Earlier this year, the SEC announced that it had entered into a settlement agreement with Perry Corp., a New York-based registered investment adviser, for violating Section 13(d) of the Securities Exchange Act of 1934. In its order, the SEC charged Perry with failing to timely file a Schedule 13D when it acquired over 5 percent of the outstanding shares of the target company in a proposed merger.
In mid-2004, Mylan Laboratories, Inc. announced a proposed acquisition of King Pharmaceuticals Inc. At the time of this announcement, Perry had invested intermittently in King shares since 2001 and had built a significant position in King. Following the merger announcement, Perry began to engage in what the SEC called “merger arbitrage.”
Perry’s “merger arbitrage” strategy was based on a belief that following the announcement of the proposed merger, in which King shares would be exchanged for Mylan shares, the price of Mylan shares would trade at a higher price than King’s shares because there would be uncertainty in the market as to whether the merger would occur (i.e., the “risk arbitrage spread”). Accordingly, Perry sold short Mylan shares while adjusting its position in King. If the merger had been completed, Perry’s King shares would have been exchanged for Mylan shares, and Perry would have used the newly issued Mylan shares to cover its short sales. Perry’s profits would have been based on the risk arbitrage spread. If the merger had not been completed, however, Perry’s “merger arbitrage” strategy would have been frustrated, and it could have faced a loss.
Three weeks after the merger was announced, a third party investor with a significant position in Mylan announced its opposition to the merger, which decreased the likelihood that the merger would be approved by Mylan’s stockholders. If the third party investor would have succeeded in blocking the merger, Perry would have lost its anticipated profits from its merger arbitrage trades and faced a potential loss.
According to the SEC’s order, Perry then decided simultaneously to engage in two types of transactions. Perry purchased 2.1 percent of Mylan shares in open-market transactions. Perry also entered into a series of equity swaps that effectively established a short position in 7.8 percent of Mylan’s shares, which offset the Mylan shares already held by Perry. These transactions enabled Perry to increase the number of Mylan shares it could vote in favor of the merger (and thus counter the third party investor while drastically reducing the economic risk of owning the shares). Ultimately, Perry acquired beneficial ownership of 9.9 percent of Mylan’s shares through these transactions. Perry did not, however, file a Section 13D within 10 days after it acquired beneficial ownership of more than 5 percent of Mylan’s shares. For reasons unrelated to Perry’s trading, the Mylan/ King merger was not completed.
In general, under Rule 13d-1, investors must report their beneficial ownership of more than 5 percent of the voting securities of a class of such securities of an issuer on a Schedule 13D within 10 days of crossing the 5 percent threshold. After making a Schedule 13D filing, an investor must amend the Schedule 13D whenever there is a material change in the investor’s beneficial ownership, including an increase or decrease in beneficial holdings of the issuer of 1 percent or more.
Under Rule 13d-1(b), however, certain institutional investors, including registered investment advisors, may report their beneficial ownership of an issuer’s securities on a shortform Schedule 13G on a delayed basis and be subject to less stringent ongoing reporting requirements.
Rule 13d-1(b) generally permits an eligible institutional investor to report its beneficial ownership in an issuer on a Schedule 13G so long as the institutional investor has acquired the securities (i) in the ordinary course of business and (ii) not with the purpose or effect of changing or influencing the control of the issuer. An eligible institutional investor that files a Schedule 13G under Rule 13d-1(b) must report its beneficial ownership in the issuer within 45 days after the end of the year in which it acquired more than 5 percent but not more than 10 percent of the issuer’s securities. (If the institutional investor initially acquires beneficial ownership of more than 10 percent of the issuer’s securities, however, it must file a Schedule 13G within 10 days after the end of the month in which it crossed the 10 percent threshold.) Thereafter, the eligible institutional investor must amend its Schedule 13G within 45 days after the end of each calendar year during which it beneficially owns more than 5 percent of the issuer’s securities. In addition, if the eligible institutional investor crosses the 10 percent threshold as of the last day of a given month, it must amend the Schedule 13G within 10 days after the end of that month.
The SEC charged Perry with failing to timely file a Schedule 13D when it acquired beneficial ownership in more than 5 percent of Mylan’s shares, in violation of Section 13(d) and its Rule 13d-1. According to the SEC’s order, Perry decided not to file a Schedule 13D based on Perry’s view that it was entitled to defer filing in reliance on Rule 13d-1(b) because it was an eligible institutional investor that had purchased Mylan shares in the ordinary course of its business and without purpose or effect of changing or influencing the control of the issuer. The SEC found, however, that because the series of transactions through which Perry acquired beneficial ownership of a large block of Mylan stock were for the exclusive purposes of voting the shares in the proposed merger and influencing the outcome of the vote, they were not made in the ordinary course of Perry’s business. Thus, although Perry was an institutional investor who would otherwise have been eligible to use Rule 13d-1(b), because the “ordinary course of business” requirement of Rule 13d-1(b) was not met, Perry was not entitled to rely on Rule 13d 1(b) to defer its reporting. The SEC therefore concluded that Perry should have filed a Schedule 13D within 10 days after it became the beneficial owner of more than 5 percent of Mylan’s shares. Under the terms of its settlement with the SEC, Mylan agreed to pay a $150,000 penalty without admitting or denying the SEC’s findings.
The Perry case is noteworthy for several reasons. First, the Perry case is one of only a handful of cases in which the only violation charged is a failure to comply with Section 13(d) reporting requirements. Often, a charge for a violation of Section 13(d) is made in connection with charges for other violations, such as insider trading or other Rule 10b-5 actions. This action demonstrates that the SEC is monitoring Section 13(d) filings made by investors and may indeed bring enforcement actions based only on an investor’s failure to comply with Section 13(d).
Second, this is the first time the SEC has provided significant guidance regarding the “ordinary course of business” requirement of Rule 13d-1(b). The SEC interpreted “ordinary course of business” to mean acquisition of securities for “passive investment or ordinary market making purposes as part of the qualified institutional investor’s routine business operations.” The SEC also noted that institutional investors’ acquisitions of securities for the purposes of influencing the outcome of a proposed transaction, such as to vote in favor of a merger, can never satisfy the “ordinary course of business” requirement of Rule 13d 1(b), and, in such cases, institutional investors must always report beneficial ownership on a Schedule 13D – irrespective of whether the institutional investor routinely engages in these types of transactions.
Finally, the Order could impact institutional investors’ reporting requirements under Section 16 of the Exchange Act. In general, Section 16 requires “insiders,” including beneficial owners of more than 10 percent of an issuer’s securities, to disclose their trades in and beneficial ownership of the issuer’s securities and requires disgorgement of an insider’s short-swing profits. Rule 16a 1(a)(1), which generally tracks Rule 13d 1(b), exempts certain institutional investors from having to file Section 16 reports if they acquire shares in the ordinary course of business and not for the purpose or effect of changing or influencing control of the issuer. If an institutional investor that beneficially owns more than 10 percent of an issuer’s securities is found not to have acquired shares in the ordinary course of business for the purposes of Rule 13d 1(b), the SEC may take the position that the institutional investor is likewise not exempted from Section 16 reporting requirements, and would consequently be required to report all of its trades in the issuer’s securities and be subject to disgorgement of any short-swing profits.