwert (1996) documents that between 1975 and 1991, target CAR is on average 23.1 percent in the window of trading days from two months prior to a merger announcement to six months after the announcement. Using a more recent sample from 1984 to 2004, Chatterjee, John, and Yan (2013) find that target CAR is 30.4 percent in the window from three months prior to six months after the merger announcement. They also find that the premium of the offer price over the stock price on trading day -63 is, on average, 62.4 percent.
This post comes to us from Iftekhar Hasan, Lin Tong, and An Yan at Fordham University’s Gabelli School of Business. It is based on their recent paper, “Social Connections and Information Leakage: Evidence from Target Stock Price Run-Ups in Takeovers,” available here.