Abstract

In this paper, we examine informed stock options transactions in firms that have been sued for security law violations via shareholder class action lawsuits. We explore whether there is an increase in possibly informed stock option transactions prior to a lawsuit – which may be suggestive of informed insider trading in the options market. In addition, we examine whether the wealth performance sensitivity (WPS) of insiders affects the abnormal trading volume in stock options around litigation announcements. Finally, we examine whether company-specific fundamentals have a significant effect on the abnormal trading volume in stock options surrounding litigation. We calculate abnormal options volume using an event study constant mean approach and use a matched firm analysis to compare the options trading in sued versus non-sued firms. We then estimate a series of regressions to examine the effect of WPS and firm specific fundamentals on the abnormal trading volume of stock options trading around litigation dates in a multivariate setting. We find that the volume of options traded during the event window preceding a litigation announcement is abnormally high relative to the estimation period and also abnormally high compared to matched firms. Moreover, financial statement variables collected during the financial quarter encompassing the date of the litigation announcement have a substantially more noticeable and prominent effect when corporations are litigated for financial reasons or whose lawsuits pass the defendants’ motions to dismiss. Our study is the first to present evidence of unusually high options trading volume prior to impending legal action. In addition, we contribute to the body of knowledge that explores the impact of wealth performance sensitivity on suspicious trading behavior.