Risk Arbitrage

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Risk Arbitrage

The purchase of stock in a corporation that appears to be the target of an imminent takeover in the hope of making large profits if the takeover occurs.

Risk arbitrage is practiced by investors called risk arbitrageurs. The strategy can return large profits if a takeover occurs but can also result in large losses if the transaction does not take place. Obviously, then, the more information an arbitrageur has about a possible takeover, the less risk the strategy involves. Buying Securities of takeover candidates on the basis of rumors is legal, but it is illegal for an arbitrageur to purchase securities based on inside, or nonpublic, information. Insider trading violates rule 10(b)-5 of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78a et seq., which is a federal law that governs the operation of the stock exchanges and over-the-counter trading.

To obtain information, arbitrageurs often develop relationships with investment banking firms and corporations, as well as with other sources of information and financial backing. These activities alone do not constitute a violation of the Securities Exchange Act, but if the risk arbitrageur uses these relationships or resources to gather information that is not available to the general public, the resulting purchase of securities is illegal.

In the late 1980s, the Securities and Exchange Commission (SEC) began to investigate several prominent risk arbitrageurs for their roles in insider trading. This action, combined with the increasing number of corporate takeovers, brought the issue of risk Arbitrage to the headlines of Wall Street and the world. Between 1980 and 1988 in the U.S. District Court for the Southern District of New York alone, fifty-seven arbitrageurs were criminally prosecuted for insider trading. One of the bestknown cases involved risk arbitrageur Ivan Boesky, who allegedly realized a $9.075 million net profit through stock trades he made based on nonpublic information about three different mergers and takeovers. As part of the settlement with the SEC and the federal courts, Boesky was barred from any future securities trading.

Because risk arbitrage can involve significant blocks of shares worth hundreds of thousands, even millions, of dollars, this practice can have a large impact on both the market and the value of the company's stock. Professionals in the securities field generally agree that risk arbitrage based on inside information has a negative effect on the market, as well as on the reputation of arbitrageurs in general. Many of these commentators, however, are concerned that existing securities laws do not reach risk arbitrageurs who do not owe a fiduciary duty to the people who are harmed by the arbitrageur's use of nonpublic information. The Securities and Exchange Act specifies that a violation of rule 10(b)-5 requires the accused violator to have breached a fiduciary duty to the injured party.

Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980), is one of the leading cases on rule 10(b)-5 liability. Vincent F. Chiarella was employed at a financial printer and, as part of his duties, handled a series of documents that detailed an upcoming takeover bid; although the names were left blank or falsified, Chiarella was able to figure out the companies involved. Then, without disclosing that he had inside information, he bought stock in the companies that were targeted in the takeover; when the takeover was made public, he sold the shares and made a profit of approximately $30,000. Shortly thereafter, Chiarella was indicted on seventeen counts of violating rule 10(b)-5. The U.S. Supreme Court reversed the conviction, however, on the grounds that Chiarella had not violated the rule because he was not a fiduciary and therefore did not have a duty to disclose.

Further readings

Hazen, Thomas Lee. 1989. "Volatility and Market Inefficiency: A Commentary on the Effects of Options, Futures, and Risk Arbitrage on the Stock Market." Securities Law Review 21.

Steckman, Laurence A. 1988. "Risk Arbitrage and Insider Trading—A Functional Analysis of the Fiduciary Concept Under Rule 10b-5." Touro Law Review 5 (October).

Cross-references

Mergers and Acquisitions.

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