On July 21, 2009, the U.S. Securities and Exchange Commission (the “SEC”) announced that it had entered into a settlement with Perry Corp., a New York-based registered investment adviser to five private investment funds, in connection with the SEC’s claim that Perry failed to timely file a Schedule 13D disclosure statement pursuant to Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 13d-1 thereunder. In its order (the “Order”),13 the SEC accused Perry of failing to timely report its beneficial ownership of more than 5% of the shares of common stock of Mylan Inc. (f/k/a Mylan Laboratories Inc.). In general, beneficial owners14 of more than 5% of a voting equity security registered under Section 12 of the Exchange Act must report their beneficial ownership either on Schedule 13D or, if eligible, on a short-form Schedule 13G within 10 days after crossing the 5% threshold. Rule 13d-1(b), on which Perry relied, allows certain institutional investors to defer filing a Schedule 13G until 45 days after the end of a calendar year if they continue to own more than 5% as of the end of the year.
According to the Order, Perry engaged in “merger arbitrage,” a trading strategy by which Perry desired to profit from Mylan’s announced agreement to acquire King Pharmaceuticals Inc. by purchasing shares of King and selling short a corresponding number of shares of Mylan. As part of this strategy, the King shares would be exchanged for Mylan shares if the merger was consummated and Perry could use these Mylan shares to cover its short sales. As a result, Perry presumably would profit from the “risk arbitrage spread” created when the securities of an acquiring company (Mylan) trade at a higher price than the shares of the issuer it is attempting to purchase (King). This pre-merger spread typically reflects market uncertainty about the likelihood of the consummation of the transaction with the spread widening if there are indications that the merger will not be completed and narrowing as confidence grows that the merger will be completed.
The SEC alleged that Perry was concerned about losing its anticipated profits from the merger arbitrage because of opposition to the merger from an activist investor that became known after Perry’s initial risk-arbitrage trades. In reaction to this threat, Perry allegedly sought to purchase Mylan shares in order to obtain more voting rights to counter the activist investor’s opposition. The SEC accused Perry of purchasing these shares without any public disclosure through a Schedule 13D filing to increase its return on its merger arbitrage strategy, and of limiting its economic exposure to Mylan’s common stock by entering into swap agreements with certain banks to insulate itself from any decrease in the market price of Mylan common stock.
The Order stated that Perry was initially advised by outside counsel to defer reporting its beneficial ownership of Mylan shares in reliance on Rule 13d-1(b). Rule 13d-1(b) allows for deferred reporting only if the securities were acquired by a qualified institutional investor (i) in the “ordinary course of his business” and (ii) “not with the purpose nor with the effect of changing or influencing the control of the issuer.” According to the Order, Perry was not entitled to the extended filing deadline of a qualified institutional investor since Perry did not purchase the Mylan shares in the “ordinary course of his business.” This is the first time that the SEC has provided any significant insight into the “ordinary course of business” prong of Rule 13d-1(b). According to the Order, the SEC narrowly interprets “ordinary course of business” to mean routine business operations that are either for “passive investment” or “ordinary market making purposes.” As the following excerpt from the Order also makes clear, it is the SEC’s view that a qualified institutional investor could never satisfy the “ordinary course of business” requirement when purchasing shares in order to vote the shares in favor of a proposed transaction or to otherwise influence an issuer or the outcome of a transaction:
Irrespective of whether transactions of this type are routine for an institutional investor, reliance on Rule 13d-1(b)(1)(i) based on the “ordinary course of business” provision is inappropriate when transactions of the type executed by Perry are undertaken. The exception to the ordinary 10-day disclosure requirements of Section 13(d) for qualified institutional investors is available only where such investors are acquiring securities for passive investment or ordinary market making purposes as part of their routine business operations.
