'Arb' Investors Go Long Shareholder Activism

Some savvy players see limited downside at Sovereign Bancorp given the crowd it has drawn.
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Savvy investors are throwing away the playbook when it comes to

Sovereign Bancorp's

(SOV)

$3.6 billion acquisition of

Independence Community Bank

(ICBC)

.

Typically, when sophisticated traders want to bet on a takeover, they do so by exploiting the market's aversion to risk -- in the case of mergers, the risk that a deal won't be consummated. A merger arbitrager makes his living buying the shares of takeover targets at prices slightly below the acquiring company's bid, hoping to make up the spread when the transaction goes through.

Another hallmark of such trades is to short shares of the acquirer, betting on the incremental fall in stock price that often besets a company when it combines with a smaller rival.

In the case of Sovereign and Independence, however, some arbs are taking an entirely different route. These traders are now staking out long positions in shares of both banks, essentially betting that both stocks will rise over time.

It's a risky strategy that leaves these traders exposed to potential losses if things don't go as planned. On Wall Street, such a daring trade is characterized as a "Texas hedge."

The rationale for this unconventional approach to playing the Independence/Sovereign merger is the growing opposition from Sovereign shareholders to the bank's simultaneously announced deal to sell a 20% equity stake in itself to Spain's

Banco Santander

for $2.4 billion.

The way these arbs see it, Sovereign will become more attractive to a potential suitor if it's forced to scrap the deal with Santander in the face of mounting shareholder pressure. Meanwhile, Sovereign either goes ahead with the deal for Independence, or the Philadelphia-based bank drops out and another buyer jumps in and makes a bid for the smallish New York lender.

"I see it as a potential win-win situation," says an executive with one New York arb firm that's playing the Texas hedge. "There's limited downside risk to a stock when you have an activist investor rattling the cages."

The arb executive, who didn't want to be identified, says he doesn't see Relational Investors backing down in it efforts to block the Santander deal, even if Sovereign's largest shareholder can't convince the

New York Stock Exchange

to block the transaction. The executive says that over time, activist shareholders with clout often are successful in forcing management changes at a company.

Sovereign shares, which closed Monday at $22.79, are almost back to the $23.30 they traded at on the day the deal was announced. Independence shares, at $38.38, are trading $3.64 below Sovereign's proposed $42-a-share acquisition price.

Relational, which owns 7.3% of Sovereign's shares, has become the most vocal leader of an effort to get the NYSE to either block the Santander deal or order Sovereign to hold a shareholder vote on it. Relational's campaign got a big boost last week when Franklin Mutual Advisors, a subsidiary of

Franklin Resources

(BEN) - Get Report

, formally called on the NYSE to scuttle the Santander and Independence deals.

This week, Franklin, Sovereign's second-biggest shareholder, upped the ante by publishing an "open letter" to Sovereign's board, calling on it to terminate both deals.

So far, however, there's no indication that Sovereign is about to back down. Several days ago, Sovereign took out a full-page advertisement in several newspapers defending the transactions. The bank also has gone to court to stop an effort by Relational to gain review of its corporate books and records.

It's also way too soon to say how the NYSE will react to the demand that it block the deals. While NYSE officials say they will take a serious look at the shareholder request, the exchange has never interfered with a proposed merger involving any of its listed companies.

Derek Meisner, an attorney with Kirkpatrick & Lockhart and a former senior SEC enforcement attorney, says the dispute no doubt "piques the interest regulators," but it's hard to predict how the NYSE will rule given its sparse track record in this area.

Jill Fisch, a professor of securities law at Fordham University School of Law, says she wouldn't bank on the NYSE stopping the deals. She says most courts have ruled that corporations have wide latitude in how they can structure their transactions.

If that's true, then it's Sovereign, and not the arbs playing the Texas hedge, holding the strongest cards in this battle.