Not since Felix and Oscar teamed up in the Odd Couple has there been a more curious collaboration.[1]  Pershing Square Capital Management L.P. and Valeant Pharmaceuticals International, Inc. have entered into a short-term marriage of convenience to facilitate Valeant’s hostile acquisition of Allergan, Inc. in a $53 billion deal.  As with many relationships, onlookers have questions: “What does she see in him?” here yields to “Why does Valeant need Pershing Square?”  Beyond this initial question about whether this relationship makes sense, there is also a second and more traditional legal issue: Can a strategic bidder really tip a hedge fund that it is about to make a tender offer if they use the right cosmetics?  Isn’t that precisely what Rule 14e-3 was supposed to preclude?  This column will examine both these questions.

Only one question about this hook up between a strategic bidder and a hedge fund is not being asked: What does Pershing Square get from this?  Here, the answer is obvious: it incurred a paper profit of $1 billion on its stake in Allergan on the announcement of Valeant’s merger proposal.  Other hedge funds would undoubtedly like to receive similar proposals from other bidders, and conceivably the generally unromantic M&A scene could see a number of very lucrative one night stands between ardent Prince Charming suitors and less-than-bashful maiden hedge funds.  But adults may still wonder: How long will these relationships last?

I. The Bidder/Hedge Fund Pairing

What does Valeant see in Pershing Square?  One answer might be that Pershing Square brought a considerable dowry with it.  It purchased some 9.7% of Allergan’s stock, through a nominee that it created, over the interval between February 25 and April 21, 2014, just before Valeant and Pershing Square each filed their Schedule 13D.[2]  For the highly leveraged, cash-short Valeant, this may have been important, but this was extremely costly financing, because Valeant will have to buy these shares from Pershing Square at its offered merger price (whereas Valeant could instead have acquired the same shares itself at roughly the price Pershing Square paid before announcing its offer).

Some believe that Pershing Square could acquire Allergan stock cheaper and faster than Valeant, because it mainly purchased not stock, but derivatives.  Possibly, there is an element of truth to this, but investment bankers could buy for Valeant in over-the-counter markets in the same manner.  The real difference here lies in the fact that Pershing Square, as a non-competitor to Allergan, could (and did) obtain speedy Hart-Scott-Rodino clearance that allowed it to convert its options into Allergan shares.[3]  Thus, the advantage to using an agent may lie more in timing than in cost.  Speed may have indeed been important to Valeant if it was focused on exploiting the provision in Allergan’s charter that allowed 25% of Allergan’s shareholders to call a special meeting at which shareholders can remove the board.  Yet, there is an inconsistency here that deserves attention: for antitrust purposes, Pershing Square was an independent actor, but for securities law purposes, it claims to be a co-bidder with Valeant.  Can it have it both ways?

Pershing Square seems exposed to very few economic risks.  If antitrust regulators were ultimately to veto an Allergan/Valeant merger (or if the deal otherwise craters), it would hold a large block whose stock price might sink back to the pre-announcement level, but that would require sinking on the order of the Titanic.[4]  Although Pershing Square must also buy a block of stock in Valeant, it buys at a 15% discount off the market price and only if the Valeant/Allergan merger first receives all necessary stockholder and regulatory approvals.  This is about as riskless as it gets.

Before other bidders emulate Valeant and seek out hedge funds as agents, they might consider other alternatives.  A bidder in Valeant’s position might have used equity swaps to the same effect.  The bidder would take the long side, and the counterparty bank, the short side.  Sensing the bidder’s intent, the bank on the other side of the equity swap would almost certainly hedge its position by acquiring a similar equity stake.  Then, the question becomes: how would the bank vote these shares?  Many suspect that the bank would vote the shares as its customer, the bidder, wanted it to do.  Of course, if there were any formal agreement to do so, this would give the bidder “beneficial ownership” of the shares.  If there were no such formal agreement, the Second Circuit’s ultimate resolution in CSX Corp. v. Children’s Inv. Fund Management (U.K.), L.L.P.[5] seems to make it clear that equity swaps can be used to assemble a block today (without the bidder acquiring beneficial ownership).

