Chapter 2

Regulatory Considerations

Character is doing the right thing when no one is looking.

—J. C. Watts

Inside M&A: The limitations of regulation and the lehman brothers meltdown

Even though regulations are needed to promote appropriate business practices, they may also produce a false sense of security. Regulatory agencies often are coopted by those they are supposed to be regulating due to an inherent conflict of interest. The objectivity of regulators can be skewed by the prospect of future employment in the firms they are responsible for policing. No matter how extensive, regulations are likely to fail to achieve their intended purpose in the absence of effective regulators.

Consider the 2008 credit crisis that shook Wall Street to its core. On September 15, 2008, Lehman Brothers Holdings announced that it had filed for bankruptcy. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron, with $126 billion and $81 billion in assets, respectively.

In the months leading up to Lehman's demise, there were widespread suspicions that the book value of the firm's assets far exceeded their true market value and that a revaluation of these assets was needed. However, little was known about Lehman's aggressive use of repurchase agreements or repos. Repos are widely used short-term financing contracts in which one party agrees to sell securities to another party (a so-called counterparty), with the obligation to buy them back, often the next day. Because the transactions are so short-term in nature, the securities serving as collateral continue to be shown on the borrower's balance sheet. The cash received as a result of the repo would increase the borrower's cash balances and be offset by a liability reflecting the obligation to repay the loan. Consequently, the borrower's balance sheet would not change as a result of the short-term loan.

In early 2010, a report compiled by bank examiners indicated how Lehman manipulated its financial statements, with government regulators, the investing public, credit rating agencies, and Lehman's board of directors being totally unaware of the accounting tricks. Lehman departed from common accounting practices by booking these repos as sales of securities rather than as short-term loans. By treating the repos as a sale of securities (rather than a loan), the securities serving as collateral for the repo were removed from the books, and the proceeds generated by the repo were booked as if they had been used to pay off an equivalent amount of liabilities. The resulting reduction in liabilities gave the appearance that the firm was less leveraged than it actually was despite the firm's continuing obligation to buy back the securities. Since the repos were undertaken just prior to the end of a calendar quarter, their financial statements looked better than they actually were.1

The firm's outside auditing firm, Ernst & Young, was aware of the moves but continued to pronounce the firm's financial statements to be in accordance with generally accepted accounting principles. The Securities and Exchange Commission (SEC), the recipient of the firm's annual and quarterly financial statements, failed to catch the ruse. In the weeks before the firm's demise, the Federal Reserve had embedded its own experts within the firm and they too failed to uncover Lehman's accounting chicanery. Passed in 2002, Sarbanes-Oxley, which had been billed as legislation that would prevent any recurrence of Enron-style accounting tricks, also failed to prevent Lehman from “cooking its books.” As required by the Sarbanes-Oxley Act, Richard S. Fuld, Lehman's chief executive at the time, certified the accuracy of the firm's financial statements submitted to the SEC.

When all else failed, market forces uncovered the charade. It was the much maligned “short-seller” who uncovered Lehman's scam. Although not understanding the extent to which the firm's financial statements were inaccurate, speculators borrowed Lehman stock and sold it in anticipation of buying it back at a lower price and returning it to its original owners. In doing so, they effectively forced the long-insolvent firm into bankruptcy. Without short-sellers forcing the issue, it is unclear how long Lehman could have continued the sham.

Chapter overview

This chapter focuses on the key elements of selected federal and state regulations and their implications for M&As. Considerable time is devoted to discussing the prenotification and disclosure requirements of current legislation and how decisions are made within the key securities law and antitrust enforcement agencies. Furthermore, the implications of the Dodd-Frank bill passed in 2010 are discussed in detail. This chapter provides only an overview of the labyrinth of environmental, labor, benefit, and foreign (for cross-border transactions) laws that affect M&As. Table 2.1 provides a summary of applicable legislation.

Table 2.1. Laws Affecting Mergers and Acquisitions

Law	Intent
Federal Securities Laws
Securities Act (1933)	Prevents the public offering of securities without a registration statement; defines minimum data requirements and noncompliance penalties
Securities Exchange Act (1934)	Established the Securities and Exchange Commission (SEC) to regulate securities trading. Empowers SEC to revoke registration of a security if issuer is in violation of any provision of the 1934 act
Section 13	Defines content and frequency of, as well as events triggering, SEC filings
Section 14	Defines disclosure requirements for proxy solicitation
Section 16(a)	Defines what insider trading is and who is an insider
Section 16(b)	Defines investor rights with respect to insider trading
Williams Act (1968)	Regulates tender offers
Section 13D	Defines disclosure requirements
Sarbanes-Oxley Act (2002)	Initiates extensive reform of regulations governing financial disclosure, governance, auditing standards, analyst reports, and insider trading
Federal Antitrust Laws
Sherman Act (1890)	Made “restraint of trade” illegal. Establishes criminal penalties for behaviors that unreasonably limit competition
Section 1	Makes mergers creating monopolies or “unreasonable” market control illegal
Section 2	Applies to firms already dominant in their served markets to prevent them from “unfairly” restraining trade
Clayton Act (1914)	Outlawed certain practices not prohibited by the Sherman Act, such as price discrimination, exclusive contracts, and tie-in contracts, and created civil penalties for illegally restraining trade. Also established law governing mergers
Celler-Kefauver Act of 1950	Amended Clayton Act to cover asset as well as stock purchases
Federal Trade Commission Act (1914)	Established a federal antitrust enforcement agency; made it illegal to engage in deceptive business practices
Hart-Scott-Rodino Antitrust Improvement Act (1976)	Requires a waiting period before a transaction can be completed and sets regulatory data submission requirements
Title I	Defines what must be filed
Title II	Defines who must file and when
Title III	Enables state attorneys general to file triple damage suits on behalf of injured parties
Other Legislation Affecting M&As
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)	Reforms executive compensation; introduces new hedge/private equity fund registration requirements; provides oversight for credit rating agencies; increases Federal Reserve and SEC regulatory authority; gives government authority to liquidate systemically risky firms; and enables government regulation of consumer financial products
State Antitakeover Laws	Define conditions under which a change in corporate ownership can take place; may differ by state
State Antitrust Laws	Similar to federal antitrust laws; states may sue to block mergers, even if the mergers are not challenged by federal regulators
Exon-Florio Amendment to the Defense Protection Act of 1950	Establishes authority of the Committee on Foreign Investment in the United States (CFIUS) to review the impact of foreign direct investment (including M&As) on national security
U.S. Foreign Corrupt Practices Act	Prohibits payments to foreign government officials in exchange for obtaining new business or retaining existing contracts
Regulation FD (Fair Disclosure)	All material disclosures of nonpublic information made by publicly traded corporations must be disclosed to the general public
Industry Specific Regulations	Banking, communications, railroads, defense, insurance, and public utilities
Environmental Laws (federal and state)	Define disclosure requirements
Labor and Benefit Laws (federal and state)	Define disclosure requirements
Applicable Foreign Laws	Cross-border transactions subject to jurisdictions of countries in which the bidder and target firms have operations

A review of this chapter is available (including practice questions) in the file folder entitled Student Study Guide on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, enabling students to test their knowledge of this chapter in a “real-time” environment.

Federal securities laws

Whenever either the acquiring or the target company is publicly traded, the two are subject to the substantial reporting requirements of the current federal securities laws. Passed in the early 1930s, these laws were a direct result of the loss of confidence in the securities markets following the crash of the stock market in 1929.²

Securities Act of 1933

Originally administered by the FTC, this legislation requires that all securities offered to the public must be registered with the government. Registration requires, but does not guarantee, that the facts represented in the registration statement and prospectus are accurate. Also, the law makes providing inaccurate or misleading statements in the sale of securities to the public punishable with a fine, imprisonment, or both. The registration process requires a description of the company's properties and business, a description of the securities, information about management, and financial statements certified by public accountants.

Securities Exchange Act of 1934

The Securities Exchange Act extends disclosure requirements stipulated under the Securities Act of 1933 covering new issues to include securities already trading on the national exchanges. The Act also established the Securities and Exchange Commission, the purpose of which is to protect investors from illegal financial practices or fraud by requiring full and accurate financial disclosure by firms offering stocks, bonds, and other securities to the public. In 1964, coverage was expanded to include securities traded on the Over-the-Counter (OTC) market. The act also covers proxy solicitations (i.e., mailings to shareholders requesting their vote on a particular issue) by a company or shareholders. For a more detailed discussion of proxy solicitations, see Chapter 3.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protections Act, discussed in more detail later in this chapter, strengthened the SEC's enforcement powers by allowing the commission to impose financial penalties against any person, rather than just regulated entities. Furthermore, it expands federal court jurisdiction by allowing the SEC to bring enforcement actions against persons, even when the violations take place outside of the United States.

