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Globe Investor Stock trading patterns prior to mergers raise more red flags

Production at Hudbay 777 mine in Flin Flon, Manitoba.

Brian Pieters

Just before its takeover last month by HudBay Minerals Inc. the shares of Norsemont Mining went on a tear.

Starting Dec. 1, the shares soared 47 per cent in the space of a few weeks, despite the fact the deal had yet to be made public. The day the takeover bid was announced, on Jan. 10, the reaction was relatively ho-hum. The stock rose a modest 5 per cent.

A super-sized rally preceding the public announcement of a takeover raises difficult questions: Was the run-up in Norsemont shares simply a case of traders realizing the company was a likely takeover target and bidding up its price? Or did word of the pending deal leak out, allowing unscrupulous investors to take advantage?

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HudBay president David Garofalo declined to speculate on why shares in Norsemont, a junior exploration company with an attractive Peruvian copper deposit, rallied shortly before his company's offer was publicly unveiled. "I honestly couldn't tell you," he says about the rise. "It's frustrating to see that kind of activity ahead of a bid, but it's not uncommon, unfortunately."

The Globe and Mail is conducting periodic reviews of stock moves before takeovers in the mining sector to test the extent to which some investors may be acting on supposedly confidential information. The topic has been in the spotlight since the Ontario Securities Commission launched a highly publicized case in November alleging that prominent Toronto lawyer Mitchell Finkelstein leaked information about pending takeovers to a former fraternity brother.

An analysis of stock prices cannot, by itself, establish whether leaked information is driving trades, but it can point to unusual patterns that deserve attention. A review by the newspaper last year of 14 bids for mining companies found that the shares of the target companies had an uncanny winning record. In every case, they rose in the week before the deals were made public.

The Globe's new review of trading activity covers six recent acquisitions of Canadian-listed natural resource companies. In addition to Norsemont Mining, it found an unusual trading pattern in the case of Petrolifera Petroleum Ltd. .

Shares of Petrolifera, a Calgary-based junior oil company, zoomed ahead by 29 per cent on heavy volume in the week before the announcement of its acquisition by Gran Tierra Energy last month. While the shares rose a further 26 per cent on the day the deal was unveiled, the preannouncement activity was dramatic enough to prompt an investigation by the Alberta Securities Commission.

The commission declined to comment, as did Petrolifera president Gary Wine. "Probably it's best if I just leave everything as no comment right now. We're talking with the ASC about this specific issue, so I'd rather not say any comment," he said.

While the Petrolifera case is under review, the much more dramatic surge in shares of Toronto-based Norsemont before its acquisition hasn't led the Ontario Securities Commission to seek information from either it or HudBay, according to executives at the two companies. HudBay's Mr. Garofalo says both companies were concerned about the rise.

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The Globe's review of trading patterns incorporates an analysis by Fatma Sonmez, a finance professor at Queen's University's School of Business. Using a sophisticated asset-pricing model to probe trading in the 30 days before bids, Dr. Sonmez detected suspicious activity in two-thirds of the 14 cases reviewed last year.

In her review of the six more recent acquisitions, Dr. Sonmez found unusual activity only in the cases of Norsemont and Petrolifera. There were no signs of abnormal trading in the takeovers of Consolidated Thompson Iron Mines Ltd. by Cliffs Natural Resources Inc.; Western Coal Corp. by Walter Energy; Fronteer Gold Inc. by Newmont Mining Corp. and Ventana Gold Corp. by an affiliate of Brazilian billionaire Eike Batista.

The Ontario Securities Commission declined to be interviewed about trading activity in any of the companies.

In her analysis, Dr. Sonmez calculated whether price movements just before deals were out of line with what would be expected, given the trend in the broader market and the volatility of the target company's shares. A move in a stock's price ahead of a takeover isn't noteworthy if the shares are rallying in line with the broader market. It raises questions, however, if returns streak well ahead of a flat or falling market and are accompanied by higher-than-average volume.

While the analysis raises warning flags, it can't prove anything untoward happened in any of the acquisitions. Dr. Sonmez says stocks can shoot up before takeovers because savvy investors are correctly anticipating deals. Share prices can also advance because of corporate developments unrelated to the acquisition. But leakage of confidential information can also play a role.

The latest six takeovers took place after the OSC launched its case against Mr. Finkelstein. "Maybe that is having an impact," Dr. Sonmez says, when asked about why the incidence of unusual trading was lower in the most recent review than in the earlier one.

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Sharp upward moves before acquisitions hurt the acquiring company, because a higher share price makes the premium offered by the acquirer look cheap. That may make some shareholders reluctant to tender to a takeover bid and could possibly derail the acquisition. In the case of the Norsemont acquisition, the soaring share price "narrowed the spot premium, which was very substantial when we put our offer in," HudBay's Mr. Garofalo says.

In the absence of a thorough investigation of trading records by regulators, it is almost impossible to determine exactly why shares of a company moved the way they did. But in the case of Norsemont, the stock price appears to have moved upward in tandem with the state of the confidential takeover talks, as outlined in HudBay's offer to purchase the company.

Norsemont shares traded flat from late October until early December, when they began to rally, just after executives for the two sides sat down for takeover talks. There was another uptick that started around Dec. 20, just after Norsemont approached its five major shareholders asking whether they would agree to sell their stock to HudBay, and then another jump in the shares in the days just before the deal was announced.

In an interview, Norsemont CEO Patrick Evans said the trading reflected positive developments. For one thing, it was natural for the shares to be rising because Antares Minerals, a similar junior exploration company with an attractive deposit near its own in southern Peru, had received a takeover bid in October. Norsemont was "the next logical takeover target," he said.

Mr. Evans also says the company released data in December showing its deposit was more valuable than previously thought, and that investors contacted about tendering their shares agreed to keep the pending takeover confidential. It would be "pretty dumb of anybody" to be trading on the basis of material undisclosed information, he said.

Still, Mr. Garolafo said both sides were worried by the stock action, and took steps to keep the talks private. Executives from the two companies even avoided being seen in public together. "But still the stock ran and that's always unfortunate when that happens. I know that, on their side, they were frustrated as well because obviously that exposes them, so that's not a good thing. It's never, never good to have that kind of situation."

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