The open issue with swaps is whether a bidder can feel comfortable that the shares will be voted as it wants.  This may be worth the risk, as a bidder who uses swaps earns the profit on the shares covered by the swap.  Valeant surrendered that profit to obtain clearer, contractually fixed voting rights.  Overall, a strategic bidder should prefer using a hedge fund as its agent only when either (a) it needs assured and quick access to the voting rights that will be acquired by its agent, or (b) it suspects that Hart-Scott-Rodino clearance may otherwise be slow and/or difficult.

One of the mysteries surrounding Valeant’s bid is why it did not attempt a proxy contest at the Allergan annual meeting, instead of seeking to call a special meeting to remove its board based on a 25% shareholder vote.  The latter approach may have created greater need for an ally (such as Pershing Square) that would quickly assemble a 10% block, because traditional institutional investors tend to be more passive and might not respond to a consent solicitation asking them to join in the call for a special shareholder meeting.

Another motivation for this alliance may have been that it gave Valeant at the outset momentum, a claim that inevitable victory was assured, and immediate voting support.  But this was costly, and another bidder, willing to move at a slower pace, could have itself assembled options or swaps at a lower cost.  The bottom line is that some bidders may want such an alliance and others conclude that too much is paid for too little.  Time will tell, but much may hinge on the next issue.

II. The Rule 14e-3 Issues

Rule 14e-3 prohibits any use, or tipping, of material nonpublic information about a tender offer, without any need to show a fiduciary breach, but it applies only once a “person has taken a substantial step or steps to commence…a tender offer.”[6]  As a result, Valeant and Pershing Square have two distinct defenses to any claim or claims that Valeant illegally tipped Pershing Square and/or that Pershing Square illegally traded in advance of Valeant’s tender offer.  First, they will predictably assert that they were “co-bidders” and thus there was only a single “offering person” under Rule 14e-3 so that there could be no unlawful tipping or trading.  Second, even if their characterization of themselves as “co-bidders” is not accepted, they can argue that as of the time of Pershing Square’s purchases in February through April, 2014, Valeant had not yet taken a “substantial step.”  The second of these defenses is highly fact dependent and cannot be resolved on the publically available information, but the first is primarily a question of law.

To assess the co-bidder defense, it is necessary to examine the actual facts more closely.  Pershing Square signed a confidentiality agreement with Valeant on February 9, 2014; on February 11, 2014, Pershing Square formed a nominee entity, PS Fund 1, L.L.C. (“PS Fund”); next, on February 25, 2014, Pershing Square and Valeant entered into a letter agreement pursuant to which they agreed to create (in their term) a “Co-Bidder Entity” to acquire Allergan securities.[7]  PS Fund was, of course, this Co-Bidder Entity, and Valeant agreed to contribute $75.9 million to it.[8]  This modest contribution (roughly 0.1% of the $53 billion total cost) only had to be paid by Valeant on the earlier of 60 days later (roughly, April 25^th) or the date that Pershing Square provided notice that it had acquired stock (or derivatives convertible into stock) equal to 4% of Allergan’s outstanding shares.[9]  Pershing Square began buying Allergan shares on that same date (February 25, 2014), but quickly shifted its purchases to call options.  Only on April 3, 2014 (as Pershing Square was approaching the 5% ownership level) was the PS Fund’s L.L.C. agreement actually amended to add Valeant as a member.[10]  That 5% triggering level was reached on April 11, 2014, and then, as is characteristic in these transactions, Pershing Square picked up the pace of its purchases during the ten day window allowed by Section 13(d) of the Williams Act.[11] Thus, when it and Valeant each filed their Schedule 13Ds on April 21, 2014, PS Fund reported ownership of 9.7% of Allergan’s stock.  But virtually all of this amount was paid for by Pershing Square.  Then, a day later, on April 22, 2014, Valeant announced its acquisition proposal for Allergan.  Approximately two months later, on June 18, 2014, Valeant announced a formal tender offer.

