Are outside director trades informative? Evidence from acquiring firms

• Published date: 01 June 2021
• Author: Rachel E. Gordon
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/irfi.12286

ORIGINAL ARTICLE

Are outside director trades informative?

Evidence from acquiring firms

Rachel E. Gordon

Department of Finance, Towson University,

Towson, Maryland

Correspondence

Rachel E. Gordon, Department of Finance,

Towson University, 8000 York Road, Towson,

MD 21252.

Email: rgordon@towson.edu

Abstract

I show that nonroutine trades by acquirer outside directors

premerger contain a significant amount of private informa-

tion and these directors trade opportunistically on the infor-

mation. I find that outside directors sell shares before less

valuable deals and purchase shares before more value

enhancing deals. Mergers with selling (buying) beforehand

are associated with 22% lower (41% higher) announcement

returns. Their trades provide more information than other

insiders' trades, appear concentrated in harder-to-value

firms, and intensify when more directors trade. Further,

more outside directors appear to trade opportunistically in

firms where the Chief Executive Officer (CEO) has signifi-

cant power, suggesting agency problems may exist.

KEYWORDS

corporate governance, directors, insider trading, mergers

JEL CLASSIFICATION

G14; G30; G34

Outside directors (ODs) are tasked with representing shareholders' interests through monitoring management,

providing advice, and promoting value-enhancing decisions. Their role is particularly important around mergers,

where deals are complex and it may be difficult to determine the deal quality and impact on shareholder value. ODs

need to have sufficient private information about the advantages or disadvantages of a potential deal to make

informed decisions to benefit shareholders. One way to proxy for private information is to use personal trading

I would like to thank John Bai, David Becher, Diane Denis, Philip English, Mara Faccio, Eli Fich, Jennifer Juergens, Michelle Lowry, Greg Nini, and Ralph

Walkling as well as seminar participants at the Financial Management Association 2014 meeting, the Southern Financial Association2014 meeting,

University of Missouri, Babson College, LaSalle University, San Jose State University, Eastern Michigan University, Drexel University, and Promontory

Financial Group for their helpful comments.

Received: 23 March 2018 Revised: 6 June 2019 Accepted: 30 August 2019

DOI: 10.1111/irfi.12286

© 2019 International Review of Finance Ltd. 2019

International Review of Finance. 2021;21:447–477. wileyonlinelibrary.com/journal/irfi 447

behavior (Hossain, Heaney, & Koh, 2016; Lakonishok & Lee, 2001; Ravina & Sapienza, 2010; Seyhun, 1986). In this

paper, I use nonroutine acquirer OD trades before a merger announcement to identify whether ODs have private

information, the degree of their information relative to other insiders, whether they trade opportunistically on their

merger information, and in what situations this behavior is more likely to occur.

Ravina and Sapienza (2010) show that OD trades contain private information. Their study finds that OD pur-

chases, in general, and OD sales before bad news or earnings restatements signal successful trading on private infor-

mation; mergers, however, are excluded from their analysis. Existing insider trading research on mergers provides

evidence that key insiders (e.g., CEOs, top executives, or the board of directors as a whole) act on private information

(Akbulut, 2013; Billett & Qian, 2008; Boehmer & Netter, 1997; Hossain et al., 2016; Seyhun, 1990; Shams, Duong, &

Singh, 2016); yet, this literature does not examine whether ODs by themselves possess sufficient information con-

cerning an upcoming merger to fulfill their fiduciary responsibilities on behalf of shareholders. These studies state or

assume that any information contained in OD trades is irrelevant or not as significant as other insiders. For a firm

event as significant as a merger, ODs should have as much private information about the upcoming event as key

inside personnel and whether they use this information opportunistically remains unclear.

More recent literature on mergers focuses on trading behavior by the entire board of directors in acquirers

(Hossain et al., 2016; Shams et al., 2016). These papers use both routine and nonroutine types of trades leading to

mixed conclusions about the boards' private information. Hossain et al. (2016) find that only purchases are related to

mergers whereas Shams et al. (2016) find that both purchases and sales are related. Neither paper validates whether

the ODs on the board have private information about the upcoming deal. Moreover, Shams et al. (2016) find that

the boards' trades are less informative when there is a high percentage of independent directors on the board. This

finding indicates that either ODs are not trading on private information or that ODs do not have as much private

information as the other directors. My paper fills the gap in the literature by examining the degree of private infor-

mation contained within the nonroutine trades of ODs before acquisitions and whether ODs possess sufficient infor-

mation to provide advice concerning an upcoming merger.

If ODs have sufficient private information about merger quality to trade, then the direction of their nonroutine

trades should be related to the merger returns at least to the same extent as other insider trades. Purchases

premerger indicate that ODs believe the deal will be value-enhancing, thereby benefiting shareholders. Conversely,

sales before a merger signify that ODs believe the deal will be potentially detrimental, thereby harming shareholders.

Selling shares then raises a follow-up question: If ODs believe a value-destroying merger will occur, why do they

allow the merger to proceed? I explore the situations when this type of behavior is more likely to occur.

To assess whether ODs trade on their private information, I obtain data on public, private, and subsidiary mergers

for U.S. public acquirers as well as data on insider trades from 1992 to 2013. My primary proxy of private informa-

tion is the nonroutine sales or purchases by acquirer ODs in the 6 months before a deal announcement. Nonroutine

trades more accurately portray use of private information (Beneish, Marshall, & Yang, 2017; Brochet & Srinivasan,

2014; Cohen, Malloy, & Pomorski, 2012). I follow Cohen et al., 2012) to define nonroutine trades as an insider con-

sistently trading in the same month for at least 3 years.

First, I identify whether any correlation exists between when ODs trade and if the firm announces a merger.

Second, I examine the direction of OD trades in relation to merger announcement returns to test whether OD trades

contain as much, or more, private information regarding an upcoming deal compared to other insiders in the firm.

When ODs appear to engage in opportunistic trading, I then explore why some ODs are more willing to assume the

risks of trading on their private information. Finally, I examine the profitability to investors of following premerger

trades by ODs compared to following all insider premerger trades.

In the sample, 60% of firms with director trades announce a merger. I find a that ODs' nonroutine buying in a

given 6-month period increases the likelihood of a future value-enhancing deal and ODs' nonroutine selling in a

given 6-month period increases the likelihood of a future value-destroying merger. The correlation between the

direction of OD trades and the type of future merger suggests that these nonroutine OD trades may be based on pri-

vate deal information and may opportunistic in nature. To determine whether this relationship is not just spurious

448 GORDON