It is interesting to note that a literal reading of Rule 13d-1(b)(1)(i), which provides for acquisitions in the “ordinary course of his business” (emphasis ours), suggests that appropriate consideration should be given to the investment strategy of a particular investor. This suggests the possibility that the prong would be satisfied if the investor is in the business of buying shares solely for the purpose of influencing a shareholders vote. The SEC made clear in the Order, quoting from the legislative history of the provisions of Section 13(d), that its position is that “ordinary course of business” is to be determined “irrespective of whether transactions of this type are routine for an institutional investor” and that it requires either passive investment or ordinary market making activities.15
Also of interest in the Order is that the SEC did not determine that Perry was required to file a Schedule 13D because it had acquired the Mylan shares with the purpose or effect of changing or influencing control of the issuer, the second prong of the Rule 13d-1(b) test. Presumably, this was because Mylan was the acquiring entity in the proposed merger and would not have undergone a change of control had the merger gone through. Seemingly, the SEC did not want to argue that buying shares solely with the purpose of affecting the outcome of a vote to approve a merger transaction fails to satisfy the Rule 13d-1(b)(1)(i) requirement to not acquire the shares “with the purpose nor with the effect of changing or influencing the control of the issuer.” Ostensibly, the SEC would have needed to address difficult change of control issues for an acquiror in a merger. Therefore, in this case, it is difficult to conclude that an investor such as Perry would be a “passive investor,” the rule itself does not contain a pure “passive” standard. Instead, the SEC chose to introduce a passive intent requirement in the “ordinary course of business” prong. Of course, this prong of the rule does not actually state a passive intent requirement either and, as a result, the interpretation blurs the two prongs of the 13d-1(b) test and may be subject to challenge.
The basic concept that a risk arbitrageur is not a passive investor and cannot defer filing a Schedule 13G until 45 days after the end of a calendar year but instead must file a Schedule 13D within 10 days of crossing the 5% threshold, was previously articulated by the SEC in a no-action letter.16 In Faith Colish, the SEC stated that acquisitions of shares of target entities by professional risk arbitrageurs, when made after a public announcement of a tender offer or a proposed tender offer, are made in connection with a transaction which, if consummated, would have the effect of changing control of the issuer, and that such acquisitions thereby fail to satisfy the basic requirements of one of the prongs of Rule 13d-1(b). And, in fact, the Order in Perry states that when the activist investor announced an intention to launch a tender offer for Mylan shares, Perry did file a Schedule 13D within 10 days thereafter based on its voting rights in Mylan stock.
What is unclear after the Perry Order is whether the SEC’s focus on the “ordinary course of business” prong leaves the door open for an investor in similar circumstances to rely on Rule 13d-1(c) and file a short-form disclosure statement on form Schedule 13G within 10 days of crossing the 5% threshold, rather than filing a Schedule 13D. A Schedule 13G filed pursuant to the passive investor requirement of Rule 13d-1(c) is not subject to an “ordinary course of business” requirement, since the Rule only includes the requirement that the investor not have acquired the shares with the purpose or effect of changing or influencing the control of the issuer. In light of the SEC’s interpretation of “ordinary course of business,” it is unlikely that activities similar to those in the Order would be viewed by the SEC as being eligible for filing on Schedule 13G. If faced with these facts, it will be interesting to see if the SEC feels compelled to argue that passive intent also is inherent in the requirement not to acquire the shares with the purpose or effect of changing or influencing control of the issuer.17
Finally, it is important to note that this Order also impacts compliance with Section 16 of the Exchange Act. Rule 16a-1(a)(1) exempts certain qualified institutional investors who acquire more than 10% of equity voting securities registered under Section 12 of the Exchange Act from the coverage of Section 16 if they satisfy the “ordinary course of business” requirement as well as the requirement not to acquire the shares with the purpose or effect of changing or influencing control of the issuer. Therefore, if an investor is found not to have acquired shares in the ordinary course of business for purposes of Section 13, it not only will affect the investor’s eligibility to file a short-form disclosure statement on Schedule 13G by the extended deadline of 45 days after the end of a calendar year, but will also jeopardize the investor’s ability to rely on the exemption provided in Rule 16a-1(a)(1).
The activities at issue in this case were one of the earliest instances where concerns over so-called “empty voting” rights were raised. The term “empty voting” refers to situations where a person holding voting rights in connection with a shareholder vote has no economic stake in the shares being voted.18 The issue has been much discussed in academic literature and the press and this scrutiny may have contributed to the SEC’s decision to take this enforcement action.
The SEC determined in its Order that Perry was required to file a Schedule 13D within 10 days of acquiring 5% of the outstanding shares of Mylan, and that it failed to do so. Perry, for its part, without admitting or denying any of the SEC’s findings, agreed to a civil penalty of $150,000, censure, and a cease-and-desist order from any future violations of Rule 13(d).
The SEC’s actions in this proceeding demonstrate the agency’s continued monitoring of filing requirements under Section 13(d) and signal investor exposure to having their reporting determinations challenged by other investors with differing interests. Investors should be aware that engaging in risk arbitrage and related activities can have important consequences regarding their compliance with the disclosure requirements of Sections 13(d) and 16 of the Exchange Act and their ability to rely on the deferred filing of a short-form disclosure statement on Schedule 13G pursuant to Rule 13d-1(b).