Sunday, September 13, 2009

The risks of "risk arb"

A couple of weeks ago, the US District Court, District of Connecticut dismissed a class action lawsuit brought against United Rental by hedge funds and other entities who had invested in it back in 2007.

Back in the still-heady days of 2007, Cerberus had represented that it would buy United Rental Inc. (URI), and this led to purchases of URI stock by various speculative third parties, engaging in a practice naturally called "merger arb," or known, sometimes, more ominously as "risk arb." At the time of such an announcement, a target stock's price on the market is generally below the acquirer's bid price -- the difference is known as the "control premium." The risk arb guys, buying the stock on the market, are better that the deal will be consummated as planned, and they can pocket the risk premium for themselves, minus their transaction costs.

Of course there is a very brief window during which that play is possible, because usually there are enough risk-arbers around to push the market price up to the big price well before the deal closes. Sometimes the market price gets above the bid price, which can mean either of a couple of things: somebody is betting that another suitor will appear, turning the deal into an auction; or there is simply a "greater fool" effect at work.

But back to 2007. By November of that year, the folks at Cerberus had troubles. They saw that the credit markets were tightening, and Chrysler -- which they ownesd at this point -- was eating up their cash. So Cerberus pulled out of the UR deal. URI's stock price took a big hit, and the company received liquidated damages.

At least the less numble of the risk arb types took a beating. They didn't take it lying down, though. They brought a lawsuit on the theory that when URI management first received intimations from Cerberus that they might need to "renegotiate" the acquisition, that fact should have been and was not made public. 07-cv-01708-JCH First New York Securities LLC, et al v. United Rentals Inc et al

That is the case that was dismissed last month, on the grounds essentially that the assertions in the complaint, accepted as true for the purpose of the motion, do not entail a strong inferenece of scienter.

This case may be important in the evolving understanding of how scienter must be pleaded under the evolving standards of the PSLRA. But my initial reaction to it was simply: "Man up, wimps! You knew you were taking this risk. That's how the capitalist cookie crumbles." Given that simple unsophisticated reaction, I have to give the court in this matter three cheers.

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