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Chapter 2

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The Legal and Regulatory Framework

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Federal Securities Law

Seven main pieces of federal legislation
Securities Act of 1933 Securities Exchange Act of 1934 Public Utility Holding Company Act of 1935 Trust Indenture Act of 1939 Investment Company Act of 1940 Investment Advisers Act of 1940 Securities Investor Protection Act of 1970
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 More recent developments

Securities Act Amendments of 1975 Shelf registration (Rule 415) [1982] allows registration of total amount of securities planned over two-year period; actual issuance date(s) chosen by firm according to its needs for funds or to market conditions Private Securities Litigation Reform Act (1995) Securities Litigation Uniform Standard Act of 1998
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Operation of Securities Acts

Securities Act of 1933 recording of information Securities Exchange Act of 1934 basis of later amendments applicable to takeover activities

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Tender Offer Regulation The Williams Act of 1968

Section 13(d) [amended 1970] must file Schedule 13D with SEC within 10 days of acquiring 5% or more of the stock of any public corporation Public tender offer for ownership of more than 5% must file Schedule 14D

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 Acquiring firms must disclose in Schedule 14D-1 intentions/business plans for target Section 14(d)(4)-(7) regulates terms of tender offer Target management as advisors to target shareholders must file Schedule 14D-9 with recommendations Section 14(e) prohibits misrepresentation or deceptive practices in connection with tender offers

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Insider Trading
Three broad categories of insider trading regulation
Rule 10b-5 defines fraud, deceit Rule 14e-3 insider trading in context of tender offer Insider Trading Sanctions Act of 1984 more general

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 Traditional insider trading rules

Section 16(a) insiders and 10% owners must report transactions Section 16(b) can bring suit to return profits of insider trades completed within a six-month period

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The Racketeer Influenced and Corrupt Organization Act of 1970 (RICO)

Requirements: Conspiracy and repeated acts Allows seizure of assets of accused when suit is filed Provides for treble damages for winning plaintiffs
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Court Cases and SEC Rules

Liability under Rule 10b-5 (fraud, deceit) Two principles of insider trading
Illegal for insiders to trade on basis of inside information Illegal for outsiders to trade on basis of information which they have "misappropriated"

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Other Disclosure Requirements

Notification of stock exchanges of any material development Disclosure of merger talks
Management must inform investors of material developments affecting stock price Boards may not deny substantive merger talks Either keep information secret so none leaks or fully disclose accurate information
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State Regulation of Takeover Activity

States are primary regulators of corporate activity Limitation states cannot restrict interstate commerce

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 State legislation
Illinois antitakeover law [1982] struck down as too favorable to target management over shareholders, bidders Indiana act [1987] upheld that majority of shareholders must approve transfer of voting rights New York/New Jersey act five-year moratorium on second-step transactions Delaware law [1988] three-year moratorium on second-step transactions
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 Rationale to permit more considered response to two-tier and partial tender offers Antitakeover laws have negative effects on share prices of firms Laws should balance shareholder protection and competition between bidders vs. discouraging "abusive" takeovers
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Antitrust Policy
Antitrust regulations reflect two opposing views
Merger activity as anticompetitive Merger activity as an expression of competitive processes

Main regulatory bodies

Department of Justice (DOJ) Federal Trade Commission (FTC)
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Antitrust Statutes
Sherman Act of 1980
Section 1 prohibits mergers that would tend to create monopoly or market control Section 2 directed against firms that have already become dominant in the view of the government

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 Clayton Act of 1914

Original Act
Created the Federal Trade Commission (FTC) Section 5 Gives FTC power to prevent firms from engaging in harmful business practices Section 7 Illegal for a company to acquire the stock of another company if competition could be adversely affected Loophole companies circumvent by using asset acquisitions

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 1950 amendment
Federal Trade Commission (FTC) has power to block asset purchases as well as stock purchases Incipiency doctrine FTC could block mergers if it judges there is a tendency toward increased concentration

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 Hart-Scott-Rodino Act of 1976

Title I Department of Justice (DOJ) has power to issue civil investigative demands (CIDs) in antitrust investigation

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 Title II premerger notification provision

Applies to acquiring firms with sales or assets of $100 million or more and acquired firms with sales or assets of $10 million or more, or vice versa Information submitted to DOJ and FTC to determine legality Thirty-day waiting period for mergers and 15 days for tender offers Either agency may request 20-day extension of waiting period for mergers and 10 days for tender offers
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 Title III Parens Patriae Act

Each state is the parent or protector of consumers and competitors State attorneys general are given power to initiate triple damage suits State itself does not need to be injured by violation