Reporting Requirements

Companies that are required to file annual and other periodic reports with the SEC are those with assets of more than $10 million and whose securities are held by more than 500 shareholders. Even if both parties are privately owned, an M&A transaction is subject to federal securities laws if a portion of the purchase price is going to be financed by an initial public offering of stock or a public offering of debt by the acquiring firm.

Section 13: Periodic Reports

Form 10K, or the annual report, summarizes and documents the firm's financial activities during the preceding year. The four key financial statements that must be included are the income statement, the balance sheet, the statement of retained earnings, and the statement of cash flows. Form 10K also includes a relatively detailed description of the business, the markets served, major events and their impact on the business, key competitors, and competitive market conditions. Form 10Q is a highly succinct quarterly update of such information.

If an acquisition or divestiture is deemed significant, Form 8K must be submitted to the SEC within 15 days of the event. Form 8K describes the assets acquired or disposed, the type and amount of consideration (i.e., payment) given or received, and the identity of the person (or persons) for whom the assets were acquired. In an acquisition, Form 8K also must identify who is providing the funds used to finance the purchase and the financial statements of the acquired business. Acquisitions and divestitures are usually deemed significant if the equity interest in the acquired assets or the amount paid or received exceeds 10% of the total book value of the assets of the registrant and its subsidiaries.

Section 14: Proxy Solicitations

Where proxy contests for control of corporate management are involved, the act requires the names and interests of all participants in the proxy contest. Proxy materials must be filed in advance of their distribution to ensure that they are in compliance with disclosure requirements. If the transaction involves shareholder approval of either the acquirer or the target firm, any materials distributed to shareholders must conform to the SEC's rules for proxy materials.

Insider Trading Regulations

Insider trading involves individuals who buy or sell securities based on knowledge that is not available to the general public. Historically, insider trading has been covered under the Securities and Exchange Act of 1934. Section 16(a) of the act defines “insiders” as corporate officers, directors, and any person owning 10% or more of any class of securities of a company. The Sarbanes-Oxley Act (SOA) of 2002 amended Section 16(a) of the 1934 act by requiring that insiders disclose any changes in ownership within two business days of the transaction, with the SEC posting the filing on the Internet within one business day after the filing is received.

The SEC is responsible for investigating insider trading. Regulation 10b-5, issued by the SEC, prohibits the commission of fraud in relation to securities transactions. In addition, Regulation 14e-3 prohibits trading securities in connection with a tender offer based on information that is not available to the general public. Individuals found guilty of engaging in insider trading may be subject to substantial penalties and forfeiture of any profits.³

The Williams Act: Regulation of Tender Offers

Passed in 1968, the Williams Act consists of a series of amendments to the Securities Act of 1934. The Williams Act was intended to protect target firm shareholders from lightning-fast takeovers in which they would not have enough information or time to assess adequately the value of an acquirer's offer. This protection was achieved by requiring more disclosure by the bidding company, establishing a minimum period during which a tender offer must remain open, and authorizing targets to sue bidding firms.

The disclosure requirements of the Williams Act apply to anyone, including the target, asking shareholders to accept or reject a takeover bid. The major sections of the Williams Act as they affect M&As are in Sections 13(D) and 14(D). The Williams Act requirements apply to all types of tender offers, including those negotiated with the target firm (i.e., negotiated or friendly tender offers), those undertaken by a firm to repurchase its own stock (i.e., self-tender offers), and those that are unwanted by the target firm (i.e., hostile tender offers).⁴

Sections 13(D) and 13(G): Ownership Disclosure Requirements

Section 13(D) of the Williams Act is intended to regulate “substantial share” or large acquisitions and serves to provide an early warning for a target company's shareholders and management of a pending bid. Any person or firm acquiring 5% or more of the stock of a public corporation must file a Schedule 13(D) with the SEC within 10 days of reaching that percentage threshold.

The permitted reporting delay allows for potential abuse of the disclosure requirement. In late 2010, activist hedge fund investor William Ackman and real estate company Vornado Realty Trust surprised Wall Street when they disclosed that they had acquired nearly 27% of mega-retailer J.C. Penney's outstanding shares. Once the investors exceeded the 5% reporting threshold, they rapidly accumulated tens of millions of shares during the ensuing ten-day period, driving J.C. Penney's share price up to 45%.

The information required by Schedule 13(D) includes the identity of the acquirer, his or her occupation and associations, sources of financing, and the purpose of the acquisition. If the purpose of buying the stock is to take control of the target firm, the acquirer must reveal its business plan for the target firm. The plans could include the breakup of the firm, suspending dividends, a recapitalization of the firm, or the intention to merge it with another firm. Otherwise, the purchaser of the stock could indicate that the accumulation was for investment purposes only.

Under Section 13(G), any stock accumulated by related parties, such as affiliates, brokers, or investment bankers working on behalf of the person or firm, are counted toward the 5% threshold. This is intended to prevent an acquirer from avoiding filing by accumulating more than 5% of the target's stock through a series of related parties. Institutional investors, such as registered brokers and dealers, banks, and insurance companies, can file a Schedule 13(G)—a shortened version of Schedule 13(D)—if the securities were acquired in the normal course of business. Case Study 2.1 illustrates how derivatives may have been used to circumvent SEC disclosure requirements.

Case Study 2.1

A Federal Judge Reprimands Hedge Funds in Their Effort to Control CSX

Investors who are seeking to influence a firm's decision making often try to accumulate voting shares. Such investors may attempt to acquire shares without attracting the attention of other investors, who could bid up the price of the shares and make it increasingly expensive to accumulate the stock. To avoid alerting other investors, certain derivative contracts called “cash settled equity swaps” allegedly have been used to gain access indirectly to a firm's voting shares without having to satisfy 13(D) prenotification requirements.

Using an investment bank as a counterparty, a hedge fund could enter into a contract obligating the investment bank to give dividends paid on and any appreciation of the stock of a target firm to the hedge fund in exchange for an interest payment made by the hedge fund. The amount of the interest paid is usually based on the London Interbank Offer Rate (LIBOR) plus a markup reflecting the perceived risk of the underlying stock. The investment bank usually hedges or defrays risk associated with its obligation to the hedge fund by buying stock in the target firm. In some equity swaps, the hedge fund has the right to purchase the underlying shares from the counterparty.

Upon taking possession of the shares, the hedge fund discloses ownership of the shares. Since the hedge fund does not actually own the shares prior to taking possession, it does not have the right to vote the shares and technically does not have to disclose ownership under Section 13(D). However, to gain significant influence, the hedge fund can choose to take possession of these shares immediately prior to a board election or a proxy contest. To avoid the appearance of collusion, many investment banks have refused to deliver shares under these circumstances or to vote in proxy contests.

In an effort to surprise a firm's board, several hedge funds may act together by each buying up to 4.9% of the voting shares of a target firm, without signing any agreement to act in concert. Each fund could also enter into an equity swap for up to 4.9% of the target firm's shares. The funds together could effectively gain control of a combined 19.6% of the firm's stock (i.e., each fund would own 4.9% of the target firm's shares and have the right to acquire via an equity swap another 4.9%). The hedge funds could subsequently vote their shares in the same way with neither fund disclosing their ownership stakes until immediately before an election.

The Children's Investment Fund (TCI), a large European hedge fund, acquired 4.1% of the voting shares of CSX, the third largest U.S. railroad, in 2007. In April 2008, TCI submitted its own candidates for the CSX board of directors' election to be held in June of that year. CSX accused TCI and another hedge fund, 3G Capital Partners, of violating disclosure laws by coordinating their accumulation of CSX shares through cash-financed equity swap agreements. The two hedge funds owned outright a combined 8.1% of CSX stock and had access to an additional 11.5% of CSX shares through cash-settled equity swaps.

In June 2008, the SEC ruled in favor of the hedge funds, arguing that cash-settled equity swaps do not convey voting rights to the swap party over shares acquired by its counterparty to hedge their equity swaps. Shortly after the SEC's ruling, a federal judge concluded that the two hedge funds had deliberately avoided the intent of the disclosure laws. However, the federal ruling came after the board election and could not reverse the results in which TCI was able to elect a number of directors to the CSX board. Nevertheless, the ruling by the federal court established a strong precedent limiting future efforts to use equity swaps as a means of circumventing federal disclosure requirements.

