Does this guy look like an insider trader? Photographer: Jin Lee/Bloomberg
Does this guy look like an insider trader? Photographer: Jin Lee/Bloomberg

Valeant Pharmaceuticals' fight to take over Allergan, assisted by Bill Ackman's Pershing Square Capital, is among the scorchiest of scorched-earth takeover battles. Today Allergan upped the entertainment factor by suing Valeant and Pershing Square for insider trading. The lawsuit is very clever and great fun, if you're into this sort of thing.1 In particular, don't miss paragraph 124, in which Allergan says that Valeant "Contacted Allergan sales representatives and welcomed them to Valeant," "Visited Allergan customers, announcing that they were Allergan’s new sales representatives" and "Offered rebates on both Allergan and Valeant purchases," all of which is at the very least incredibly rude, though its connection to insider trading is at best unclear.

Valeant's and Pershing's response is also pretty clever. They point to a memo from Allergan's own lawyers saying that what Valeant and Pershing did is legal and that the Securities and Exchange Commission should change the rules to make it illegal. Which somewhat undercuts Allergan's current argument that it was actually illegal all along. Valeant and Pershing also point out -- what is probably true -- that the main purpose of the lawsuit is to delay their efforts to throw out Allergan's board and buy the company.

The story is this: Valeant and Pershing Square decided to team up to buy Allergan. The division of labor was that Valeant, a drug company that likes to buy drug companies, would do the actual buying of Allergan. Pershing Square, an activist hedge fund, would front the cash (and take the risk) to buy several billion dollars worth of Allergan stock, giving Valeant a toehold, some friendly votes, and some expertise in how to wage bitter wars with corporate boards. (Which is coming in handy!)

Of course, Valeant and Pershing Square knew about this plan, because it was their plan. They came up with it. But then they went and bought a bunch of Allergan stock without telling anyone about the plan. Or someone bought a bunch of Allergan stock, anyway. Technically it was a thing called PS Fund 1, LLC, a shell company that they set up together with a little money from Valeant and a lot of money from Pershing Square.2 PS Fund 1 ended up buying 28.9 million Allergan shares at an average price of $129.28. They announced all of this in April, and the stock closed at $163.65 the next day.

Since then there's been three months or so of vicious merger wrangling, and on June 18 Valeant announced that it was launching a tender offer for Allergan.3 But well before that -- really the minute Valeant and Pershing announced their purchases -- many people freaked out, asking: Isn't this insider trading? Many other people said, no, come on, this is not insider trading. I was one of them. Here's what I said:

Insider trading is trading on material nonpublic information in violation of a duty of confidentiality. It's not illegal to trade while knowing your own intentions, even if your intentions are material. If Bill Ackman is planning to buy 9 percent of Allergan, he can buy the first 1 percent, even though he knows that he'll eventually buy more and it'll be a whole big public thing. And -- this is true -- if Valeant is planning to offer to buy 100 percent of Allergan, it can buy 9 percent first before announcing its intentions publicly. This is straightforwardly the law.

It is! And since Valeant and Pershing Square had an explicit agreement on using their information together, they're unquestionably not doing anything illegal under "normal" insider trading law. And not even Allergan argues that they are.4

But there is a special insider trading rule called Rule 14e-3. It says that if anyone "has taken a substantial step or steps to commence, or has commenced, a tender offer" for a stock, then no one else who has material information about the tender offer can buy any of the stock without first publicly disclosing the information. So the questions here are:

  1. When Pershing and Valeant bought all those Allergan shares, had anyone "taken a substantial step" to commence a tender offer?
  2. Is the person who bought the Allergan shares a different person from the person commencing the tender offer?5

Allergan says that the answer to both questions is "yes," and that therefore Pershing Square was insider trading, and therefore it stole money from innocent sellers like the in-house Allergan lawyer who's a named plaintiff in the complaint,6 and that therefore it should have to I guess give back all the shares that it bought. More importantly, Allergan thinks that this should delay Pershing's ability to call a special meeting of Allergan stockholders to vote on the deal until, I don't know, 2015 or forever or something.7

