«April 2014 Abstract Companies planning a private placement typically gauge the interest of potential buyers before the offering is publicly ...»
Hole in the Wall:
Informed Short Selling Ahead of Private Placements
Henk Berkman, Michael D. McKenzie and Patrick Verwijmeren
Companies planning a private placement typically gauge the interest of potential buyers before
the offering is publicly announced. Regulators are concerned with this practice, called wallcrossing, as it might invite insider trading, especially when the potential investors are hedge
funds. We examine privately placed common stock and convertible offerings and find evidence of widespread pre-announcement short selling. We show that pre-announcement short sellers are able to predict announcement day returns. The effects are especially strong when hedge funds are involved and when the number of buyers is high.
JEL classification: G32 Keywords: Insider trading, Hedge funds, Private placements, Wall-crossing, Short selling * Henk Berkman (firstname.lastname@example.org) is from the University of Auckland, Michael McKenzie (email@example.com) is from the University of Liverpool and the University of Sydney and Patrick Verwijmeren (firstname.lastname@example.org) is from Erasmus University Rotterdam, University of Melbourne, and the University of Glasgow. Corresponding author is Patrick Verwijmeren (Burgemeester Oudlaan 50, Room H14-27, 3000DR Rotterdam, the Netherlands, T: +31104081392, F: +31104089165).
1. Introduction The market for private placements has surpassed the traditional seasoned equity market in terms of both dollar volume and number of transactions.1 When a firm is planning a private placement, it will typically gauge the interest of potential investors in a series of confidential conversations before the offering is publicly announced. This practice is commonly referred to as ‘wall-crossing’ and regulation Fair Disclosure (Reg FD) deems the investor receiving the private information to be a ‘temporary insider’.2 Thus, having crossed the wall, an investor is expressly prohibited under the Securities Act from trading on the private information revealed during these conversations. This legal restriction of the trading activity of wall-crossers is understandable given that the announcement of a private placement will often have a material price impact.3 While the academic literature has yet to consider the issue of wall-crossings, it has drawn the attention of the regulatory authorities. For example, in a testimony before the U.S. Senate Banking, Housing and Urban Affairs Committee, the then chairman of the Securities and Exchange Commission (SEC), Christopher Cox, stated that the SEC would create a new working group to enhance the efforts to combat insider trading by hedge funds and one of the enforcement priorities was short selling based on insider information in private placements (Mahoney et al., 2008). The SEC’s decision to target hedge funds is understandable as hedge De Jong, Dutordoir and Verwijmeren (2011) document that approximately 95 percent of convertible issues in the period 2003 – 2007 were privately placed. Huson, Malatesta and Parrino (2010), Chen, Dai and Schatzberg (2010) and Floros and Sapp (2012) provide evidence that the Private Investment in Public Equity (PIPE) market has surpassed the traditional seasoned equity market in terms of both dollar volume and number of transactions.
Wall-crossing is different from the typical form of book-building, which occurs after the public announcement of the intended security issue.
Variation in the observed announcement effects can be large. Wruck (1989), Hertzel and Smith (1993) and Hertzel, Lemmon, Linck and Rees (2002) examine the announcement effects of private placements and observe positive average announcement effects. De Jong, Dutordoir and Verwijmeren (2011) and Duca, Dutordoir, Veld and Verwijmeren (2012) find negative average announcement effects for privately placed convertible bonds.
funds are often the subject of insider trading allegations.4 The focus on private placements is also unsurprising given that wall-crossings create an obvious opportunity for insider trading.
In this paper, we investigate the trading behavior of short sellers around PIPE and Rule 144A private placements.5 The focus on short sellers is guided by statements of regulatory authorities, such as the SEC, which clearly highlight short selling as a potential problem.
Moreover, using proprietary data from Dataexplorers, we measure changes in short interest at a daily frequency and are therefore able to closely monitor the actions of these sophisticated investors, who are predominantly hedge funds. Our sample consists of private placements of common stock and convertible securities between January 2007 and August 2011, which is the period for which we have data from Dataexplorers.
Our results may be summarized as follows. First, we document significant preannouncement increases in average short interest, which is evidence of information leakage.
Second, we find that abnormal pre-announcement increases in short interest are negatively related to the stock price reaction to the public announcement of the private placement. We also observe this negative relation when we replace actual announcement returns by predicted announcement returns that are solely based on information available to wall-crossers before the offering. Both results suggest that the information received during the wall-crossing procedure is material and that some privately-informed investors take speculative positions prior to the The reputation of hedge funds as potential inside traders was reinforced with the very public arrest of the Galleon Group hedge fund founder, Raj Rajaratnam, in 2009. He has since been sentenced to 11 years in prison and fined over $150 million. Empirical evidence of insider trading by hedge funds in the syndicated loan market and around mergers and acquisitions may be found in Massoud, Nandy, Saunders and Song (2011) and Dai, Massoud, Nandy and Saunders (2011), respectively.
The main difference between PIPEs and traditional private placements is the duration of the resale restrictions on the participating investors. The restriction period was typically two years for traditional private placements, whereas for PIPEs, the shares can typically be publicly traded within 90 days. Traditional private placements have only been issued sporadically in the 21st century (Chen, Dai and Schatzberg, 2010). Rule 144A offerings are only issued to Qualified Institutional Buyers, which are typically large institutional buyers with more than $100 million of investable assets.
announcement in order to profit from this information. Third, we find that short selling before the announcement is more pronounced when there are more buyers involved in the private placement. As the number of buyers is likely to correlate closely with the number of investors who have crossed the wall, we interpret this result as supporting our hypothesis that the existence of more potential traders with private information increases the probability of informed trading in the pre-announcement period. Finally, using information on hedge fund involvement in privately-placed security offerings, we find that the observed patterns are non-existent when hedge funds are not involved and strongest when hedge funds are heavily involved.