Discussion Questions

1. Do you agree or disagree with the federal court's ruling? Defend your position.

2. What criteria might have been used to prove collusion between TCI and 3G in the absence of signed agreements to coordinate their efforts to accumulate CSX voting shares?

Section 14(D): Rules Governing the Tender Offer Process

Although Section 14(D) of the Williams Act relates to public tender offers only, it applies to acquisitions of any size. The 5% notification threshold also applies.

Obligations of the acquirer. An acquiring firm must disclose its intentions, business plans, and any agreements between the acquirer and the target firm in a Schedule 14(D)-1. This schedule is called a tender offer statement. The commencement date of the tender offer is defined as the date on which the tender offer is published, advertised, or submitted to the target. Schedule 14(D)-1 must contain the identity of the target company and the type of securities involved; the identity of the person, partnership, syndicate, or corporation that is filing; and any past contracts between the bidder and the target company. The schedule also must include the source of the funds used to finance the tender offer, its purpose, and any other information material to the transaction.

Obligations of the target firm. The management of the target company cannot advise its shareholders how to respond to a tender offer until it has filed a Schedule 14(D)-9 with the SEC within ten days after the tender offer's commencement date. This schedule is called a tender offer solicitation/recommendation statement. Target management may only tell its shareholders to defer responding to the tender offer until it has completed its consideration of the offer.

Shareholder rights: 14(D)-4 through 14(D)-7. The tender offer must be left open for a minimum of 20 trading days. The acquiring firm must accept all shares that are tendered during this period. The firm making the tender offer may get an extension of the 20-day period if it believes that there is a better chance of getting the shares it needs. The firm must purchase the shares tendered at the offer price, at least on a pro rata basis, unless the firm does not receive the total number of shares it requested under the tender offer. The tender offer also may be contingent on attaining the approval of the Department of Justice (DoJ) and the Federal Trade Commission (FTC). Shareholders have the right to withdraw shares that they may have tendered previously as long as the tender offer remains open. The law also requires that when a new bid for the target is made from another party, the target firm's shareholders must have an additional ten days to consider the bid.

The “best price” rule: 14(D)-10. The “best price” rule requires that all shareholders be paid the same price in a tender offer. Consequently, if a bidder increases what it is offering to pay for the remaining target firm shares, it must pay the higher price to those who have already tendered their shares. As a result of SEC rule changes on October 18, 2006, the best price rule was clarified to underscore that compensation for services that might be paid to shareholders should not be included as part of the price paid for their shares. The rule changes also protect special compensation arrangements that are approved by independent members of a firm's board and specifically exclude compensation in the form of severance and other employee benefits. The rule changes make it clear that the best price rule applies only to the consideration (i.e., cash, securities, or both) offered and paid for securities tendered by shareholders.

Acquirers routinely initiate two-tiered tender offers, in which target shareholders receive a higher price if they tender their shares in the first tier (round) than do those submitting their shares in the second tier. The best price rule in these situations simply means that all shareholders tendering their shares in the first tier must be paid the price offered for those shares in the first tier, and those tendering shares in the second tier are paid the price offered for second-tier shares.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act was signed in the wake of the egregious scandals at such corporate giants as Enron, MCI WorldCom, ImClone, Qwest, Adelphia, and Tyco. The act has implications ranging from financial disclosure to auditing practices to corporate governance. Section 302 of the act requires quarterly certification of financial statements and disclosure controls and procedures for CEOs and CFOs. Section 404 requires most public companies to certify annually that their internal control system is operating successfully. The legislation, in concert with new listing requirements at public stock exchanges, requires a greater number of directors on the board who do not work for the company (i.e., so-called independent directors). In addition, the act requires board audit committees to have at least one financial expert, while the full committee must review financial statements every quarter after the CEO and chief financial officer certify them.

The SOA offers the potential for a reduction in investor risk of losses due to fraud and theft.5 The act also provides for an increase in reliable financial reporting, transparency or visibility in a firm's financial statements, and greater accountability. However, the egregious practices of some financial services firms (e.g., AIG, Bear Stearns, and Lehman Brothers) in recent years cast doubt on how effective the SOA has been in achieving its transparency and accountability objectives.

The costs associated with implementing SOA have been substantial. As noted in a number of studies (see Chapter 13), there is growing evidence that the monitoring costs imposed by Sarbanes-Oxley have been a factor in many small firms going private since the introduction of the legislation. However, shareholders of large firms that are required to overhaul their existing governance systems under Sarbanes-Oxley may in some cases benefit significantly.⁶ In an effort to reduce some of the negative effects of Sarbanes-Oxley, the SEC allowed foreign firms to avoid having to comply with the reporting requirements of the Act. As of June 15, 2007, foreign firms whose shares traded on U.S. exchanges constituted less than 5% of the global trading volume of such shares during the previous 12 months are no longer subject to the Sarbanes-Oxley Act. This regulatory change affects about 360 of the 1,200 foreign firms listed on U.S. stock exchanges.⁷

New York Stock Exchange listing requirements far exceed the auditor independence requirements of the Sarbanes-Oxley Act. Companies must have board audit committees consisting of at least three independent directors and a written charter describing their responsibilities in detail. Moreover, the majority of all board members must be independent, and nonmanagement directors must meet periodically without management. Board compensation and nominating committees must consist of independent directors. Shareholders must be able to vote on all stock option plans.

The SOA also created a quasi-public oversight agency, the Public Company Accounting Oversight Board (PCAOB). The PCAOB is charged with registering auditors, defining specific processes and procedures for compliance audits, quality control, and enforcing compliance with specific SOA mandates.

Antitrust laws

Federal antitrust laws exist to prevent individual corporations from assuming so much market power that they can limit their output and raise prices without concern for any significant competitor reaction. The DoJ and the FTC have the primary responsibility for enforcing federal antitrust laws. The FTC was established in the Federal Trade Commission Act of 1914 with the specific purpose of enforcing antitrust laws such as the Sherman, Clayton, and Federal Trade Commission Acts.⁸

Generally speaking, national laws do not affect firms outside their domestic political boundaries. There are two important exceptions: antitrust laws and laws applying to the bribery of foreign government officials.⁹ Outside the United States, antitrust regulation laws are described as competitiveness laws, and are intended to minimize or eliminate anticompetitive behavior. As illustrated in Case Study 2.6, the European Union antitrust regulators were able to thwart the attempted takeover of Honeywell by General Electric—two U.S. corporations with operations in the European Union. Remarkably, this occurred following the approval of the proposed takeover by U.S. antitrust authorities. The other exception, the Foreign Corrupt Practices Act, is discussed later in this chapter.

The Sherman Act

Passed in 1890, the Sherman Act makes illegal all contracts, combinations, and conspiracies that “unreasonably” restrain trade. Examples include agreements to fix prices, rig bids, allocate customers among competitors, or monopolize any part of interstate commerce. Section I of the Sherman Act prohibits new business combinations that result in monopolies or in a significant concentration of pricing power in a single firm. Section II applies to firms that already are dominant in their targeted markets. The act applies to all transactions and businesses involved in interstate commerce or, if the activities are local, all transactions and business “affecting” interstate commerce. Most states have comparable statutes prohibiting monopolistic conduct, price-fixing agreements, and other acts in restraint of trade having strictly local impact.

The Clayton Act

Passed in 1914 to strengthen the Sherman Act, the Clayton Act was created to outlaw certain practices not prohibited by the Sherman Act and so help government stop a monopoly before it developed. Section 5 of the act made price discrimination between customers illegal, unless it could be justified by cost savings associated with bulk purchases. Tying of contracts—in which a firm refuses to sell certain important products to a customer unless the customer agrees to buy other products from the firm—also was prohibited. Section 7 prohibits one company from buying the stock of another company if their combination results in reduced competition within the industry. Interlocking directorates also were made illegal when the directors were on the boards of competing firms.

Unlike the Sherman Act, which contains criminal penalties, the Clayton Act is a civil statute. The Clayton Act allows private parties that were injured by the antitrust violation to sue in federal court for three times their actual damages. State attorneys general also may bring civil suits. If the plaintiff wins, the costs must be borne by the party that violated the prevailing antitrust law, in addition to the criminal penalties imposed under the Sherman Act.

Acquirers soon learned how to circumvent the original statutes of the Clayton Act of 1914, which applied to the purchase of stock. They simply would acquire the assets, rather than the stock, of a target firm. In the Celler-Kefauver Act of 1950, the Clayton Act was amended to give the FTC the power to prohibit assets as well as stock purchases.