Although Valeant describes Pershing Square as its “co-bidder,” Pershing Square has no obligation to pay anything to tendering Allergan shareholders and will not acquire any interest in the shares so tendered.  Nor does Pershing Square share its profits on PS Fund’s purchases with Valeant, at least if the transaction goes off as planned.[12]  Pershing Square’s only obligation is, at Valeant’s election, to buy $400 million in Valeant stock at a 15% discount to help fund the ultimate merger transaction (but only once all regulatory and shareholder approvals are obtained).[13]  Although $400 million is not trivial, it represents less than 1% of the roughly $53 billion expected total cost of the Allergan acquisition.  Such a contribution, which is at a 15% discount, also seems modest in comparison to the reported $1 billion profit Pershing Square had made as of April 22 when Valeant announced its merger proposal.

From this perspective, the only difference between a transaction in which the bidder simply tips the hedge fund and this transaction is Pershing Square’s contingent agreement to contribute $400 million in a bargain purchase to buy Valeant stock.  A cynic might describe this as the price that Pershing Square paid for its tip.  Although Pershing Square must also vote in favor of Valeant, it remains free to accept any higher bid that may materialize.  Thus, they are partners only in a limited sense and only up to the point that Valeant’s bid is topped.  Pershing Square must also hold its Valeant stock for one year after the Allergan acquisition, but this is consistent with the normal short-term holding period of an activist hedge fund.

From a policy perspective, if this is enough to immunize this tipping of the offer from the application of Rule 14e-3, then a loophole has been created that is roughly the size of the Washington Square Arch.  There would be little to distinguish this case from the next case to follow in which the strategic bidder tips three hedge funds, calling each its “co-bidder,” and they buy 25% of the target in the ten-day window before they all file Schedule 13Ds.  If that works, an even more aggressive bidder will eventually link up with a dozen hedge funds, and they can buy majority control of the target during the ten day window.  In all these cases, they could use a nominee in which the bidder would make a token investment, and, if need be, they might all agree to purchase some stock from the bidder at a discount.  Because “standing” poison pills are no longer common, the result could be the return of the “creeping control” acquisition.

Although the concept of “co-bidder” has been around for some time, the SEC has traditionally used it as a way of expanding the disclosure obligations under Section 13(d), and not as a way of cutting back on the anti-fraud restrictions of Section 14(e).  Nor has the SEC ever suggested that a “co-bidder” was exempt from insider trading liability.  Indeed in Koppers Co., Inc. v. American Express Co.,[14] Shearson Lehman Brothers, Inc. served as both an investment banker and “co-bidder” to the tender offerer, while also holding an equity position in the target.  The target company obtained a preliminary injunction on Williams Act grounds, and the district court requested the SEC to explain its position as to the investment banker’s multiple roles.  In response, the SEC’s General Counsel replied that “violations of the federal securities laws stemming from these conflicts can be avoided through the use of well-established preventive policies and procedures, such as Chinese Walls, restricted lists, and watch lists.”[15]  The point then is that a “co-bidder” who is not itself the tender offerer was expected to use these precautions and was not free to trade for itself.

Ultimately, the parties’ characterization of Pershing Square as a “co-bidder” seems self-serving and inconsistent.  For antitrust purposes, they assert that Pershing Square acquired its 9.7% stake in Allergan for itself, but for securities law purposes, they are co-bidders.  That seems a little too cute, but the deeper point is that Rule 14e-3, itself, has no exemption for a co-bidder.  Only the person making the tender offer is permitted to purchase in anticipation of it, and Pershing Square did not make the offer.

This does not mean, however, that anyone violated Rule 14e-3.  Liability can be found only if Valeant had taken a “substantial step” at the time of Pershing Square’s purchases in February through April.  That issue is now being litigated in federal court in California (where Allergan is suing Valeant and Pershing Square).[16]  Although it is impossible to predict what discovery will show, it is interesting that the February 25^th letter agreement between Valeant and Pershing Square expressly described the latter as a “co-bidder.”  If all that Pershing Square was doing was buying a stake in Allergan in the open market (and making a contingent equity investment in Valeant), the term “co-bidder” would not logically have been used.  Inherently, the term implies not purchases in the open market, but a direct offer to shareholders.  In short, even though the parties carefully recited that no decision to make a tender offer had been made, the act of signing up a “co-bidder” may inherently be a “substantial step” towards a tender offer.

