United States: Activist Investors Cannot Rely On HSR's Passive Investor Exemption (At Least Not Yet)

Three affiliated hedge funds and their management company, which had mistakenly relied upon HSR's passive investor exemption while acquiring stock of a target company, have agreed to settle charges that their actions violated HSR. The episode shines some light on HSR's intersection with the role played by activist investors.

The U.S. Department of Justice, on behalf of the U.S. Federal Trade Commission (FTC), pursued enforcement against Third Point, LLC and three of its affiliated hedge funds for violating the notification and waiting period requirements of the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR) in connection with the 2011 acquisition by those funds of Yahoo! Inc. voting stock in open market purchases. Under HSR, parties are not permitted to acquire voting stock (in the open market or otherwise) in situations where HSR's jurisdictional tests are satisfied without first filing an HSR Form with the Justice Department and the FTC (the two federal antitrust agencies) and then observing a statutory waiting period (normally 30 calendar days) – unless an exemption from HSR applies.

Here, Third Point and its affiliated funds relied upon HSR's passive investor exemption in acquiring that Yahoo! stock. That exemption exempts acquisitions of voting stock "if made solely for the purpose of investment" and if the resulting holding would not exceed 10% of the target's company's outstanding stock. (In some situations, not applicable here, the percentage threshold is 15% for certain institutional investors.) Under HSR, voting stock is held or acquired "solely for the purpose of investment" only where the person holding or acquiring such stock "has no intention of participating in the formulation, determination, or direction of the basic business decisions of the issuer." The alleged misuse of the passive investor exemption has been one of the most prevalent bases for publicized enforcement actions by the Federal antitrust agencies since HSR first began, nearly four decades ago.

In the original release adopting the HSR rules, the FTC made clear that certain types of conduct would create a rebuttable presumption that the voting stock was not held solely for the purpose of investment. That disqualifying conduct included (among other things) nominating a candidate for the target's board of directors or having a designee serve as an officer or director of the target.

According to the Justice Department's complaint, Third Point (acting on behalf of its affiliated funds) took a number of actions inconsistent with the passive investment intent needed for the HSR exemption, including (i) contacting individuals to gauge their interest and willingness to serve as Yahoo! CEO or as a potential Yahoo! board member, (ii) taking other steps to assemble an alternate slate for the Yahoo! board, (iii) drafting correspondence to Yahoo! to announce that Third Point was prepared to join Yahoo!'s board, (iv) internally deliberating the possible launch of a proxy battle for the Yahoo! board, and (v) making public statements that Third Point was prepared to propose an alternate director slate for Yahoo!'s next annual meeting.

The complaint further alleges that each of the three affiliated funds satisfied HSR's jurisdictional thresholds in mid to late August 2011, that they filed a Schedule 13D with the U.S. Securities and Exchange Commission in early September 2011, and that they then filed HSR notifications one week later.

Third Point and its three affiliated funds have consented to the entry of a final judgment (which is subject to a 60-day public comment period). That final judgment is noteworthy in at least three respects.

First, it lacks any civil penalty. Under HSR, violators are subject to a civil penalty of up to $16,000 per day for each day in violation. The potential civil penalty could have been approximately $1,000,000 for one fund, and a bit less for each of the other two. This appears to be the first time the Federal antitrust agencies have pursued civil enforcement of an HSR violation (typically enforcement proceedings are not instituted against first-time offenders for inadvertent violations) without also imposing a monetary civil penalty. One can speculate there were insufficient votes at the FTC to support imposition of a monetary penalty (more on that below).

Second, the final judgment includes an injunction proscribing future acquisitions of voting stock of any target without first complying with HSR (unless exempted other than by the passive investor exemption) where, at the time of the particular acquisition or within the preceding four months, Third Point takes any one of nine enumerated types of actions, including nominating a candidate for the target's board of directors, soliciting proxies with respect to that target, or communicating with that target regarding possible board or management representation.

Third, the final judgment expires five years from the date of its entry, but also provides for automatic expiration in the event HSR earlier is amended to provide a flat exemption for acquisitions by any person (or at least by a noncompetitor) resulting in holdings less than a specified percentage of the outstanding voting stock of a target issuer.

We believe this third aspect of the final judgment reflects the sentiment expressed in an unusual and bitter dissent by two of the five FTC Commissioners in the FTC's 3-2 vote to pursue this enforcement action. Those two dissenters (one of whom was concurrently resigning from the FTC) argued that the majority's "narrow" interpretation of the passive investor exemption would be "likely to chill valuable shareholder advocacy while subjecting [to HSR] transactions that are highly unlikely to raise substantive antitrust concerns". The dissenters would have closed the investigation without taking any enforcement action, "as a matter of prosecutorial discretion."

The dissenters based their dissent not on the majority's conclusion that Third Point violated HSR (saying the majority's interpretation of the passive investor exemption "is neither unreasonable nor plainly contrary to the text of the statute and regulations at issue", nor is it "necessarily inconsistent with previous consent orders" involving the passive investor exemption that the Federal antitrust agencies have reached with parties). Rather, the dissenters argued that the exemption itself is too narrow, as applied here, for "pursuing an enforcement action in this matter was not in the public interest because the stock acquisition at issue here presented absolutely no threat of competitive harm and the type of shareholder advocacy pursued [by Third Point] often generates well-documented benefits to the market for corporate control."

The dissenters argued for a flat exemption from HSR for acquisitions resulting in holdings of 10% or less, or at least for reinterpreting the existing passive investor exemption to preclude reliance on the exemption only where the acquiror has actually taken one of the inconsistent actions (such as actually nominating a director or slate of directors) rather than merely exploring the possibility of doing so. The dissenters based their argument on the absence of a single enforcement action in the decades since HSR was adopted where an acquisition by a noncompetitor of 10% or less of a target's stock was alleged to cause a substantive competitive concern; and on their belief that if any such case were to occur, it easily could be remedied via a straightforward post-consummation divestiture.

Target companies often look to the HSR notification requirements to afford them early warning of activist activity, as the HSR jurisdictional thresholds often will be satisfied long before the requirement kicks in to file a Schedule 13D with the SEC. It very well may be that this early warning sign's days are numbered.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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