Hedge fund managers know the rules about disclosing their positions: If they beneficially hold more than 5% of an issuer's Securities and Exchange Commission-registered equity securities, they must file the appropriate form with the SEC. Doing so without tipping off the market to their strategies can be difficult, especially when the securities held are implicated in a proposed merger. However, hedge funds that provide inadequate detail in such filings can expect to be challenged - if not by the SEC, then by fellow shareholders. This is the lesson of last fall's proposed but uncompleted merger between Mylan Laboratories Inc. and King Pharmaceuticals Inc.

Many readers will recall the facts. As Mylan pursued a merger with King, Perry Corp. acquired roughly a 10% stake in Mylan, ostensibly to help secure approval for the deal and thereby profit from the increase in value of its existing holdings in King. At the same time, Perry hedged its Mylan position through various short sales. Thus the hedge fund was apparently in a position to influence the outcome of the merger and guarantee a return on its holdings in the target, without taking on any economic risk in respect of its position in the acquirer. But the move caught the attention of another Mylan shareholder, Carl Icahn.

Icahn sued Perry, alleging illegal vote buying, shareholder disenfranchisement and material omissions in Perry's 13D filing. Unfortunately, the legality of Perry's role and adequacy of its 13D disclosure were never addressed. Mylan dropped its merger plans for unrelated reasons, Perry disposed of its holding and Icahn withdrew his complaint. However, Icahn's attack on Perry's 13D disclosure should remind fund managers that 13D filings are far more than administrative tasks and may require significant involvement by management.

Perry's 13D provided little to no detail about the extent to which Perry had hedged its position in Mylan. More importantly, however, the Perry filing said little about Perry's role in the Mylan-King transaction as a whole and certainly not enough for other Mylan holders to assess the impact of Perry's activities on their own holdings or the proposed merger. A review of SEC filings by hedge funds suggests that the Perry approach may not be uncommon, which is exactly what troubles those trying to assess the effects of merger arbitrage funds on companies and their shareholders.

How much disclosure is needed? Merely stating that an investor has entered into hedging transactions and taken short positions, without more specific details, may not be sufficient. Even providing exact details about short positions, although technically responsive to a Form 13D, falls short of informing others of an arbitrageur's role in a transaction as a whole and arguably omits material information. Without the latter, a 13D filing may be considered misleading.

Most shareholders are ill positioned to assess the adequacy of a hedge fund's disclosure. However, those that are well positioned are unlikely to keep mum about a hedge fund too coy to disclose material conflicts of interest. Regardless of whether an SEC filing explicitly provides a line item requiring disclosure of such conflicts, some shareholders may seek to pressure the SEC into demanding more forthright disclosure.

Disclosure standards may thus be expected to evolve as both regulators and shareholders sharpen their focus on the role of merger arbitrage hedge funds in M&A activity. In the U.K., for example, the U.K. Panel on Takeovers has taken notice of similar techniques. The panel recently proposed rules requiring dealers and hedge funds to disclose positions in targets held through derivatives.

In the United States, the SEC has already denied confidential treatment for filings made by some risk and statistical arbitrage hedge funds. Merger arbitrage funds in the United States may also be well advised to approach disclosure in Section 13 and proxy filings with more deliberate detail and sensitivity to their roles in M&A transactions - and to expect more exacting scrutiny of such filings by the SEC and other shareholders. CD

Jennifer Anne Spiegel is counsel with Debevoise & Plimpton LLP and a member of the Investment Management Group, where she advises hedge funds and private equity funds with respect to fund formation. - Jennifer A. Spiegel

Jennifer Anne Spiegel is counsel with Debeviose & Plinmpton LLP and a member of the investment management group, where she advises hedge funds and private equity funds with respect to fund formation.

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