The Federal Trade Commission Act of 1914

This act created the FTC, consisting of five full-time commissioners appointed by the president for a seven-year term. The commissioners are supported by a staff of economists, lawyers, and accountants to assist in the enforcement of antitrust laws.

The Hart-Scott-Rodino Antitrust Improvements Act of 1976

Acquisitions involving companies of a certain size cannot be completed until certain information is supplied to the federal government and a specified waiting period has elapsed. The premerger notification allows the FTC and the DoJ sufficient time to challenge acquisitions believed to be anticompetitive before they are completed. Once the merger has taken place, it is often difficult to break it up. Table 2.2 provides a summary of prenotification filing requirements.

Table 2.2. Regulatory Prenotification Filing Requirements

	Williams Act	Hart-Scott-Rodino Act
Required filing	1 Schedule 13(D) within 10 days of acquiring 5% stock ownership in another firm 2 Ownership includes stock held by affiliates or agents of the bidder 3 Schedule 14(D)-1 for tender offers 4 Disclosure required even if 5% accumulation not followed by a tender offer	HSR filing is necessary whena: 1 Size of transaction test: The buyer purchases assets or securities >$63.4 million or 2 Size of person testb: Buyer or seller has annual sales or assets ≥$126.9 million and other party has sales or assets ≥$12.7 million Thresholds in (1) and (2) are adjusted annually by the increase in gross domestic product.
File with whom	Schedule 13(D) 1 6 copies to SEC 2 1 copy via registered mail to target's executive office 3 1 copy via registered mail to each public exchange on which target stock traded	1 Premerger Notification Office of the Federal Trade Commission 2 Director of Operations of the DoJ Antitrust Division
	Schedule 14(D)-1 1 10 copies to SEC 2 1 copy hand-delivered to target's executive offices 3 1 copy hand-delivered to other bidders 4 1 copy mailed to each public exchange on which target stock traded (each exchange also must be phoned)
Time period	1 Tender offers must stay open a minimum of 20 business days 2 Begins on date of publication, advertisement, or submission of materials to target 3 Unless the tender offer has been closed, shareholders may withdraw tendered shares up to 60 days after the initial offer	1 Review/waiting period: 30 days 2 Target must file within 15 days of bidder's filing 3 Period begins for all cash offers when bidder files; for cash/stock bids, period begins when both bidder and target have filed 4 Regulators can request 20-day extension

^a Note that these are the thresholds as of January 28, 2010.

^b The “size of person” test measures the size of the “ultimate parent entity” of the buyer and seller. The ultimate parent entity is the entity that controls the buyer and seller and is not itself controlled by anyone else. Transactions valued at more than $252.7 million are reportable even if the size of person test is not met.

Title I: What Must Be Filed?

Title I of the Act gives the DoJ the power to request internal corporate records if it suspects potential antitrust violations. The information requirements include background information on the “ultimate parent entity” of the acquiring and target parents, a description of the transaction, and all background studies relating to the transaction. The ultimate parent entity is the corporation at the top of the chain of ownership if the actual buyer is a subsidiary.

Title II: Who Must File and When?

Title II addresses the conditions under which filings must take place. As of January 28, 2010, to comply with the size of transaction test, transactions in which the buyer purchases voting securities or assets valued in excess of $63.4 million must be reported under the HSR Act. However, according to the size of person test, transactions valued at less than $63.4 million may still require filing if the acquirer or the target firm has annual net sales or total assets of at least $126.9 million and the other party has annual net sales or total assets of at least $12.7 million. These thresholds are adjusted upward by the annual rate of increase in gross domestic product.

Bidding firms must execute an HSR filing at the same time they make an offer to a target firm. The target firm also is required to file within 15 days following the bidder's filing. Filings consist of information on the operations of the two companies and their financial statements. The waiting period begins when both the acquirer and the target have filed. Either the FTC or the DoJ may request a 20-day extension of the waiting period for transactions involving securities and 10 days for cash tender offers. If the acquiring firm believes that there is little likelihood of anticompetitive effects, it can request early termination. In practice, only about one-fifth of total transactions annually require HSR filings; of these only about 4% are challenged by the regulators.¹⁰

If the regulatory authorities suspect anticompetitive effects, they will file a lawsuit to obtain a court injunction to prevent completion of the proposed transaction. Although it is rare for either the bidder or the target to contest the lawsuit, because of the expense involved, and even rarer for the government to lose, it does happen.¹¹ If fully litigated, a government lawsuit can result in substantial legal expenses as well as a significant cost in management time. Even if the FTC's lawsuit is overturned, the benefits of the merger often have disappeared by the time the lawsuit has been decided. Potential customers and suppliers are less likely to sign lengthy contracts with the target firm during the period of trial. New investment in the target is likely to be limited, and employees and communities where the target's operations are located would be subject to uncertainty. For these reasons, both regulators and acquirers often seek to avoid litigation.

How Does HSR Affect State Antitrust Regulators?

Title III expands the powers of state attorneys general to initiate triple-damage suits on behalf of individuals in their states injured by violations of the antitrust laws. This additional authority gives states the incentive to file such suits to increase state revenues.

Procedural Rules

When the DoJ files an antitrust suit, it is adjudicated in the federal court system. When the FTC initiates the action, it is heard before an administrative law judge at the FTC. The results of the hearing are subject to review by the commissioners of the FTC. Criminal actions are reserved for the DoJ, which may seek fines or imprisonment for violators. Individuals and companies also may file antitrust lawsuits. The FTC reviews complaints that have been recommended by its staff and approved by the commission. The commission as a whole then votes whether to accept or reject the hearing examiner's findings. The decision of the commission can then be appealed in the federal circuit courts. Under current guidelines, the FTC is committed to making a final decision on a complaint within 13 months.

As an alternative to litigation, a company may seek to negotiate a voluntary settlement of its differences with the FTC. Such settlements usually are negotiated during the review process and are called consent decrees. The FTC then files a complaint in the federal court along with the proposed consent decree. The federal court judge routinely approves the consent decree.

The Consent Decree

A typical consent decree requires the merging parties to divest overlapping businesses or restrict anticompetitive practices. If a potential acquisition is likely to be challenged by the regulatory authorities, an acquirer may seek to negotiate a consent decree in advance of consummating the deal. In the absence of a consent decree, a buyer often requires that an agreement of purchase and sale include a provision that allows the acquirer to back out of the transaction if it is challenged by the FTC or the DoJ on antitrust grounds. There is evidence that consent decrees to limit potential increases in business pricing power following a merger have proven successful by creating viable competitors.¹² Case Study 2.2 illustrates how regulators may use consent decrees to maintain competitive markets.

Case Study 2.2

Justice Department Requires Verizon Wireless to Sell Assets before Approving Alltel Merger

In late 2008, Verizon Wireless, a joint venture between Verizon Communications and Vodafone Group, agreed to sell certain assets to obtain Justice Department approval of their $28 billion deal with Alltel Corporation. The merger created the nation's largest wireless carrier. Under the terms of the deal, Verizon Wireless planned to buy Alltel for $5.9 billion and assume $22.2 billion in debt. The combined firms would have about 78 million subscribers nationwide.

The consent decree was required following a lawsuit initiated by the Justice Department and seven states to block the merger. Fearing the merger would limit competition, drive up consumer prices, and potentially reduce the quality of service, the settlement would require Verizon Wireless to divest assets in 100 markets in 22 states.

The proposed merger had raised concerns about what the impact would be on competition in the mainly rural, inland markets that Alltel served. Consumer advocates had argued that Verizon would not have the same incentive as Alltel to strike roaming agreements with other regional and small wireless carriers that would rely on it to provide service in areas where they lacked operations. By requiring the sale of assets, the Department of Justice hoped to ensure continued competition in the affected markets.

Discussion Questions

1. Do you believe requiring consent decrees that oblige the acquiring firm to dispose of certain target company assets is an abuse of government power? Why or why not?

2. What alternative actions could the government take to limit market power resulting from a business combination?

Antitrust Merger Guidelines for Horizontal Mergers

Understanding an industry begins with understanding its market structure. Market structure may be defined in terms of the number of firms in an industry; their concentration, cost, demand, and technological conditions; and ease of entry and exit. Intended to clarify the provisions of the Sherman and Clayton Acts, the DoJ issued largely quantitative guidelines in 1968 indicating the types of M&As the government would oppose. The guidelines were presented in terms of specific market share percentages and concentration ratios.

