On July 21, the Securities and Exchange Commission (SEC) charged Perry Corp., a New York investment adviser, with securities law violations for failing to report substantial stock purchases in order to vote the shares in favor of a merger. Without admitting or denying the SEC's findings, Perry consented to an entry of an administrative cease-and-desist order and agreed to pay a fine of $150,000. This action by the SEC underscores its determination to clamp down on vote-buying schemes in which investors enter into a series of hedging transactions through the use of derivative instruments to avoid any financial exposure from their ownership of a merging company's shares.
According to the SEC's cease-and-desist order, Perry failed to file required disclosure under Section 13(d) of the Securities Exchange Act of 1934 (Exchange Act) within 10 days of acquiring beneficial ownership of more than 5% of the shares of Mylan Laboratories Inc. At the time of the purchases, Mylan had announced a proposed acquisition of King Pharmaceuticals, Inc., subject to required shareholder approval. To increase the likelihood that the acquisition would be approved by Mylan's shareholders, Perry purchased Mylan shares to vote in favor of the acquisition . To avoid the economic risk attendant to owning the Mylan shares, however, Perry entered into a series of "swap" transactions designed to fully hedge its financial exposure from owning those shares.
The swap transactions required the counterparty to reimburse Perry for any decrease in the market price of Mylan shares between the time of Perry's purchase and the time its position was unwound, which effectively insulated Perry from any movements in Mylan's share price. As a result, the SEC alleged that Perry acquired almost 10% of Mylan's outstanding shares without incurring any economic risk associated with owning the shares. The SEC alleges in its order that Perry enhanced its ability to potentially profit from its "merger arbitrage" scheme by not properly disclosing its beneficial ownership as required by the Exchange Act.
Specifically, Perry financed its purchase of Mylan stock through an extension of its existing margin line of credit at its prime broker. In the three days between the trade and settlement dates, Perry drew upon its margin account to be able to cover its long position. The SEC alleged that Perry paid approximately $7 million to its broker to finance the purchase of 26 million shares of Mylan that were worth approximately $492 million. At the same time, Perry earned interest on its short positions and on the collateral it gave to the banks for the "swaps." All in, Perry paid about $5.7 million to acquire almost 10% of the outstanding voting shares of Mylan.
While Perry engaged in this strategy of "essentially buying shares," according to the SEC's order, it was enhancing its risk-arbitrage position by purchasing additional King shares as it was continuing to short Mylan shares. At the point at which Perry held its largest position in King, the investment adviser would have realized an additional $22 million gain on these additional risk-arbitrage spreads. If the acquisition had closed that day, Perry's $20 million paper loss on its Mylan shares would have turned into a net profit of $21 million on its King risk-arbitrage spread position.
According to the SEC, Perry determined not to file the required Schedule 13D disclosure statement after allegedly concluding that it had acquired the Mylan shares "in the ordinary course of its business," which therefore entitled the investment adviser to defer its reporting obligations. "Qualified institutional investors" can defer their reporting obligations when they acquire securities as part of their ordinary market making or passive investment activities. The SEC, however, concluded that Perry's acquisition of Mylan shares was, in fact, not in the ordinary course of its business. Thus, when Perry acquired more than 5% of Mylan's outstanding shares, it was immediately required to cease trading in Mylan shares and to make required disclosure under Section 13(d) within 10 days.
The SEC said that Perry had engaged in a series of transactions to acquire voting rights – a vote-buying scheme – to influence the outcome of the shareholder vote on the acquisition . Perry's acquisitions of Mylan shares were therefore not made in the ordinary course of its business because they were not made to invest in, or profit from, ownership of the Mylan shares. So even if the purchase of Mylan shares were of a routine nature for Perry, it could not, according to the SEC, rely on the Rule 13d-1(b)(1)(i) exception to the ordinary 10-day disclosure requirement of Section 13(d) for qualified institutional investors.
In addition to imposing a financial penalty, the SEC censured Perry for its disclosure violations under the Exchange Act. In so doing, the SEC sent a clear message to institutional investors that vote-buying schemes are inherently manipulative and will attract enforcement action in situations in which investors violate the disclosure requirements of the Exchange Act.
This article first appeared on Securities Law360 on August 7, 2009.
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