So is that right? Let's take the second question first. It's technical and interesting and just ever so slightly metaphysical: Is the person who bought all of the stock the same person as the person making the tender offer? PS Fund 1 bought 28.9 million shares of Allergan stock, so it's probably the buyer of the stock. And Valeant is making the tender offer. And PS Fund 1 is not Valeant. But the tender offer also says, "although none of Pershing Square, PS Fund 1 or any of Pershing Square’s affiliates is offering to acquire any shares of Allergan common stock in the offer, PS Fund 1 is considered a co-bidder for SEC purposes."

I don't really know what that means. It just says it. If it's true that PS Fund 1 is a co-bidder, then its previous purchases were purchases made by the offering person, and so don't violate Rule 14e-3. Allergan thinks it's not though:

Crucially, only Valeant is offering consideration in the form of shares and cash to Allergan’s stockholders. By contrast, 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.

If you're not "offering to acquire any shares," it is somewhat weird to call you a co-bidder.8 But that's not quite true: Pershing Square has actually agreed to commit $400 million of equity financing for the deal, beyond what it's already paid for Allergan stock. And PS Fund 1 isn't just any old company; it's a company partially owned by Valeant, the actual bidder. So there's at least a plausible case for lumping PS Fund 1 and Pershing Square together with Valeant.

The other question is whether Valeant had, at the time Pershing started buying, taken any "substantial steps" toward launching a tender offer. Those substantial steps don't have to be all that substantial,9 and there's no doubt that Valeant and Pershing had taken substantial steps toward trying to acquire Allergan. The question is whether they had taken steps toward a tender offer. Those are different questions. You can insider trade to your heart's content on plans to propose a merger.10 It's plans to launch a tender offer that create problems.11

Here's what Valeant and Pershing had agreed before they started buying:

[T]he parties acknowledge that no steps have been taken towards a tender or exchange offer for securities of Allergan and the parties agree that the consent of both Pershing Square and the Company shall be required for launching such a tender offer or an exchange offer. If a Company Transaction is being pursued by the Company through a tender or exchange offer or a merger or any related proxy or other solicitation prior to the Termination Time, each of the Company, Pershing Square and the Co-Bidder Entity will be identified as co-bidders or soliciting persons, respectively.

Allergan now calls this "a feeble, self-serving attempt to circumvent the insider trading rules," and argues that even agreeing about who needs to give permission to launch a tender offer is itself a step towards launching a tender offer. On the other hand, back in April, after reading that same language, Allergan's lawyers said that Pershing and Valeant "took express pains to sidestep Rule 14e-3 which outlaws insider-trading in connection with a tender offer, by styling themselves as co-bidders and not (yet) proceeding towards a tender offer." So it's strange that they now read that agreement to be a step toward making a tender offer.

In any case, Valeant obviously did not want to launch a tender offer. It really wanted to negotiate a merger with Allergan's board. It intended to propose a merger, it said it intended to propose a merger, and it did propose a merger. And Allergan said no.

Allergan now argues that Valeant should have expected this (probably true!), and that therefore it had to know all along that it would end up doing a tender offer. The difference between a tender offer and a merger is, basically: The board needs to agree to a merger. The shareholders can just sell into a tender offer without board permission. And if the board won't give you permission, then a tender offer is the way to go:

Based on Allergan’s response to Valeant’s prior overture, however, and as corroborated by analyst commentary in February 2014, which underscored that Allergan would not be interested merging with Valeant -- particularly where Allergan’s stockholders would be compensated in large part with Valeant stock -- Valeant was well aware that a friendly business combination would not likely occur, and conceded as much later on. Indeed, contrary to Valeant’s claim that it was looking for a friendly deal, Valeant and Pershing Square from the outset engaged in the sorts of pressure tactics commonly associated with hostile tender offers: a media blitz, multiple threatening letters to Allergan’s Board, and direct communications with Allergan’s customers and employees falsely claiming that the deal was a foregone conclusion.

