On August 24, 2015, the Federal Trade Commission entered into an agreement with hedge fund Third Point settling allegations that Third Point violated the HSR Act by acquiring shares in Yahoo! In 2011 without reporting the acquisition prior to consummation. Third Point had acquired shares valued at more than the size-of-transaction at the time but had relied on the investment-purposes-only exemption to claim that it did not need to report. Under the terms of the agreement, Third Point paid no fine, but agreed not to rely on the investment-purposes-only exemption under 16 CFR 802.10 “if they have contacted third parties to gauge their interest in joining the board of the target company, communicated with the target company about proposed candidates for its board, or engaged in other specified conduct in the four months prior to acquiring voting securities above the HSR Act threshold.” The Commission didn’t seek a fine because of several factors including it was Third Point’s first violation.
In an article appearing in the Deal on October 2, 2015, the Deal suggests that Third Point settlement has “privately set off warning bells among some activist fund managers… who argue that the regulatory move will chill insurgents and their efforts to drive changes and improve share prices at targeted companies.” The Deal suggests that the reporting requirement makes it difficult for activists to accumulate shares because such acquisitions must be reported at least to the target, which can alert the public drive up share price. The article also suggests that reporting is onerous, costing between $45,000 and $280,000 in filing fees and can run more than “$1 million” in legal fees sometimes. The article also seems to suggest that the potential competitive harm for these activist investments is low, and that an increase in the exemption, from 10 percent to 20 percent, say, should be considered seriously.
Third Point is not a controversial decision nor should it set off any alarm bells. It has been long standing FTC practice to exempt truly passive investments: investments where a shareholder is seeking board representation are not passive. Indeed, there is a large and old body of case law that finds that competitors with interlocking directorates can in fact violate the Sherman Act by facilitating the exchange of competitively sensitive business information between them. Notification of minority acquisitions moreover has been a part of the HSR landscape since its inception. The vast majority of reportable transactions are cleared without any investigation at all—some 4 percent in 2013. And the fees associated with a non-controversial transaction are hardly outrageous. For deals greater than $76.3 million but less than $152.5 million, the fee is $45,000. For deals greater than $152.5 million but less than $762.7 million, it’s $125,000. For deals greater than $762.7 million, the fee is $280,000. Legal fees associated with an HSR filing are usually around $25,000, less if not complicated. The only time parties are incurring legal fees in excess of $1 million is if there is in fact a substantive overlap between the activist and the target—as in where the activist owns an interest in a competitor of the target and serves on the board. Indeed, Starboard Value LP accumulated shares in both Staples and Office Depot and drove the parties to merge. That transaction is being investigated by the FTC and the fees are likely well in excess of $1 million. But that transaction involved a potentially significant and meaningful harm to competition—the merger of two office superstores, a merger that was challenged and blocked by the FTC 20 years ago.
The complaint about the threshold, $76.3 million, being too low for activists is really a complaint that they cannot make more money off their initial pre-disclosure market purchases. The Deal points out that share price usually goes up after the announcement of a new effort: “that stock price pike usually makes it impossible for the initial activist to accumulate further shares at prices necessary to make a profit after covering the costs of their campaign, which often include expensive proxy fights.” This is not an argument about chilling valuable, efficiency-enhancing activists.
The Deal points out several options.
- The ultimate parent entity of a non-corporate issuer (e.g., LLC, LP), is an entity that has the right to 50 percent or more of the assets upon dissolution or 50 percent or more of the profits. In a typical buy-out fund, the fund itself is its own ultimate parent because no LP controls more than 50 percent of the fund. The management LLC runs the day-to-day operations including the investment decisions of the fund but does not control under HSR. The same management LLC can be used to run several such funds. The $76.3 million/10 percent threshold is applied on a per-ultimate parent basis. A large management fund could pool acquisitions across several pre-existing funds. This is a somewhat risky approach as the FTC could allege the establishment of multiple funds with different LPs is in fact a device for avoidance.
- The fund could acquire voting securities up to the $76.3 million threshold and then acquire convertible voting securities. The acquisition of convertible voting securities is not reportable. The conversion is, however. Moreover, the value of the transaction looks at holdings at the time of acquisition. So if you acquire $10 million in shares of IBM in 1980 which are now worth $100 million. Any acquisition of IBM, even a single share, would be subject to the HSR Act. One would have to notify the conversion of the shares, if the total value of the shares to be held exceeds $76.3 million, and wait for the termination of the applicable waiting period.
Another option the Deal does not discuss is maintaining passivity until fund has acquired as many shares it wants up to the 10 percent figure. In reality, it would likely be the 5 percent figure, as acquisitions of more than 5 percent require a 13D disclosure which would then trigger the share price spike. The notifiable event under HSR should be the activism itself. So rather than begin to jockey for a board position immediately upon the acquisition of shares, wait until one has accumulated what one wants up to the 5 percent figure, notify, wait the 30 days for early termination. While one cannot accumulate more shares during this time frame at pre-spike prices, one has acquired as many as one can under the regime before having to make the strategy public. The FTC may take the position that the activist always intended to be an activist and so should have reported before crossing the $76.3 million threshold. But it is in fact the activism itself—participating in the competitively significant board processes—that should trigger the duty. So long as the “activist” remains passive, it should not violate the spirit of 802.10 and Section 1. And while the parties (and potentially the public) will know after notification that the investor is planning on going activist, the investor has already made its maximum investment in the stock.
The real lesson here is that hedge funds, just as much as buyout funds, need to keep the HSR rules in mind. There are ways to work within the system to maximize profits and achieve their goals as major shareholders. It is the cost of doing business.