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Recent SEC Enforcement Action Serves as Reminder of 13(d) Disclosure Requirements and Clarifies Limitations on “Ordinary Course of Business” Exception

July 23, 2009

 

On July 21, 2009, the U.S. Securities and Exchange Commission (the “Commission”) charged investment adviser Perry Corp. (“Perry”) with a violation of Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) for failing to timely disclose that it had purchased beneficial ownership of more than 5% of the stock in a public company. The Commission’s order provides a useful warning regarding the limitations on the use of the “ordinary course of business” exception pursuant to Rule 13d-1(b) under the Exchange Act. While the 13(d) reporting requirements generally require disclosure within 10 days after an acquisition causing an investor to beneficially own more than 5% of the shares of a public company, this “ordinary course of business” exception is sometimes relied on by institutional investors to defer their 13(d) disclosures.

Background

On July 24, 2004, Mylan Laboratories Inc. (“Mylan”) announced an agreement to acquire King Pharmaceuticals, Inc. (“King”) through a proposed merger that was subject to shareholder approval of both companies. Shortly following the merger announcement, Perry, which already held a significant position in King, entered into a series of “merger arbitrage” investments in which Perry stood to profit if the Mylan-King merger was consummated. While engaging in these investments, Perry also acquired beneficial ownership of a substantial block of Mylan’s shares (slightly less than 10%) that it intended to vote in favor of the proposed merger, while contemporaneously entering into a series of “swap” transactions that effectively eliminated any economic risk to Perry from owning the Mylan shares. In effect, Perry sought to “buy” approximately 10% of the Mylan vote in order to increase the likelihood that the Mylan-King transaction would be approved so that it would profit from its merger arbitrage investments.

Perry was incentivized not to publicly disclose that it was accumulating a significant block of Mylan shares to vote in favor of the proposed merger because the continued uncertainty over whether the Mylan shareholders would approve the merger increased the “spread” between the price of King and Mylan shares and therefore increased Perry’s potential profit. Under Rule 13d-1(b), an investor is permitted to file a Schedule 13G within 45 days after the end of the calendar year in which it made a 5% acquisition, rather than filing a more detailed Schedule 13D within 10 days after the acquisition if the investor acquired the shares (i) in the ordinary course of business and (ii) not with the purpose or 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. Perry concluded that it was permitted to defer public disclosure of its position in Mylan in reliance on Rule 13d-1(b) because Perry, as an institutional investor, held the Mylan shares “in the ordinary course of business” and without the purpose or effect of changing or influencing Mylan’s control since Mylan was to be the company surviving the merger with King and no change of control of Mylan was going to occur.

The Commission’s Order

The Commission determined that Perry’s reliance on Rule 13d-1(b) to defer disclosure of its position was inappropriate because its acquisition of Mylan’s securities was not in the ordinary course of Perry’s business. In so doing, the Commission clarified that the purpose of the “ordinary course of business” exemption was to permit qualified institutional investors an exception to the ordinary 10-day disclosure requirement where the investor is acquiring securities for passive investment or ordinary market making purposes as part of their routine business operations (such as stock exchange specialists and market makers). The exemption does not apply when investors acquire beneficial ownership of securities with the purpose of influencing the management or direction of the issuer - such as acquiring securities for the purpose of voting in favor of a merger - since, in the Commission’s view, such activities are not in the ordinary course of business.

Lessons Learned

    • The “ordinary course of business” exception is not available for acquisitions intended to influence the outcome of a transaction, even where merger arbitrage is part of the investor’s regular business activities.

    • In the current period of enhanced regulatory scrutiny and in light of widespread criticism of the Commission’s recent enforcement efforts in the Madoff and other situations, the Commission seems willing to take aggressive positions and institute enforcement actions against investors who allegedly violate disclosure requirements.

    • If a 13(d) disclosure decision is being made in situations where other sophisticated parties have opposing interests, investors should consider the possibility that such other parties may call to the Commission’s attention instances of potentially delayed or inadequate disclosure (or non-disclosure) and that the Commission may be sensitive to such whistle-blowing notifications. While it is unknown whether another Mylan shareholder, Mylan management or anyone else agitated for Commission enforcement action in this case, investors with opposing interests or another agenda may not hesitate to alert the Commission to potential violations.

    • It is noteworthy that the Commission’s order focused exclusively on the “ordinary course of business” prong of the Rule 13d-1(b) exception and did not address the second prong of the Rule 13d-1(b) exception, which provides that, in order to defer disclosure, the securities must be held without the purpose of changing or influencing “control” of the issuer. In what could be viewed as a regulatory sleight of hand, the Commission’s order provided that Perry did not hold the Mylan shares in the ordinary course of business because the shares were held with the purpose of influencing the “management or direction” of the issuer or “affecting or influencing the outcome of a transaction.” However, the Commission did not rule on whether Perry held the Mylan shares with the purpose of changing of influencing “control” of Mylan and one may conclude from the Commission’s order that it did not view Perry’s actions as influencing control given the structure of the merger as discussed above. As such, the Commission left open the possibility that under facts similar to those in Perry, an investor beneficially acquiring more than 5% of an issuer’s shares could disclose its position on a less detailed short-form Schedule 13G within 10 days after such acquisition rather than complying with the more detailed disclosure requirements of Schedule 13D within the same 10-day period by relying on Rule 13d-1(c), which only requires that shares not be held with the purpose of changing or influencing control of the issuer (and does not contain the additional requirement that the shares be held in the ordinary course of business).