Concentration ratios were defined in terms of the market shares of the industry's top four or eight firms. Because of their rigidity, the guidelines have been revised to reflect the role of both quantitative and qualitative data. Qualitative data include factors such as the enhanced efficiency that might result from a combination of firms, the financial viability of potential merger candidates, and the ability of U.S. firms to compete globally.

In 1992, both the FTC and the DoJ announced a new set of guidelines indicating that they would challenge mergers creating or enhancing market power, even if there are measurable efficiency benefits. Market power is defined as a situation in which the combined firms will be able to profitably maintain prices above competitive levels for a significant period. M&As that do not increase market power are acceptable. The 1992 guidelines were revised in 1997 to reflect the regulatory authorities' willingness to recognize that improvements in efficiency over the long term could more than offset the effects of increases in market power. Consequently, a combination of firms that enhances market power would be acceptable to the regulatory authorities if it could be shown that the increase in efficiency resulting from the combination more than offsets the increase in market power. Numerous recent empirical studies support this conclusion (see Chapter 1).

In general, horizontal mergers—those between current or potential competitors—are most likely to be challenged by regulators. Vertical mergers—those involving customer-supplier relationships—are considered much less likely to result in anticompetitive effects, unless they deprive other market participants of access to an important resource.

On August 19, 2010, the 1992 guidelines were updated to further clarify how the antitrust authorities determine what constitutes anticompetitive business combinations. In general, regulators consider targeted customers and the potential for price discrimination, market definition, market share and concentration, so-called unilateral effects, coordinated effects, ease of entry, realized efficiencies, potential for business failure, and partial acquisitions. These are considered next.

Targeted Customers and the Potential for Price Discrimination

Price discrimination occurs when sellers can improve profits by raising prices to some targeted customers but not to others. For such discrimination to exist, there must be evidence that certain customers are charged higher prices even though the cost of doing business with them is no higher than selling to other customers who are charged lower prices. Furthermore, customers charged higher prices must have few alternative sources of supply.

Market Definition

Markets are defined by regulators solely in terms of the customers' ability and willingness to substitute one product for another in response to a price increase. Markets are defined by applying a hypothetical monopolist test to identify a set of products that are reasonably substitutable for the products sold by one of the merging firms. The market may be geographically defined with scope limited by such factors as transportation costs, tariff and nontariff barriers, exchange rate volatility, and so on.

Market Share and Concentration

Regulators, which are subject to data availability, calculate market shares for all firms currently producing products in the relevant market. The number of firms in the market and their respective market shares determine market concentration. Such ratios measure how much of the total output of an industry is produced by the n largest firms in the industry. The shortcomings of this approach include the frequent inability to define accurately what constitutes an industry, the failure to reflect ease of entry or exit, foreign competition, regional competition, and the distribution of firm size.

In an effort to account for the distribution of firm size in an industry, the FTC measures concentration using the Herfindahl-Hirschman Index (HHI), which is calculated by summing the squares of the market shares for each firm competing in the market. For example, a market consisting of five firms with market shares of 30, 25, 20, 15, and 10%, respectively, would have an HHI of 2,250 (30² + 25² + 20² + 15² + 10²). Note that an industry consisting of five competitors with market shares of 70, 10, 5, 5, and 5%, respectively, will have a much higher HHI score of 5,075, because the process of squaring the market shares gives the greatest weight to the firm with the largest market shares.

The HHI ranges from 10,000 for an almost pure monopoly to approximately 0 in the case of a highly competitive market. The index gives more weight to the market shares of larger firms to reflect their relatively greater pricing power. The FTC developed a scoring system, shown in Figure 2.1, that is used as one factor in determining whether the FTC will challenge a proposed merger or acquisition.

Figure 2.1 FTC actions at various market share concentration levels. HHI, Herfindahl-Hirschman Index.Source: FTC Merger Guidelines (www.ftc.gov).

Unilateral Effects

Competition within a market may be lessened significantly merely by the elimination of a firm through a merger or acquisition. For example, a merger between two firms selling differentiated products may reduce competition by enabling the merged firms to profit by unilaterally raising the price of one or both products above the premerger level. Furthermore, a merger between two competing sellers prevents buyers from negotiating lower prices by playing one seller against the other. Finally, in markets involving undifferentiated products, a firm having merged with a large competitor may restrict output in order to raise prices.

Coordinated Effects

After a merger that diminishes competition, a firm may be better able to coordinate its output and pricing decisions with the remaining firms in the industry. Such actions could include a simple understanding of what a firm would or would not do under certain circumstances. For example, if the firm with dominant market share were to reduce output, others might follow suit with the implied intent of raising product prices.

Ease of Entry

The ease of entry into the market by new competitors is considered a very important factor in determining if a proposed business combination is anticompetitive. Ease of entry is defined as entry that would be timely, likely to occur, and sufficient to counter the competitive effects of a combination of firms that temporarily increases market concentration. Barriers to entry—such as proprietary technology or knowledge, patents, government regulations, exclusive ownership of natural resources, or huge investment requirements—can limit the number of new competitors and the pace at which they enter a market.

Efficiencies

Increases in efficiency that result from a merger or acquisition can enhance the combined firms' ability to compete and thus result in lower prices, improved quality, better service, or innovation. However, efficiencies are difficult to measure and verify because they will be realized only after the merger has taken place. An example of verifiable efficiency improvements would be a reduction in the average fixed cost of production due to economies of scale.

Alternative to Imminent Failure

Regulators also take into account the likelihood that a firm will fail if it is not allowed to merge with another firm. The regulators must weigh the potential cost of the failing firm, such as a loss of jobs, against any potential increase in market power that might result from the merger of the two firms. In 2008, U.S. antitrust regulators approved the merger of XM Radio and Sirius Radio, the U.S. satellite radio industry's only competitors, virtually creating a monopoly in that industry.¹³

Partial Acquisitions

Regulators may also review acquisitions of minority positions involving competing firms if it is determined that the partial acquisition results in the effective control of the target firm. For example, a partial acquisition can lessen competition by giving the acquirer the ability to influence the competitive conduct of the target firm in that the acquirer may have the right to appoint members of the board of directors. Furthermore, the minority investment also may blunt competition if the acquirer gains access to non–publicly available competitive information.

Antitrust Guidelines for Vertical Mergers

The guidelines described for horizontal mergers also apply to vertical mergers between customers and suppliers. Vertical mergers may become a concern if an acquisition by a supplier of a customer prevents the supplier's competitors from having access to the customer. Alternatively, the acquisition by a customer of a supplier can become a concern if it prevents the customer's competitors from having access to the supplier.

Antitrust Guidelines for Collaborative Efforts

In 2000, the FTC and DoJ jointly issued new guidelines intended to explain how the agencies analyze antitrust issues with respect to collaborative efforts. Collaborative effort is the term used by the regulatory agencies to describe a range of horizontal agreements among competitors, such as joint ventures, strategic alliances, and other competitor agreements. Note that competitors include both actual and potential ones.

Regulators evaluate the impact on market share and the potential increase in market power resulting from a proposed collaborative effort. The agencies may be willing to overlook any temporary increase in market power if the participants can demonstrate that future increases in efficiency and innovation will result in lower overall selling prices or increased product quality in the long term. In general, the agencies are less likely to find a collaborative effort to be anticompetitive if (1) the participants have continued to compete through separate, independent operations or through participation in other collaborative efforts; (2) the financial interest in the effort by each participant is relatively small; (3) each participant's ability to control the effort is limited; (4) effective safeguards prevent information sharing; and (5) the duration of the collaborative effort is short.

The regulatory agencies have established two “safety zones” that provide collaborating firms with a degree of certainty that the agencies will not challenge them. First, the market shares of the collaborative effort and the participants collectively account for no more than 20% of the served market. Second, for R&D activities, there must be at least three or more independently controlled research efforts in addition to those of the collaborative effort.

Market share considerations overwhelmed other factors when the Justice Department threatened to file suit if Google and Yahoo! proceeded to implement an advertising alliance in late 2008 (see Case Study 2.3).

Case Study 2.3

Google Thwarted in Proposed Advertising Deal with Chief Rival Yahoo!

A proposal that gave Yahoo! an alternative to selling itself to Microsoft was killed in the face of opposition by U.S. government antitrust regulators. The deal called for Google to place ads alongside some of Yahoo!'s search results. Google and Yahoo! would share in the revenues generated by this arrangement. The deal was supposed to bring Yahoo! $250 million to $450 million in incremental cash flow in the first full year of the agreement. The deal was especially important to Yahoo!, due to the continued erosion in the firm's profitability and share of the online search market.