I don't know. This feels a little unfair to me? Like, can you really accuse Valeant and Pershing Square of breaking the law because you decided to blow them off, and they should have expected you to blow them off? Perhaps Valeant and Pershing were just starry-eyed optimists and couldn't imagine, in their wildest dreams, that Allergan would say no to their proposal.

Even if they did know that, it wouldn't necessarily mean that they'd launch a tender offer. I said above that shareholders can sell into a tender offer without board permission, but that's not always true. The board can, and this board did, put in place a poison pill that essentially prevents a tender offer from closing. The only way around that is to run a proxy fight to replace the board, and Valeant and Pershing Square at least seem to have that in mind. But if they succeed in replacing Allergan's directors with their own candidates, then presumably those candidates would be willing to approve a merger.

So why launch the tender offer? It does nothing now -- shareholders can't actually tender into it because of the poison pill -- and if Valeant ever persuades or replaces Allergan's board, then it could just do a friendly merger and dispense with the tender offer. The existence of the tender offer is probably helpful in persuading Allergan shareholders to call for a special meeting and to vote for Pershing/Valeant's candidates, but it's also very unhelpful in opening the door to this lawsuit.

Anyway: Isn't all of this nuts? I mean, not the lawsuit. The lawsuit is fine. It's not the first lawsuit in this deal, and it won't be the last. Litigators gotta litigate, and in a deal as hostile as this one, if you have a clever lawsuit idea you run with it.

But this crazy stuff is the law. You can't trade on inside information if you got it in some ways, but you can if you got it in other ways. Except that if you got it in connection with a tender offer, you can't -- unless you're a co-bidder, in which case you can. And if it's a merger then it's fine. It's hard to imagine a reason for forbidding insider trading on tender-offer information, but allowing it on merger information. Obviously none of this needs to make any sense to provide employment and entertainment for the lawyers on this deal. But for the rest of us, a little sense might be nice.

1 Small world disclosure: I used to work at Wachtell, Lipton, Rosen & Katz, who are Allergan's lawyers. Actually I shared an office for a while with one of the lawyers on the brief. They were kind enough to quote me in footnote 17.

2 Allergan points out:

PS Fund 1’s LLC agreement was not amended to add Valeant as a member until April 6, 2014, and Valeant’s capital contribution -- a miniscule 3 percent of the total funds -- was not made until April 10, 2014, just one day before PS Fund 1’s ownership of Allergan stock crossed the 5% threshold on April 11, 2014.

I'm not so excited by this, since Pershing and Valeant had agreed on buying jointly and contributing capital and so forth before PS Fund 1 started buying, so the paperwork of who was a member of PS Fund 1 when doesn't get me too worked up. But yeah it does seem like an oversight not to all be members of PS Fund 1 before it started buying.

3 Well, it's an "exchange offer," since it's for cash and Valeant stock, but that's basically a species of tender offer (and gets filed on the same form as tender offers, etc.).

4 By the way, since this happened, some people have argued that U.S. law shouldn't work this way, and that any trading on material nonpublic information, regardless of how it was obtained, should be illegal. This is supposedly how many other countries' laws work, though I question how true that is in practice. (It's true sometimes, anyway.) And it's appealing because the U.S. system leads to all sorts of nonsensical arguments about whether golf buddies or prostitutes have duties of confidentiality, and who needs to know who got paid for breaching those duties.

But it still strikes me as nonsensical. Imagine you are Warren Buffett and you decide to buy some stock. You know, to a high degree of likelihood, that people will be interested in the fact that you are buying that stock. Warren Buffett's interest in a stock moves the stock. So does Bill Ackman's, or Carl Icahn's, or David Einhorn's short-selling interest. So what can you do though? Do you have to disclose your plans to buy the stock before you buy it? That hardly seems fair. And if that's the rule for Warren Buffett, how do we decide who else has to follow it? What if I want to buy 100 shares of Apple? Do I have to issue a press release first?

