Five years ago, it was reported that hedge fund Perry Capital had purchased shares of Mylan Laboratories allegedly to influence the shareholder vote in Mylan’s pending takeover of King Pharmaceuticals while entering into total return swaps that eliminated Perry’s economic risk of owning a large portion of the shares it owned. The SEC criticized the strategy as “vote buying” because the combined share and swap position gave Perry voting rights but no equity risk. Last week, Perry agreed to pay a $150,000 penalty to settle SEC charges that it failed to disclose its purchases on a timely basis pursuant to Section 13(d) of the Exchange Act.
If the merger was completed, Perry stood to profit through an arbitrage strategy involving purchasing Mylan’s stock and shorting King’s stock. In addition, Perry purchased close to 10% of Mylan’s total outstanding shares allegedly in order to vote the shares in favor of the merger, while simultaneously entering into swap transactions to hedge away its economic risk on most of its Mylan shares while retaining voting rights on those shares.
While Perry ultimately filed a Schedule 13D disclosing its Mylan stake, it did so more than two months after it had acquired more than 5% of Mylan’s outstanding shares. The SEC found that Perry’s failure to disclose its purchases on Schedule 13D within 10 days of crossing the 5% threshold violated Section 13(d) and Rule 13d-1 thereunder.
Perry argued that in lieu of making a Schedule 13D filing, it was permitted under Rule 13d-1(b) to file a shorter Schedule 13G within 45 days after the end of the calendar year in which the 5% threshold was crossed. A Schedule 13G filing is available to specified institutional investors who (1) acquired securities “in the ordinary course of [their] business,” and (2) “not with the purpose nor with the effect of changing or influencing the control of the issuer, nor in connection with or as a participant in any transaction having such purpose or effect. . . .” The SEC concluded that it was inappropriate to rely “on Rule 13d-1(b)(1)(i) based on the ‘ordinary course of business’ provision” because Perry had purchased the shares to acquire voting rights and for the “exclusive purpose” of influencing the outcome of the vote. According to the SEC order, Perry’s total return swaps evidenced this “exclusive purpose” since, as a result of the swaps, “Perry’s acquisition of Mylan shares was not made in order to invest in, or profit from, ownership of the Mylan shares.” The SEC explained:
When institutional investors acquire, directly or indirectly, the beneficial ownership of securities with the purpose of influencing the management or direction of the issuer or affecting or influencing the outcome of a transaction – such as acquiring securities, or an interest in securities, for the purpose of voting those securities in favor of a merger – the acquisition of those securities cannot be said to be in the “ordinary course of [the institutional investor’s] business . . . .”
Because the SEC focused on the “ordinary course” prong of Rule 13d-1(b), the SEC order does not directly address whether an investor in similar circumstances would have been eligible to report its ownership on Schedule 13G pursuant to Rule 13d-1(c) within 10 days of the end of the month in which the 5% beneficial ownership threshold was crossed. Rule 13d-1(c) requires the passive investor intent of Rule 13d-1(b) but is not limited to institutional investors who are acting in the ordinary course of business.
Although the SEC has long been concerned with practices that it characterizes as “vote buying” or “empty voting,” its decision in this case does not reach the merits of Perry’s strategy. Because shareholder voting is governed primarily by state law, the SEC’s main tool in regulating empty voting is to require more disclosure. Notably, the $150,000 penalty is modest compared to the millions in profits or losses that Perry had placed at risk on the closing of the Mylan/King merger. In the past few years, the SEC has said that it intends to address empty voting through regulatory changes to ensure that investors’ interests are protected. Within the past year, particularly on the heels of the CSX decision, the SEC has also indicated it would re-examine Section 13(d) requirements with respect to stakes held through derivative instruments such as total return swaps. Pending such reform, investors engaged in non-traditional ownership and voting arrangements should proceed with caution when considering whether Schedule 13D disclosure is necessary.
See In re Perry Corp., Securities Exchange Act Release No. 60351, Investment Advisers Act Release No. 2907 (July 21, 2009).