No prediction is here made as to the outcome of that litigation.  But whether alliances between strategic bidders and activist hedge funds will become common remains an open question and may depend on the case’s outcome—as will the vitality of Rule 14e-3.  So far, Valeant and Pershing Square seem able to cooperate better than Felix and Oscar, but we are still in Act I.

Endnotes

[1] Some readers may be so young or forgetful as not to remember Felix (as played by Tony Randall) and Oscar (as played by Jack Klugman on TV and Walter Matheau in the movie). Suffice it to say that the laidback slob (Oscar) and uptight fussbudget (Felix) drove each other crazy.

[2] Most of the facts discussed in this column come from the Schedule 13D executed by Pershing Square Capital Management on April 21, 2014. Trading data is set forth on p. 14 thereof.

[3] On May 1, 2014, PS Fund 1 exercised its call options to purchase more than 24 million shares of Allergan common stock and paid the forward purchase price on over 3 million additional shares of Allergan common stock. Conversion of options into stock required Hart-Scott-Rodino approval. These call options were largely “in the money,” meaning that the decision to purchase options was probably to delay the point at which regulatory approval had to be obtained.

[4] But the Allergan stock would have to fall from its $163.65 price on April 22 to below $125.54 per share, its price on February 25, 2014 (when Pershing Square began its purchasing) before Pershing Square would experience a loss on all its acquired shares.

[5] 562 F. Supp. 511 (S.D.N.Y. 2008), rev’d in part, 654 F. 3d 276 (2d Cir. 2011). Although Judge Kaplan at the district court found that the two hedge funds did have beneficial ownership of CSX shares covered by the swap, this finding was reversed by the Second Circuit. Both courts declined to “sterilize” (i.e., bar voting of) the shares, which is probably the only real deterrent here. Hence, so long as no joint co-bidder agreement is signed, a bidder can safely exploit equity swaps.

[6] See Rule 14e-3(a), 17 C.F.R §240.14e-3(a).

[7] This February 25, 2014, letter agreement (the “Co-Bidder Agreement”) is attached to the April 22, 2014, Schedule 13D filed by each of Valeant and Pershing Square as Exhibit 99.3.

[8] See Paragraph 1(a) of the Co-bidder Agreement.

[9] Id at Paragraph 1(a). Thus, Valeant could logically assume that it was likely that Pershing Square was expecting to buy at least 4% of Allergan on February 25, 2014.

[10] This document was filed as Exhibit 99.4 to the Co-Bidder Agreement.

[11] See Section 13(d)(1) of the Securities Exchange Act of 1934, 15 U.S.C. §78m(1) (requiring filing within ten days or such shorter time as SEC by rule may require).

[12] Under Paragraph 3(a) of the Co-Bidder Agreement, if a third party does top Valeant’s price, then it is entitled to 15% of the gain on the shares purchased by Pershing Square. Otherwise, each party receives the gain or loss on the shares it purchased, which means that Valeant receives the gain on the Allergan shares purchased with its $75.9 million.

[13] See Paragraph 2(a) of the Co-Bidder Agreement. Pershing Square is also required to hold the shares that it receives in Valeant pursuant to any merger agreement with Allergan for at least one year following the merger transaction. See Paragraph 2(c).

[14] 689 F. Supp. 1371 (W.D. Pa. 1988). Appendix A to this decision sets forth the opinion of then SEC General Counsel Daniel L. Goelzer, which was delivered in response to the Court’s request.

[15] Id. at 1415.

[16] See Allergan, Inc. v. Valeant Pharmaceuticals International, Inc., (C.D. Cal.) (SACV No. 14-1214-DOC).

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and Director of its Center on Corporate Governance. A version of this article was originally published in the New York Law Journal on September 18, 2014.