So I'm a fan of the general rule that you can use your own information about your own plans to inform your trading. And if you own that information then it's a little weird to say you can't give it to someone else, though I guess there are arguments the other way there.

5 Also possibly of interest is Rule 14e-3(c):

(c) Notwithstanding anything in paragraph (a) of this section to contrary, the following transactions shall not be violations of paragraph (a) of this section:

(1) Purchase(s) of any security described in paragraph (a) of this section by a broker or by another agent on behalf of an offering person;

Obviously Pershing is not a broker, but is it "another agent on behalf of" Valeant?

6 I guess it's a little weird that she's a named plaintiff? It would be funny if senior executives had been selling shares into Pershing Square's buying, but they don't seem to have been particularly. Pershing was buying from Feb. 25 through April 21; the only Form 4 filer that I found selling during that time was the executive vice president of HR, Scott Sherman, who sold 4,500 shares for $139.85 on the last day of Pershing Square's buying, right before Valeant announced its bid. Bad timing! But he also sold 10,000 shares the next day, after the announcement, at $163.

7 Here's the letter that Allergan sent to the Delaware court that is thinking about the special meeting:

As the Court is aware from the cases that have been pending before it, Pershing Square and Valeant have indicated their intention to seek to call a Special Meeting of Allergan's stockholders. Accordingly, in light of the bylaw provisions described above, the violations of the Exchange Act alleged in Allergan's federal action may be relevant to the Allergan board's consideration of any Special Meeting request (if any such request is ever made).

The idea is that now if Pershing requests a special meeting, Allergan can say that Pershing broke the law, and under its bylaws it can ignore special meeting requests "made in a manner that involved a violation of Regulation 14A under the Exchange Act, or other applicable law." So Allergan can drag out a litigation in a California federal court for a while, and put off the special meeting until it's resolved.

8 And there are times when Pershing Square wants to present itself not as a co-bidder, but as just a regular shareholder of Allergan -- and it's done just that. So from the complaint:

In a May 19, 2014 letter from Mr. Ackman to Mr. Gallagher, Mr. Ackman wrote, (1) “I find it inappropriate that Allergan’s lead independent director was unwilling to speak to a shareholder without management present”; (2) “Mr. Pyott has also apparently criticized Pershing Square, explaining that our views should not be considered, as we are somehow conflicted because of our relationship with Valeant. To set the record straight, Pershing Square is Allergan’s largest shareholder with nearly 10% of the common stock of the company . . . . We are interested only in maximizing the value of our investment in Allergan” ...

9 I mean! Subject to everything else I said, and the additional way more important caveats of:

  • nothing here is ever legal advice, and
  • don't insider trade.

10 Here's a treatise:

Courts have tended to interpret this "substantial step" requirement very broadly, finding the requirement satisfied in cases where the acquirer retained a law firm, or a consulting firm, or entered into a confidentiality agreement, or participated in meetings "much more serious than any previous discussion between the parties."

Valeant had retained a law firm, anyway.

11 Here's another law firm memo:

While the concept of “substantial steps to commence a tender offer” has been construed liberally, it is highly likely that Valeant has been careful to avoid any actions that could be characterized as steps towards commencement of a tender offer. Instead, Valeant is likely to pursue the acquisition by making public merger proposals ("bear hugs") together with a proxy contest to change the Board of Directors.

One might ask why Rule 14e-3 is focused only on tender offers and not on other acquisition structures? The answer is simply that the Williams Act gave the SEC authority to adopt rules regulating tender offers and this rule was adopted in 1980, at a time when tender offers were the principal means of acquisitions and there were concerns about people trading based on advanced knowledge of tender offers. This was during the era of “raiders,” who often made tender offers, and well before the current era of “activists."

To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.