This study relates to the broader insider trading literature. Prior studies have examined situations in which private information has leaked through “Chinese walls” designed to separate, for example, commercial and investment banking within the same bank.6 We make three contributions to this insider trading literature. First, we differ from the above studies by examining an explicit breach of trust between a firm and potential investors. Second, we provide new evidence in the context of private placements. Henry and Koski (2010) find no evidence of increased pre-announcement short selling in public seasoned equity offerings. However, public seasoned equity offerings are less likely to be targeted by insider traders, due to the lower involvement of hedge funds in that market and the higher scrutiny compared to private security offerings. We establish that pre-announcement short selling is widely present in private placements but not in public offerings. Third, we are able to observe the identity of the buyers in Ivashina and Sun (2011) and Massoud, Nandy, Saunders and Song (2011) find evidence of insider trading by institutions that obtain private information by lending in the syndicated loan markets; Acharya and Johnson (2007) find that informed banks exploit information in the credit default swap market; and Bodnaruk, Massa and Simonov (2009), Dai, Massoud, Nandy and Saunders (2011) and Beny and Seyhun (2012) find information leakage around merger and acquisition events. On the other hand, Griffin, Shu and Topaloglu (2012) find no evidence that investment bank clients use inside information to trade around merger and earnings announcements.
private placements and contribute to the literature by showing how placing securities with hedge funds affects the probability of insider trading.
Our study also contributes to the burgeoning literature on short selling. While it has been suggested that short sellers are informed traders who are particularly skillful at digesting public information (see Engelberg, Reed and Ringgenberg, 2012), we are able to focus on short sellers’ use of non-public information. Our findings are consistent with studies that observe increased short selling before negative earnings surprises (e.g., Christophe, Ferri and Angel, 2004;
Boehmer, Jones and Zhang, 2012) and before the appearance of negative firm-specific news in the media (Fox, Glosten and Tetlock, 2010).
Our results have clear regulatory implications and suggest that the limited resources of the regulators should be focused on examining placements with a high degree of hedge fund involvement and a large number of wall-crossers. Furthermore, our results suggest that regulators may wish to provide more extensive and timely disclosures of short interest.7 Disclosure of short interest would be of great interest to the parties directly involved in private placements, and would help market participants and enforcement authorities in filtering out suspicious private placements, thereby increasing the integrity of stock markets.
The remainder of this paper is organized as follows. Section 2 describes insider trading regulation in the context of wall-crossings, and Section 3 develops the hypotheses. In Section 4 we describe our data and in Sections 5 and 6 we present our results. We provide additional tests in Section 7 and conclude in Section 8.
Section 417 of the Dodd-Frank Act requires a study of “the feasibility, benefits and costs of requiring reporting publicly, in real time short sale positions of publicly listed securities.” The U.K., France and Spain have recently adopted rules requiring short sellers to disclose their positions (see Jones, Reed and Waller, 2012).
2. Wall-Crossings and Insider Trading Regulation Reg FD requires that companies disclose material information to all investors at the same time. Exemptions to this rule do exist, however, as communications without public disclosure can be made to those who owe the issuer a duty of trust or confidence, such as an attorney or an accountant. These exclusions also apply to communications made to any person for legitimate business purposes, subject to the proviso that they expressly agree to maintain the information in confidence. This class of exclusions is relevant when a firm is considering raising capital through a private placement, as it allows issuers and underwriters to confidentially gauge interest in an offering prior to any public disclosure.
In general, private placements are initially marketed on an anonymous basis by an underwriter to a limited number of institutional investors. This is sometimes called a presounding, sounding-out or pre-marketing campaign. If an investor is interested, they sign a confidentiality agreement and are informed of the identity of the issuer and the specifics of the offering. It is at this point that the investor legally crosses the wall and becomes a temporary insider. As such, they are restricted from trading in the issuer’s securities until a public announcement of the offering has been made or else face the risk of prosecution for insider trading.
In 2004, potential irregularities in wall-crossing attracted the attention of the U.S regulator. The SEC sent out requests for documents to securities brokers and other firms that sell securities to hedge funds in private transactions. The agency was concerned that these firms may have leaked news of forthcoming deals to favored clients, allowing them to profit by trading the stock ahead of the announcement (Pulliam, 2004). Subsequently, the SEC made the decision to focus on the trading activity of hedge funds and one of the enforcement priorities was short selling based on insider information in private placements (Mahoney et al., 2008).8 Since 2005, the SEC has filed complaints against a variety of hedge fund managers. The SEC accused them of engaging in illegal insider trading by short selling issuer securities on the basis of material, non-public information prior to the announcement of a private offering, notwithstanding their agreement to keep information about the offering confidential and to refrain from trading prior to the public announcement. Appendix A provides a brief description of these cases. Most of the defendants consented to final judgments, without admitting or denying the accusations, leading to civil fines and repayment of unlawful profits. The amounts can be high and exceeded $15 million in the case of SEC versus Langley Partners. In the cases where the judges did make rulings, a not guilty verdict was returned in some cases because the judge ruled that the announcement effect was too small for information to be deemed “material” (see Hartlin, 2009).