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The report concludes trading volume and volatility in the 30 days preceding the announcement of a takeover deal ‘suggests that informed trading is more pervasive than would be expected based on the actual number of prosecuted cases.’LUCAS JACKSON/Reuters

Insider trading continues to be "pervasive" before merger and acquisition deals but rarely leads to prosecutions, according to an analysis of unusual trading patterns by a team of professors in Canada and the United States.

The new study found abnormal trading in 25 per cent of 1,800 U.S. takeover deals between 1996 and 2012. The review examined trading in put and call options, which are attractive vehicles to use for insider trading and typically have lower trading volumes than common shares, making it easier to identify unusual patterns.

Regulators in Canada and the U.S. have long faced accusations of doing too little to crack down on illegal insider trading in advance of major deals, allowing insiders to reap large gains by buying securities before the transactions are announced. However, securities commissions have said the cases are difficult to detect and even harder to prove in court and prosecute successfully.

The report concludes trading volume and volatility in the 30 days preceding the announcement of a takeover deal "suggests that informed trading is more pervasive than would be expected based on the actual number of prosecuted cases."

The study is a working paper published in May by Patrick Augustin of McGill University in Montreal and co-authors Menachem Brenner and Marti Subrahmanyam, both of New York University.

The unusual trading was most pronounced in low-priced call options that are out-of-the-money at the time of purchase and short-dated to expire quickly, which the authors say are among the securities that would mostly likely be used by someone with insider knowledge of a pending deal.

For options with those features, the unusually beneficial trading results could have happened by chance in only three cases in a trillion, the study concludes.

Call options give investors a way to bet that a company's share price will rise in the future by allowing holders the option to buy shares in the future at a set price and by an agreed date. They can be appealing tools because a buyer can make a far larger bet with less money than is needed to buy shares outright.

Prof. Augustin said the study was initially sparked by media reports about unusual trading prior to a takeover bid for H.J. Heinz Co., which was unveiled in February, 2013.

The U.S. Securities and Exchange Commission reached a $5-million (U.S.) settlement agreement last October with two men accused of buying out-of-the-money Heinz call options before the announcement based on confidential information. The options surged by 1,700 per cent after the takeover deal was announced, making an initial $90,000 investment worth $1.8-million.

Prof. Augustin said the study overall showed there was some unusual trading in common shares before some takeover announcements, but far more action in the options market.

"We just believe it might be useful to look at little bit deeper into the options market, in addition to the stock market," he said in an interview.

Prof. Augustin said the researchers are stressing that all cases of abnormal trading that they detected do not necessarily involve illegal insider trading. It is possible some insiders had approval to trade shares at some point in the 30 days before a deal was announced, and it is possible some outsiders made good educated bets based on careful study of a company.

In many cases, however, the trading appeared blatant. The report said it found many cases where there was a "sudden and significant spike" in the volume of trading in call options prior to the announcement of a deal when there had been "an extended period of no trading" at all, making it especially unlikely the trades were the result of ordinary market forces.

The study said cases that resulted in SEC prosecutions for illegal insider trading showed the same patterns of unusual "pervasive and non-random" trading before the deals. But the authors said many other cases with similarly unusual trading patterns did not result in prosecutions.

"The modest number of civil lawsuits for insider trading in options made by the SEC appears small in comparison to the persuasive evidence we document," the study says.

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