GO
Loading...

Valeant’s Deal With Ackman May Be Too Clever to Be Legal

Tiptoeing on a tightrope past insider trading laws may be deft and clever, but it doesn't make it right.

For months, William A. Ackman, the hedge fund manager, has nonchalantly said, repeatedly, that his purchase of Allergan shares worth over $1 billion ahead of a takeover offer from Valeant Pharmaceuticals did not constitute insider trading. And, technically, he may be correct.

Read MoreAllergan sues Ackman, Valeant, alleging insider trading

Mr. Ackman had not been tipped off clandestinely. There was no secret phone call or briefcase full of money. Instead, Valeant's chief executive, J. Michael Pearson, called Mr. Ackman directly and told him about his company's intent, seeking a partnership of sorts in which Mr. Ackman would build a large position in Allergan stock and help Valeant press Allergan's board to acquiesce to a deal.

Bill Ackman
Adam Jeffery | CNBC
Bill Ackman

The tactic was certainly novel. It was the first time a company had teamed up with an activist investor before a bid. Both Mr. Ackman and Valeant said the arrangement was reviewed by an army of lawyers, including Robert S. Khuzami, the former head of enforcement at the Securities and Exchange Commission, and was strictly within the law. Mr. Ackman and Valeant — as a well as a number of spectators — argued that the proposal adeptly skirted laws against insider trading because, in this instance, Valeant's chief executive, who would normally be considered the source of the tip in this situation, did not breach any fiduciary duty because Valeant was teaming up with Mr. Ackman as part of the takeover. Some even heralded the move as the next big innovation in activism.

More from The New York Times:
Graham Is Not Slowing Down After Sale of The Washington Post
Americans Are Bad at Math, but It's Not Too Late to Fix
Judge's Ruling Against Bank of America Showcases a Novel EnforcementStrategy

Still, something hasn't smelled right about these clever machinations. An analyst at Sanford C. Bernstein quite rightly titled a report "How Can It Be Legal?"

Late last week, Allergan, the maker of Botox, offered an argument for why the arrangement might not be legal after all. Most important, even if it were legal, it clearly undermines the public's confidence that all investors get to play on "a level playing field," the Bernstein analyst said.

Allergan sued Valeant and Mr. Ackman, contending that they did indeed engage in insider trading and that Mr. Ackman should be forced to disgorge the shares he controls.

While Mr. Pearson may not have breached a fiduciary duty to Valeant by sharing information about the planned takeover bid with Mr. Ackman — that's an S.E.C. rule known as 10b-5 — Allergan argues they violated another S.E.C. rule that makes it illegal to share information before a takeover bid when it is part of a tender offer, in which the suitor goes directly to shareholders, bypassing the board. Valeant, after being rejected by Allergan's board, began a tender offer for Allergan on June 18. (If you're asking why the S.E.C. prevents one kind of insider trading and not others, that's a good question.)

Read MoreI did not front-run Allergan stock, Ackman says

At the time that Valeant first came forward with its bid, those observers who said the maneuver was legal did so specifically because the company and Mr. Ackman said they did not plan to start a tender offer.

But Mr. Pearson recently acknowledged, in an unscripted moment during a conference call, that he anticipated pursuing a tender offer from the outset. "On April 22, we announced our offer for Allergan. We suspected at the time it would ultimately have to go directly to Allergan shareholders. We were correct."

That runs counter to what the company said initially. "Valeant and Pershing Square went so far as to claim in writing that they were not contemplating a tender offer — a feeble, self-serving attempt to circumvent the insider trading rules — yet then agreed in the same document on the procedures each would follow if a tender offer were to occur," Allergan said in its lawsuit, referring to Mr. Ackman's fund, Pershing Square Capital Management.

Of course, Valeant has long argued that it is impossible for it or for Mr. Ackman to have been involved in insider trading because they are effectively partners in the bid for Allergan. They described themselves as "co-bidders." (People close to Valeant also say that Mr. Pearson's unscripted words are being misconstrued and that he wasn't referring to making a tender offer, rather he was saying Valeant always planned to communicate with Allergan shareholders.)

But the idea that Valeant and Pershing Square are co-bidders is questionable: "Mr. Ackman and the other Pershing Square entities are together offering precisely zero to Allergan stockholders — they are seeking to sell Allergan stock as Valeant seeks to buy it. Ackman is not going to be a board member of Valeant, will not otherwise be a control person of Valeant and is not going to receive any business or asset of Allergan as a result of the tender offer," Allergan argued in its suit.

The case will most likely rest on how a judge interprets the S.E.C.'s arcane rule, known as 14e-3. That rule says, "If any person has taken a substantial step or steps to commence, or has commenced, a tender offer" it will be considered "a fraudulent, deceptive or manipulative act" for "any officer, director, partner or employee or any other person acting on behalf of the offering person or such issuer, to purchase or sell" stock.

Read MoreLawmaker to press SEC on Ackman's Allergan tactics

Valeant and Mr. Ackman will inevitably argue that at the time Pershing Square purchased the stock, they had not taken steps to start a tender offer. Further, they will most likely contend that they are protected by another arcane rule that allows purchases of stock of a target company if it is done "by a broker or by another agent on behalf of an offering person." In this case, the offering person would be Valeant.

Photo: Bryce Duffy|Stone Sub|Getty Images

At the moment, neither Valeant nor Mr. Ackman is trying to argue the merits of the case. Instead, Mr. Ackman, in a statement, simply derided Allergan's lawsuit as "a shameless attempt by Allergan to delay the shareholders' fundamental right to call a special meeting and vote their shares." He said, "This scorched-earth approach is further evidence of the board's and management's further entrenchment." In truth, Allergan's litigation may be as much about the law as it is a defensive tactic.

Whatever the case, Valeant and Mr. Ackman's actions, at least from a public policy perspective, may have been too clever by half. When Sanford C. Bernstein wrote a note to clients at the time the offer was first announced, it described Pershing Square as having found an opportunity for "regulatory arbitrage."

Now a judge will decide whether it was truly regulatory arbitrage or something more sinister.

Valeant and Mr. Ackman might benefit from reading a court decision about another hedge fund, the Children's Investment Fund, which lost a 2008 case to CSX in which it had secretly amassed a large stake. The judge wrote: "Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formalistic arguments even when it is apparent that they have defeated the purpose of the law."

By CNBC anchor and New York Times reporter Andrew Ross Sorkin