The Justice Department argued that the alliance would have limited competition for online advertising, resulting in higher fees charged to online advertisers. The regulatory agency further alleged that the arrangement would make Yahoo! more reliant on Google's already superior search capability and reduce Yahoo!'s efforts to invest in its own online search business. The regulators feared this would limit innovation in the online search industry.

On November 6, 2008, Google and Yahoo! announced the cessation of efforts to implement an advertising alliance. Google expressed concern that continuing the effort would result in a protracted legal battle and risked damaging lucrative relationships with their advertising partners.

The Justice Department's threat to block the proposal is a sign that Google can expect increased scrutiny in the future. High-tech markets often lend themselves to becoming “natural monopolies” in markets in which special factors foster market dominance by a single firm. Examples include Intel's domination of the microchip business, as economies of scale create huge barriers to entry for new competitors; Microsoft's preeminent market share in PC operating systems and related application software, due to its large installed customer base; and Google's dominance of Internet search, resulting from its demonstrably superior online search capability.

Discussion Questions

1. In what way might the DoJ actions result in increased concentration in the online search business in the future?

2. What are the arguments for and against regulators permitting “natural monopolies”?

Dodd-frank wall street reform and consumer protection act

Comprehensive in scope, the Dodd-Frank Act (the Act) substantially changed federal regulation of financial services firms, as well as some nonfinancial public companies. Generally speaking, the Act's objectives include restoring public confidence in the financial system and preventing future financial crises that threaten the viability of financial markets. The Act's provisions range from giving shareholders a say on executive compensation to greater transparency in the derivatives markets to new powers granted to the Federal Deposit Insurance Corporation (FDIC) to liquidate financial firms whose failure would threaten the U.S. financial system (i.e., systemic risk).

While the implications of the legislation are far reaching, the focus in this book is on those aspects of the Act directly impacting corporate governance; the environment in which mergers, acquisitions, and other restructuring activities take place; and participants in the corporate restructuring process. The provisions of the Act that have the greatest impact on the subject matter addressed in this book are summarized in Table 2.3 according to the categories governance and executive compensation, systemic regulation and emergency powers, capital markets (i.e., the ways businesses are financed), and financial institutions. These provisions are discussed in more detail in the chapters in which they are most applicable.

Table 2.3. Selected Dodd-Frank Act Provisions

Provision	Requirements
Governance and Executive Compensationa
Say-on-Pay	In a nonbinding vote on the board, shareholders may vote on executive compensation packages every two or three years.
Say on Golden Parachutes	Proxy statements seeking shareholder approval of acquisitions, mergers, or sale of substantially all of the company's assets must disclose any agreements with executive officers of the target or acquiring firm with regard to present, deferred, or contingent compensation.
Institutional Investor Disclosure	Institutional managers (e.g., mutual funds, pension funds) must disclose their say on pay and on golden parachutes' voting records annually.
Clawbacks	Public companies are required to develop and disclose mechanisms for recovering incentive-based compensation paid during the three years prior to earnings restatements.
Proxy Access	SEC has authority to require U.S. public firms to include shareholder nominees submitted in proxy materials.
Broker Discretionary Voting	Public stock exchanges are required to prohibit brokers from voting shares without direction from owners in the election of directors, executive compensation, or any other significant matter as determined by the SEC.
Compensation Committee Independence	SEC to define rules requiring stock exchanges to prohibit listing any issuer that does not comply with independence requirements governing compensation committee members and consultants.
Systemic Regulation and Emergency Powers
Financial Stability Oversight Council	To mitigate systemic risk, the Council, which consists of ten voting members and is chaired by the Secretary of the Treasury, monitors U.S. financial markets to identify domestic or foreign banks and some nonbank firms whose default or bankruptcy would risk the financial stability of the United States.
New Federal Reserve (Fed) Bank and Nonbank Holding Company Supervision Requirements	Bank and nonbank holding companies with consolidated assets exceeding $50 billion must • Submit plans for their rapid and orderly dissolution in the event of failure (i.e., living wills) • Provide periodic reports about the nature of their credit exposure • Limit their credit exposure to any unaffiliated company to 25% of its capital • Conduct semiannual “stress tests” to determine capital adequacy • Provide advance notice of intent to purchase voting shares in financial services firms
Limitations on Leverage	For bank holding companies whose consolidated assets exceed $50 billion, the Fed may require the firm to maintain a debt-to-equity ratio of no more than 15-to-1.
Limits on Size	The size of any single bank or nonbank cannot exceed 10% of deposits nationwide. The limitation does not apply to mergers involving troubled banks.
Capital Requirements	Bank capital requirements are to be left to the regulatory agencies and should reflect the perceived risk of bank or nonbank institutions.
Savings and Loan Regulations	Fed gains supervisory authority over all savings and loan holding companies and their subsidiaries.
Federal Deposit Insurance Corporation (FDIC)	The FDIC may guarantee obligations of solvent insured depository institutions if the Fed and the Systemic Risk Council determine that a liquidity event has occurred in the financial markets (i.e., investors cannot sell assets without incurring an unusual and significant loss).
Orderly Liquidation Authority	The FDIC may seize and liquidate a financial services firm whose failure threatens the financial stability of the United States to ensure the speedy disposition of the firm's assets and to ensure that losses are borne by shareholders and bondholders, while losses of public funds are limited.b
Capital Markets
Office of Credit Ratings	Proposes rules for internal controls, independence, transparency, and penalties for poor performance, making it easier for investors to sue for “unrealistic” ratings. Office to conduct annual audits of rating agencies.
Securitization	Issuers of asset-backed securities must retain an interest of at least 5% of any security sold to third parties.
Hedge and Private Equity Fund Registration	Advisers to private equity and hedge funds with $100 million or more in assets under management must register with the SEC as investment advisers; those with less than $100 million will be subject to state registration. Registered advisors to provide reports and be subject to periodic examinations.
Clearing and Trading of Over-the-Counter (OTC) Derivatives	Commodity Futures Trading Commission (CFTC) and SEC to mandate central clearing of certain OTC derivatives on a central exchange and the real-time public reporting of volume and pricing data, as well as the parties to the transaction.
Financial Institutions
Volcker Rule	Prohibits insured depository institutions and their holding companies from buying and selling securities with their own money (so-called proprietary trading) or sponsoring or investing in hedge funds or private equity funds. Underwriting and market-making activities are exempt. Proprietary trading may occur outside the United States as long as the bank does not own or control the entity in which it is investing. Sponsoring private funds is defined as serving as a general partner or in some way gaining control of such funds. Banks may sponsor such funds if they provide trust or investment advisory services and if the bank's name is not used in marketing the fund.
Consumer Financial Protection Bureau	Creates an agency to write rules governing all financial institutions offering consumer financial products, including banks, mortgage lenders, and credit card companies, as well as pay day lenders. The authority will apply to banks and credit unions with assets over $10 billion and all mortgage-related businesses. While institutions with less than $10 billion will have to comply, they will be supervised by their current regulators.
Federal Insurance Office	Monitors all aspects of the insurance industry (other than health insurance and long-term care), coordinates international insurance matters, consults with states regarding insurance issues of national importance, and recommends insurers that should be treated as systemically important.

^a See Chapter 3 for more details.

^b See Chapter 16 for more details.

The full impact of the bill is not likely to be known for years, since many of the rules needed to implement the new regulatory powers have yet to be written by the regulators. However, certain things seem likely. The regulatory costs associated with operating large financial firms will escalate sharply, potentially impacting both the cost and availability of credit. With the growth of such firms likely to slow, large banks are more likely to be valued as regulated utilities rather than as growth stocks.

On the plus side, large banks may warrant higher valuation multiples if investors view them as less risky. Smaller community banks and credit unions (i.e., those with less than $10 billion in total assets) are less affected by the act, since they will avoid many of its provisions such as new capital requirements and FDIC assessments to help pay for the new legislation. While these smaller institutions will have to comply with the new consumer protection bureau's regulations, enforcement will remain with their current federal and state regulators, enabling these institutions to “shop” for the most favorable regulator.

Conglomerates with significant investments in financial institutions may choose to exit such businesses as compliance costs and the potential for slower earnings growth diminishes their attractiveness. Also, the Volcker rule, which restricts the ability of banks to invest alongside their borrowers, will limit banks as lenders and investors in LBOs, a common practice during the LBO boom that ended in 2007. The elimination of broker discretionary voting in such matters as executive compensation and board elections removes votes that senior management and directors often counted on in past proxy solicitations.