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Antitrust Guidelines
Merger guidelines of 1968
Mechanical application of concentration tests Antitrust could be triggered if share of the top four firms exceeded 10-20%

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 Merger guidelines of 1982 and later years

Quantitative test shifted to HerfindahlHirschman Index (HHI)
Concentration measure based on the sum of the squared market shares of each firm in the industry

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 Examples
10 firms each with 10% market share: HHI = 10 (102) = 1,000 10 firms each with 1% market share, 1 firm with 90%: HHI = 902 + 10 (1) = 8,110

Critical concentration levels:

HHI less than 1,000 no challenge Postmerger HHI between 1,000 and 1,800 investigation if HHI increased by 100 Postmerger HHI more than 1,800 challenge if HHI increased by 50

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 Theory that high concentration results in tacit collusion is invalid because:

Product differences heterogeneity Frequency of quality changes Frequency of new products Technological changes Contract complexities and variations Cost differences among suppliers

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 Nonhorizontal mergers less likely to cause competitive problems State antitrust activity
Increased power of states granted by HartScott-Rodino Act of 1976 National Association of Attorneys General (NAAG) active in lawsuits

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Private Antitrust Suits

Business competitors have strong influence on antitrust policy Business firms can sue other firms under antitrust laws Private antitrust suits may be used as blackmail

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Regulatory Bodies
Railroads
Surface Transportation Board (STB) established in 1995 STB replaced Interstate Commerce Commission STB must file notices to DOJ

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 Commercial banks
Agencies
Comptroller of the Currency national banks Board of Governors of the Federal Reserve System state banks Federal Deposit Insurance Corporation (FDIC)

Bank mergers subject to Section 7 of Clayton Act of 1914

Clayton Act modified by the Bank Merger Act of 1966 Attorney General has 30 days to challenge any merger approved by one of the three agencies
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 Telecommunications
Federal Communications Commission (FCC) Mergers are subject to FCC review, but FCC defers to DOJ and FTC

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International Antitrust
International Competition Policy Advisory Committee recommends explicit antitrust policies United Kingdom
Director General of Office of Fair Trading Secretary of State for Trade and Industry Monopolies and Mergers Commission
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 Japan
Japanese government has 30 days (can extend by 60 days) to review transaction Review not required in stock for stock deals

Europe
Premerger notification to Minister of Competition of European Union European Union renders decision within five months
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Regulation by Publicity
Pressure on government regulators to limit and penalize use of junk bonds Managers feared their use in takeovers Junk bonds fulfill several beneficial roles
Finance the takeover of underperforming firms Fill financing gap for new risky growth firms Use in takeovers lead to value enhancement for shareholders
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Illustrative Examples of Application of HHI

1a. Assume an industry dominated by a single large firm which controls 50% of the market. The remaining 50% of the market is controlled by five firms each with a 10% market share.

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What is the 4-firm concentration ratio? 50 + 10 + 10 + 10 = 80% What is the HHI? 1(50)2 + 5(10)2 = 2,500 + 500 = 3,000 Whatever the measure of concentration, this market would be classified as highly concentrated.
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1b. Now suppose that two of the smaller firms in this industry merge.
What would be the effect on the 4-firm concentration ratio? 50 + 20 + 10 + 10 = 90% What would be the effect on the HHI? 1(50)2 + 1(20)2 + 3(10)2 = 2,500 + 400 + 300 = 3,200
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Both measures of concentration have increased. The market was already highly concentrated, and the increase in the HHI is 200 points. A challenge of the merger between two of the smaller firms would occur based on the HHI tests.

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1c. Suppose that the merger in 1b increases the ability of the merged firm to compete with the dominant firm. For example, suppose the merged firm is able to take away 10% of the market from the larger firm.

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What is the effect of this on the 4-firm concentration ratio? 40 + 30 + 10 + 10 = 90% (no change from 1b) What is the effect on HHI? 1(40)2 + 1(30)2 + 3(10)2 = 1,600 + 900 + 300 = 2,800

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The HHI has declined by 400 points, reflecting reduction in market share of the dominant firm.

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2a. Now consider an unconcentrated industry (defined in the 1982 merger guidelines as an industry with an HHI below 1,000). Twenty-five firms in an industry each have a market share of 4%.

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What is the 4-firm concentration ratio? 4 + 4 + 4 + 4 = 16% What is the HHI? 25(4)2 = 400

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2b. Two of the firms in the industry propose to merge. What is the effect on the 4-firm concentration ratio? 8 + 4 + 4 + 4 = 20%

What is the effect on the HHI? 23(4)2 + 1(8)2 = 368 + 64 = 432

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Using the 4-firm ratio, antitrust action might be taken. Using the HHI, the industry would still be classified as unconcentrated.

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