Covered shorts: the long and short of it

The New York Times has an interesting article on covered shorts. That is the tactic where you are both long and short the same stock.

This is what The Perry Corporation, a New York-based hedge fund seems to have done by buying shares in Mylan Pharaceuticls while simultaneously shorting shares (or more technically having Bear Stearns and Goldman Sachs short the shares).

So if the shares go up, Perry makes money on the long position but loses on the short position. On the other hand if the shares go down, Perry will lose money on their stock position, but make it up on the short position.

Of course this begs the question, Why? Why incur the transaction costs etc for no gain. The short answer is that they now have voting rights without being exposed to price fluctuations.

These voting rights are especially valuable in this case since the firm whose stock is being bought and sold is King Pharaceuticals. King is involved in a drawn out proxy contest as they are being taken over by Mylan. This takeover has grown heated as Carl Icahn (a shareholder in Mylan) moved to block the deal.

Not surprisingly, Icahn and shareholder rights groups are not pleased with Perry's deal.

Icahn:

"If hedge funds or any other investors are permitted to dictate the outcome of corporate elections without having economic interest in the companies, then any semblance of corporate democracy we still have in our country would become a travesty"

Nell Minow of the Corporate Library:

"It undermines the whole concept of linking ownership and control. It is not illegal, but the question is, 'Should it be?' I say, 'Yes.' The vote should accompany some kind of underlying interest."

What is curious however is that the article also states that Perry hopes

"to profit from the spread between the price Mylan offered for King shares, $16.49, and King's actual share price, which closed yesterday at $12.42. If the deal is completed, Perry stands to make over $28 million, based on figures in a filing with the Securities and Exchange Commission on Tuesday."

Unfortunately the article does not say how this profit would be accomplished and (as stated above) the rest of the article says that Perry's has no economic interest in the deal. (mmm, well $28 million seems to be interesting to me. ;) )

So how did they accomplish getting voting rights and gaining if the stock price appreciates? Two strategies come to mind. Note: the article and the illustration do NOT suggest that this is possible, so this is pure speculation.

• The short sale could be done via a limit order arrangement whereby the shares will only be sold in the event that the stock price goes below some price limit. This would prevent losses while allowing Perry to profit if the deal is done.
• With derivatives. Perry may have puts on the shares at the current price. The put would be allowed to expire if the price appreciates.

Unfortunately, as the article says, the details are still fairly "opaque" so we may have to wait and see.