Increasing the ease with which credit rating agencies can be sued in addition to increasing bank capital requirements could limit the availability of credit and boost the cost of borrowing. The new law exposes the rating agencies to liability as experts if they allow ratings to be included in public documents for bond sales such as registration statements filed with the SEC. While this liability could be mitigated by no longer requiring such ratings in prospectuses, investors will still demand some means of evaluating credit risk or higher financial returns to compensate for the uncertainty associated with some investments.

Does the Dodd-Frank Act End Government Bailouts?

Not likely. Intended to provide an efficient method of liquidating firms deemed “too big to fail,” the Orderly Liquidation Authority (OLA) in some ways enhances the government's ability to deal with such firms. The OLA establishes a payments priority that differs somewhat from Chapter 7 of the U.S. Bankruptcy Code. The new priority is intended to ensure that the brunt of losses in liquidation is borne by shareholders and creditors, not the taxpayer. If the government cannot recoup all taxpayer funds provided to the firm to fund the liquidation, it may enact a special assessment on other financial institutions regulated by the Federal Reserve.

Since it is similar to the current FDIC model for taking over and dismantling failing banks, the OLA is likely to perpetuate regulation through deal making. The FDIC commonly has liquidated failing banks by merging the bank with another financially healthy bank or has sold the assets to other investors, often with federal guarantees to pay for future losses on the acquired assets.¹⁴ Such guarantees are equivalent to an infusion of taxpayer funds into the failing firm (i.e., a bailout). Moreover, by selling failing institutions to larger banks, which is usually the case, the OLA is making more banks larger and more interconnected and potentially “too big to fail.” Finally, the OLA applies only to firms whose operations are entirely domestic, since there is currently no cross-border mechanism for resolving bank failures with operations in multiple countries. Consequently, none of the existing large multinational financial firms will be affected by the OLA.

As the receiver of the failing company, the OLA also allows for the FDIC to provide financial assistance to the firm to fund the receivership in exchange for a senior claim on the firm's assets. While the Act forbids the use of taxpayer monies to prevent the liquidation of any financial company, the government has demonstrated a willingness in times of crisis to stretch the law, as was done with the Toxic Asset Recovery Program (TARP) in 2008. Consequently, such funds may be used to sustain rather than wind down the firm. See Chapter 16 for more details on the OLA.

Finally, if the Fed and the Financial Stability Oversight Council concur, the FDIC can guarantee the liabilities of any solvent financial institution if they perceive a danger to the stability of the financial system. This authority gives these agencies wide latitude, since the criteria for implementing guarantees are highly subjective. The mere exercising of the OLA to dismantle an insolvent bank could negatively impact other banks as investors became concerned about the solvency of other financial institutions. This contagion could be used to justify government guarantees of the liabilities of these institutions.

Does the Dodd-Frank Act Address Systemic Risk Adequately?

Yes and no. It is doubtful that the Act discourages sufficiently individual firms from putting the system at risk. Since a failing firm posing systemic risk imposes costs on the financial markets well in excess of the costs it incurs, additional disincentives for assuming excessive risk need to exist—for example, paying in advance in proportion to the firm's contribution of risk to the system. The Act does not do this and threatens to make the situation worse by requiring other large financial firms to pay for the costs of liquidating the failing firms through a special FDIC assessment at a time when firms subject to the assessment are also likely to be experiencing financial duress.

The Act also fails to address huge systemically important segments of the financial markets. These include the implicit government guarantees of debt issued by the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), which own more than one-half of all U.S. residential mortgages, including a large percentage of subprime mortgages. Other systemically important markets not covered by the Act include the sale and repurchase agreements (repo) market, whose failure was at the center of the Lehman bankruptcy and the potential for runs on money market funds, which, following the Lehman bankruptcy, helped bring financial markets to a standstill.

State Regulations Affecting Mergers and Acquisitions

Numerous regulations affecting takeovers exist at the state level. The regulations often differ from one state to another, making compliance with all applicable regulations a challenge. State regulations often are a result of special interests that appeal to state legislators to establish a particular type of antitakeover statute to make it more difficult to complete unfriendly takeover attempts. Such appeals usually are made in the context of an attempt to save jobs in the state.

State Antitakeover Laws

With almost one-half of U.S. corporations incorporated in Delaware, Delaware corporate law has a substantial influence on publicly traded corporations. Delaware corporate law generally defers to the judgment of business managers and board directors in accordance with the “business judgment rule,” except in change of control situations. In takeover situations, managers are subject to an enhanced business judgment test. This requires a target board to show that there are reasonable grounds to believe that a danger to corporate viability exists and that the adoption of certain defensive measures is reasonable. While Delaware law is the norm for many companies, firms incorporated in other states often are subject to corporate law that may differ significantly from Delaware law. What follows is a discussion of commonalities across states.¹⁵

States regulate corporate charters. Corporate charters define the powers of the firm and the rights and responsibilities of its shareholders, boards of directors, and managers. However, states are not allowed to pass any laws that impose restrictions on interstate commerce or that conflict in any way with federal laws regulating interstate commerce. State laws affecting M&As tend to apply only to corporations incorporated in the state or that conduct a substantial amount of their business within the state.

These laws often contain fair price provisions, requiring that all target shareholders of a successful tender offer receive the same price as those tendering their shares. In a specific attempt to prevent highly leveraged transactions, such as leveraged buyouts, some state laws include business combination provisions, which may specifically rule out the sale of the target's assets for a specific period. By precluding such actions, these provisions limit LBOs from using the proceeds of asset sales to reduce indebtedness.

Other common characteristics of state antitakeover laws include cash-out and share control provisions. Cash-out provisions require a bidder whose purchases of stock exceed a stipulated amount to buy the remainder of the target stock on the same terms granted those shareholders whose stock was purchased at an earlier date. By forcing the acquiring firm to purchase 100% of the stock, potential bidders lacking substantial financial resources effectively are eliminated from bidding on the target. Share control provisions require that a bidder obtain prior approval from stockholders holding large blocks of target stock once the bidder's purchases of stock exceed some threshold level. The latter provision can be particularly troublesome to an acquiring company when the holders of the large blocks of stock tend to support target management.

State Antitrust Laws

As part of the Hart-Scott-Rodino Act of 1976, the states were granted increased antitrust power. State laws are often similar to federal laws. Under federal law, states have the right to sue to block mergers, even if the DoJ or FTC does not challenge them.

State Securities Laws

State blue sky laws are designed to protect individuals from investing in fraudulent security offerings. State restrictions can be more onerous than federal ones. An issuer seeking exemption from federal registration will not be exempt from all relevant registration requirements until a state-by-state exemption has been received from all of the states in which the issuer and offerees reside.

National Security-Related Restrictions on Direct Foreign Investment in the United States

While in existence for more than 50 years, the Committee on Foreign Investment in the United States (CFIUS) made the headlines in early 2006 when Dubai Ports Worldwide proposed to acquire control of certain U.S. port terminal operations. The subsequent political firestorm catapulted what had previously been a relatively obscure committee into the public limelight. CFIUS operates under the authority granted by Congress in the Exon-Florio amendment (Section 721 of the Defense Production Act of 1950). CFIUS includes representatives from an amalgam of government departments and agencies with diverse expertise to ensure that all national security issues are identified and considered in the review of foreign acquisitions of U.S. businesses.

The president can block the acquisition of a U.S. corporation based on recommendations made by CFIUS under certain conditions. These conditions include the existence of credible evidence that the foreign entity exercising control might take action that threatens national security and that existing laws do not adequately protect national security if the transaction is permitted.¹⁶

Concerns expressed by CFIUS about a proposed technology deal prevented U.S. networking company 3Com from being taken private by Bain Capital in early 2008. Under the terms of the transaction, a Chinese networking equipment company, Huaewi Technologies, would have obtained a 16.6% stake and board representation in 3Com. CFIUS became alarmed because of 3Com's sales of networking security software to the U.S. military.

The U.S. foreign corrupt practices act

The Foreign Corrupt Practices Act prohibits individuals, firms, and foreign subsidiaries of U.S. firms from paying anything of value to foreign government officials in exchange for obtaining new business or retaining existing contracts. Even though many nations have laws prohibiting bribery of public officials, enforcement tends to be lax. Of the 38 countries that signed the 1997 Anti-Bribery Convention of the Organization for Economic Cooperation and Development, more than one-half of the signatories have little or no enforcement mechanisms for preventing the bribery of foreign officials, according to a 2010 study by Transparency International. Three of the world's fastest-growing economies—China, India, and Russia—have not yet signed the agreement.

