We All Knew It. And Now There Seems to be Proof.

There's a flurry of activity in the stock of Company X, for no apparent reason. And then, after the fact, after the acquisition (or merger) has been publicly announced, then it all makes sense: Insider trading, we think.

But the evidence is seemingly all anecdotal. So maybe it just looks bad, and that's why the Securities and Exchange Commission isn't prosecuting right and left.

Three professors (two from New York University and one from McGill) have done the math, however, and the evidence is overwhelming. In fact, they say, as many as a quarter of all deals involving public companies may also involve insider trading.

Their study, reported by Andrew Ross Sorkin in the DealBook section of today's New York Times (full article here; full 81-page report with some really dramatic charts, here), makes for depressing reading:

...[We] document pervasive directional options activity, consistent with strategies that would yield abnormal returns to investors with private information. This is demonstrated by positive abnormal trading volumes, excess implied volatility and higher bid-ask spreads, prior to M&A announcements.

Isn't it possible that this is simply coincidence? The authors, who studied deals between 1996 and 2012, scoff: the probability of similar actions occurring randomly is about "three in a trillion." Remind me to buy a Lotto ticket tonight.

As Sorkin writes,

The results are persuasive and disturbing, suggesting that law enforcement is woefully behind — or perhaps is so overwhelmed that it simply looks for the most egregious examples of insider trading, or for prominent targets who can attract headlines.

In other words, in the words of an income-tax professor of mine, "Be aggressive, but don't be stupid." (He would add that if you had to think about whether something was aggressive or stupid, "it's usually stupid.")  Just don't be so aggressive that the SEC has to notice, and you should be fine.

And by the way: while the SEC focuses largely on stock trading, the study suggests that much of the most questionable activity occurs around options. 

As you might expect, the study found that "the bigger the deal and the more trading volume in the stock of the target company, the more likely there will be insider trading." Not -- perhaps surprisingly -- because there were more bankers and lawyers involved with the deal (and therefore more people to leak information to the media and others). But simply because "the anticipated abnormal stock price performance upon announcement is larger" and because it's easier to hide the illicit trading in a bigger pool.

We all knew it was probably happening. Now we know for sure. Sigh.