The Securities and Exchange Commission is raising eyebrows on Wall Street with an investigation into a $10 billion hedge fund that tried to dodge the old adage of “no pain, no gain” in a failed drug-industry merger.
At issue are the elaborate financial maneuverings of the Perry Capital hedge fund, as it tried to straddle both sides of a $5.4 billion merger between Mylan Laboratories and King Pharmaceuticals in 2004. Richard Perry, the fund’s namesake manager and an ex-Goldman Sachs arbitrageur, wanted to boost the deal’s odds of success since he was a large King shareholder.
To that end, Perry entered a complex swap transaction with Goldman and Bear Stearns; he acquired nearly 10 percent of Mylan’s stock, became the company’s largest shareholder—and simultaneously shorted the stock. In other words, Perry ended up with weighty voting power in both companies, and almost no risk to him regardless of whether the merger succeeded or died.
The merger eventually did die for several reasons, an accounting scandal at King among them. Now, however, the SEC wants Perry to detail his actions (it has sent him a Wells notice) and explain why the agency shouldn’t levy penalties against him. At issue: whether Perry could buy his way into voting control of Mylan, when he had no economic interest in its governance or fate.
“I haven’t seen it before,” says John Chen, a merger arbitrage analyst at Cathay Financial. “I have never seen someone get voting control but not economic control.”
Spokespeople for Mylan and King, as well as Perry, did not return phone calls seeking comment. In a previously released statement, however, Perry said, "As we have previously advised our investors, the staff of the Securities and Exchange Commission has been conducting an informal inquiry in connection with Perry Capital's trading in the securities of Mylan Labs. We believe that we have acted properly at all times and with the advice of counsel."
If Perry’s technique catches on, it could become a major threat to a company’s ability to retain control in the face of investor opposition.
Black
Indeed, in a paper published in early January, University of Texas law professors Henry Hu and Bernard Black explore what they call the relatively new practice of “decoupling” and “empty voting”—which they define as “holding more votes than economic ownership” (see box above, right).
Their theory is that thanks to the explosion of derivative investments and other instruments in the capital markets, outside and inside investors alike can easily “decouple economic ownership of shares from voting rights to those shares," they write. "This decoupling—which we call the 'new vote buying'—is largely hidden from public view and is largely untouched by current regulation. Hedge funds have been especially creative in decoupling voting rights from economic ownership."
They assert that over the past year or so, the new vote buying has affected the outcomes of shareholder votes and takeover battles on three continents. Indeed, they specifically refer to the Perry-Mylan case when they worry about potential risks from empty voting. “The more Mylan (over)paid for King,” they wrote in their paper, “the more Perry stood to profit.”
More importantly, they warn, the modern derivative now has the potential to affect voting outcomes; if hedge funds can use the technique to undercut the voting rights of other shareholders, insiders could do the same to all outside investors.
In an interview, Hu cautioned corporate executives not to overreact to the Perry case. “I don’t know how big of a problem this is,” he stressed. Although his report lays out a number of substantive solutions, “it’s premature to push for any of them.”
Ease Of Playing Both Sides
Still, Hu says, what Perry did in the Mylan-King case is pretty easy to do; an investor just needs to enter in the right equity swaps. Indeed, the paper notes published reports had suggested that hedge fund giant Citadel was rumored to have followed the same strategy as Perry in the Mylan-King deal.
This is not the first time Perry has attracted the attention of regulators after pursuing an aggressive investment strategy during a potential merger. In 2002 the investor found himself in the middle of a high-profile legal controversy in New Zealand, when he breached local shareholder rules by failing to give notice that he owned nearly 16 percent of Rubicon, a forestry and biotechnology company spun off in the breakup of Fletcher Challenge. He was accused of entering into an equity swap arrangement with Deutsche Bank and UBS Warburg to avoid disclosure as a major Rubicon holder. Perry was initially ordered to forfeit some shares and sell the rest, but eventually was cleared of any wrongdoing.
Hu
These actions potentially raise major corporate governance issues, Hu asserts. He points out that the vote is the only weapon the shareholder has to impact a company’s operations. “If you tamper with that, it underscores the whole notion of how corporate governance works,” he adds.
Hu says one step the SEC could take to avoid such controversies is to require investors to disclose their holdings based on economic ownership and access to votes, not merely the current policy of disclosing the number of outstanding shares owned. “This can avoid game playing,” he explains.
Despite the raised eyebrows, however, exactly what SEC rule Perry might have violated is unclear—and some industry observers suspect the answer is “none.” Merger arbitrage is a common strategy on Wall Street and many players are hedge funds which, by definition, play both sides of announced deals. “It’s very interesting and I think in terms of legality, I don’t think it is clear cut,” says Chen, who also cautions that he is not a lawyer.
One question is the timing of Perry’s filing of Schedule 13-D, the form that requires investors to disclose when they acquire 5 percent of a company. According to the Nov. 19, 2004 filing, Perry passed the 5 percent threshold weeks before he submitted the required document regarding his Mylan stake to the SEC.
Rubin
Brian Rubin, partner with Sutherland Asbill & Brennan and formerly a lawyer with the enforcement divisions at both the SEC and NASD, says the SEC appears to be considering 10b-5 fraud charges. Rule 10b-5—Employment of Manipulative and Deceptive Devices—bars individuals from trying to defraud, make false material statements or deceive in connection with the purchase or sale of any security.
The Perry fund “may have not accurately indicated its ‘Purpose of transaction’,” Rubin says. Indeed, in his initial 13-D, Perry did not elaborate on his motives or strategy regarding his Mylan stake.
Lee
Jason Lee, co-chair of the securities enforcement defense group at Shartsis Friese, believes the SEC will scrutinize whether material omissions or misstatements occurred in the disclosures, with an eye towards whether a reasonable investor would have considered that missing information in making an investment decision. But, he said in an interview: “Making headway in proving this could be difficult because Perry Capital has indicated that the firm received advice of counsel on this issue. Depending on the nature of this advice, Perry may have a strong argument to negate one of the hardest elements to prove in a fraud case: intent.”
Even if Perry is found not to have broken any law, Rubin says the transaction simply “may not have passed the smell test.”
“This is an issue CFOs need to worry about,” Hu warns. “When you see certain patterns in terms of shareholder votes, how do they interpret it? Are they the will of all shareholders or just the hedge fund? How is corporate governance supposed to work when the shareholder concept is undermined?”
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