United States: Hart-Scott-Rodino Act Implications of Institutional Investor Activism

A recent newspaper article recounted the successful efforts of a large mutual fund manager to obtain a seat on the board of a company in which the fund had made a significant investment. The article indicated that the fund manager intended to use its position to urge management of the issuer to take certain actions that the fund manager believed would benefit the issuer and its shareholders. The fund manager's efforts may have some Hart-Scott-Rodino Act¹ implications, of which you should be aware.

As you know, if the HSR Act's size-of-person tests are met, an acquisition of voting securities valued at more than $50 million² may require premerger notification filings and compliance with a waiting period, unless an exemption applies. One such exemption allows any person to acquire up to 10% of the stock of an issuer, regardless of the value of the resulting holdings, provided the person acquires its shares solely for the purpose of investment.³ Another exemption allows a so-called "institutional investor" to acquire up to 15% of the stock of an issuer, again regardless of the value of the holdings, provided that the institutional investor acquires the shares in the ordinary course of its business and solely for the purpose of investment.⁴ Both of these exemptions apply to transactions which may be valued at well in excess of $50 million.

The phrase "solely for the purpose of investment" has been narrowly defined and interpreted by the Federal Trade Commission, essentially to mean that the investor must intend to be a totally passive shareholder. Such an investor may vote its shares, but it cannot have any "intention of participating in the formulation, determination, or direction of the basic business decisions of the issuer."⁵ The Statement of Basis and Purpose and subsequent interpretive lore explain this limitation as precluding the investor from (1) nominating a candidate for the board of directors of the issuer, (2) proposing corporate action that requires shareholder approval, (3) soliciting any proxies, (4) having a controlling shareholder, officer, director or employee that simultaneously serves as an officer or director of the issuer,⁶ (5) being a competitor of the issuer, or (6) doing any of the above with respect to a parent or affiliate of the issuer.⁷

The HSR Act is applicable only to acquisitions, and the "investment purpose" test is applied at the time of a potentially reportable acquisition. That is, an acquisition that satisfies other applicable criteria for reporting is exempt if the acquiring person has the requisite passive investment intention at the time of the acquisition. An acquisition that is exempt because made solely for the purpose of investment does not become retroactively reportable if the investor subsequently decides to play a more active role in the affairs of the issuer.⁸ However, any acquisition of additional shares occurring after that time will normally be subject to the HSR Act's reporting and waiting period requirements, as the investment exemption no longer applies.

These issues are of obvious relevance to any investor who has claimed the exemption, later changes its intentions and takes a board seat or otherwise participates in management, and then wishes to acquire any additional shares. The institutional investor that decides more actively to influence or participate in management must re-assess its entitlement to exemption in case it considers acquiring additional shares. The issuer is also affected since HSR Act filings, if required, must be made by both the investor and the issuer. But the institutional investor will usually be in the best position to determine its own filing requirements, and then to alert the issuer to any filing requirements that it may have.

These considerations are also relevant to parties considering a merger or other transaction in which shares held by an investor (which often would not be a party to the transaction) will be exchanged for or replaced by newly issued voting securities of the same issuer or a different issuer. Such an acquisition is potentially reportable under the HSR Act if valued in excess of $50 million, unless the investor qualifies for exemption at the time the new or replacement shares are issued.

For example, if Company Y merges into Company X, and the shareholders of Company Y receive newly issued shares of Company X in exchange for (or upon cancellation of) their shares of Company Y, any of those shareholders may have HSR Act reporting requirements if as a result of the merger they will hold shares of Company X worth more than $50 million. Each shareholder must determine for itself whether it will hold a potentially reportable quantity of shares and, if so, whether the investment exemption (or any other exemption) applies. An investor that receives advance notice of such a transaction must be sure to verify that its acquisition of different voting securities as a result of that transaction does not trigger a filing requirement.

In such a situation, the issuer of the new or replacement shares may also have an obligation to determine whether any person receiving potentially reportable quantities of its shares qualifies for exemption. If that shareholder does not qualify for exemption, the issuer (as well as the shareholder) may have an HSR Act reporting requirement and could be subject to possible civil penalties if a reportable acquisition is made without complying with the Act.⁹

We are not aware of any case law defining the issuer's responsibility to verify whether its minority shareholders have HSR filing obligations in connection with a transaction in which the issuer will engage. But common sense suggests that, because the issuer will normally be involved in planning for or negotiating the transaction, the issuer should conduct some due diligence, to assure that any shareholders that will hold potentially reportable quantities of its shares as a result of the transaction – and particularly any shareholders who are known not to be passive – are aware of and have considered their obligations under the HSR Act.

Thus, in any transaction in which an issuer's stock will be exchanged or cancelled and the shareholders will receive any voting securities in return, and particularly where a shareholder has a board seat or has otherwise participated in management or attempted to influence management, the issuer should satisfy itself that that shareholder has considered whether it has its own (and therefore the issuer also has additional) HSR Act filing and waiting period requirements. Failure to do so could result in possible civil penalty liability for both the shareholder and the issuer and could delay closing of the main transaction.

1 The Hart-Scott-Rodino Act (or "HSR Act") is §7A of the Clayton Act, 15 U.S.C. §18a.

2 Under the HSR rules, an acquisition of voting securities is valued according to the total number of shares of the issuer held as a result of the acquisition, not the incremental number of shares that are acquired at any one time.

3 15 U.S.C. §18a(c)(9); 16 C.F.R. §802.9

4 16 C.F.R. §802.64. The types of entities that may qualify as "institutional investors" are listed in §802.64(a).

5 16 C.F.R. §801.1(i)(1)

6 Note that a number of these are actions viewed as inconsistent with a passive investment intent. However, if the shareholder is represented on the issuer's board of directors, that status disqualifies the investor from claiming the HSR exemption, regardless of how the investor uses its position on the board.

7 43 Fed. Reg. 33450, 33465 (1978)

8 However, if that change of mind occurs too quickly after the stock purchase, it may cast doubt on the bona fides of the purchaser's previous reliance on the investment exemption. Civil penalties have been assessed for failure to file in a number of cases of this type.

9 Where HSR filings by a shareholder and the issuer are required in addition to those made by the parties to the main transaction, there are two separate waiting periods, both of which must have expired or been terminated before the main transaction can be completed.