The U.S. law permits “facilitation payments” to foreign government officials if relatively small amounts of money are required to expedite goods through foreign custom inspections or to gain approval for exports. Such payments are considered legal according to U.S. law and the laws of countries in which such payments are considered routine.¹⁷

Fair disclosure (regulation FD)

The U.S. Securities and Exchange Commission adopted this regulation on August 15, 2000, to address concerns about the selective release of information by publicly traded firms. The rule aims to promote full and fair disclosure. Regulation FD requires that a publicly traded firm that discloses material nonpublic information to certain parties must release that information to the general public. Such parties could include stock analysts or holders of the firm's securities who may well trade on the basis of the information.

Rather than less information about stock prices provided by managers concerned about litigation, there are indications that there has been an increase in voluntary disclosure following the adoption of the Regulation FD. In theory, an increase in the availability of such information should reduce earnings' “surprises” and lower stock price volatility. However, studies provide conflicting results, with one study reporting an increase in share price volatility and another showing no change following the implementation of Regulation FD.¹⁸ Investors may view the reliability of such information as problematic.

Consistent with the trend toward increased voluntary disclosure of information, the fraction of U.S. acquirers disclosing synergy estimates when announcing a deal has increased from 7% in 1995 to 27% of total transactions in 2008, with much of the increase coming since the introduction of Regulation FD. A public disclosure of synergy can help the acquirer to communicate the potential value of the deal to those investors lacking the same level of information available to the firm's board and management. Deals in which synergies are disclosed tend to be larger than average (i.e., potentially more complex), are more likely to involve equity whose value depends on the future earnings of the combined acquiring and target firms, and take longer to complete, which introduces additional uncertainty. Disclosing synergies expected from a deal is associated with an increase in average announcement period abnormal returns of 2.6%.¹⁹

Regulated Industries

In addition to the DoJ and the FTC, a variety of other agencies monitor activities (including M&As) in certain industries, such as commercial banking, railroads, defense, and cable TV.

Banking

According to the Bank Merger Act of 1966, any bank merger not challenged by the attorney general within 30 days of its approval by the pertinent regulatory agency cannot be challenged under the Clayton Antitrust Act. Currently, three agencies review banking mergers. Which agency has authority depends on the parties involved in the transaction. The Office of the Comptroller of the Currency has responsibility for transactions in which the acquirer is a national bank. The Federal Deposit Insurance Corporation oversees mergers where the acquiring bank or the bank resulting from combining the acquirer and target will be a federally insured, state-chartered bank that operates outside the Federal Reserve System. The third agency is the Board of Governors of the Federal Reserve System (the Fed). It has the authority to regulate mergers in which the acquirer or the resulting bank will be a state bank that is also a member of the Federal Reserve System. Although all three agencies conduct their own review, they consider reviews undertaken by the DoJ in their decision-making process.

The regulatory landscape for acquiring so-called thrift institutions changed significantly in 2010. The Dodd-Frank legislation eliminated the Office of Thrift Supervision and transferred responsibility for regulating savings and loan associations, credit unions, and savings banks (collectively referred to as thrift institutions) to other regulators. Specifically, the Fed will supervise savings and loan holding companies and their subsidiaries; the FDIC will gain supervisory authority of all state savings banks; and the Office of the Comptroller of the Currency will supervise all federal savings banks.

M&A transactions involving financial institutions resulting in substantial additional leverage or in increased industry concentration will also come under the scrutiny of the Financial Stability Oversight Council created by the Dodd-Frank Act to monitor so-called systemic risk. The Council is empowered, among other things, to limit bank holding companies with $50 billion or more in assets or a nonbank financial company that is regulated by the Federal Reserve from merging with, acquiring, or consolidating with another firm. In extreme cases, the Council may require the holding company to divest certain assets if such company is deemed to constitute a threat to the financial stability of U.S. financial markets. Under the new legislation, the size of any single bank or nonbank cannot exceed 10% of deposits nationwide. However, this constraint may be relaxed for mergers involving failing banks.

The impetus for much of this new regulation came from the rapidity with which financial markets gave way in 2008. In one instance the regulatory authorities chose to intervene, and in another instance they did not (i.e., Lehman Brothers—see the case study at the beginning of this chapter). In an effort to minimize damage to the financial markets, the Federal Reserve moved well beyond its traditional regulatory role when it engineered a merger between commercial bank J. P. Morgan Chase and failing investment bank Bear Stearns.

Communications

The federal agency charged with oversight defers to the DoJ and the FTC for antitrust enforcement. The Federal Communications Commission (FCC) is an independent U.S. government agency directly responsible to Congress. Established by the 1934 Communications Act, the FCC is charged with regulating interstate and international communication by radio, television, wire, satellite, and cable. The FCC is responsible for the enforcement of such legislation as the Telecommunications Act of 1996. This act is intended to promote competition and reduce regulation while promoting lower prices and higher-quality services.²⁰

Railroads

The Surface Transportation Board (STB), the successor to the Interstate Commerce Commission (ICC), governs mergers of railroads. Under the ICC Termination Act of 1995, the STB employs five criteria to determine if a merger should be approved. These criteria include the impact of the proposed transaction on the adequacy of public transportation, the impact on the areas currently served by the carriers involved in the proposed transaction, and the burden of the total fixed charges resulting from completing the transaction. In addition, the interest of railroad employees is considered, as well as whether the transaction would have an adverse impact on competition among rail carriers in regions affected by the merger.

Defense

During the 1990s, the defense industry in the United States underwent substantial consolidation. This is consistent with the Department of Defense's (DoD) philosophy that it is preferable to have three or four highly viable defense contractors that could more effectively compete than a dozen weaker contractors. Although defense industry mergers are technically subject to current antitrust regulations, the DoJ and FTC have assumed a secondary role to the DoD. As noted previously, efforts by a foreign entity to acquire national security–related assets must be reviewed by the Council on Foreign Investment in the United States.

Other Regulated Industries

Historically, the insurance industry was regulated largely at the state level. Acquiring an insurance company normally requires the approval of state government and is subject to substantial financial disclosure by the acquiring company. Under the Dodd-Frank Act, the Federal Insurance Office was created within the U.S. Treasury to monitor all nonhealthcare-related aspects of the insurance industry. As a “systemic” regulator, its approval will be required for all acquisitions of insurance companies whose size and interlocking business relationships could have repercussions on the U.S. financial system.

The acquisition of more than 10% of a U.S. airline's shares outstanding is subject to approval by the Federal Aviation Administration. Effective March 8, 2008, the 27-nation European Union and the United States agreed to reduce substantially restrictions on cross-border flights under the Open Skies Act.

Public utilities are highly regulated at the state level. Like insurance companies, their acquisition requires state government approval. In 2006, the federal government eliminated the 1935 Public Utility Holding Company Act, which limited consolidation among electric utilities unless in geographically contiguous areas. Proponents of the repeal argue that mergers would produce economies of scale, improve financial strength, and increase investment in the nation's aging electricity transmission grid.

Environmental laws

Failure to comply adequately with environmental laws can result in enormous potential liabilities to all parties involved in a transaction. These laws require full disclosure of the existence of hazardous materials and the extent to which they are being released into the environment. Such laws include the Clean Water Act (1974), the Toxic Substances Control Act of 1978, the Resource Conservation and Recovery Act (1976), and the Comprehensive Environmental Response, Compensation, and Liability Act (Superfund) of 1980. Additional reporting requirements were imposed in 1986 with the passage of the Emergency Planning and Community Right to Know Act (EPCRA). In addition to EPCRA, several states also passed “right-to-know” laws, such as California's Proposition 65. The importance of state reporting laws has diminished because EPCRA is implemented by the states.

Labor and benefit laws

A diligent buyer also must ensure that the target is in compliance with the labyrinth of labor and benefit laws. These laws govern such areas as employment discrimination, immigration law, sexual harassment, age discrimination, drug testing, and wage and hour laws. Labor and benefit laws include the Family Medical Leave Act, the Americans with Disabilities Act, and the Worker Adjustment and Retraining Notification Act (WARN). WARN governs notification before plant closings and requirements to retrain workers.

Employee benefit plans frequently represent one of the biggest areas of liability to a buyer. The greatest potential liabilities often are found in defined pension benefit plans, postretirement medical plans, life insurance benefits, and deferred compensation plans. Such liabilities arise when the reserve shown on the seller's balance sheet does not accurately indicate the true extent of the future liability. The potential liability from improperly structured benefit plans grows with each new round of legislation, starting with the passage of the Employee Retirement Income and Security Act of 1974. With it the laws affecting employee retirement and pensions were strengthened by additional legislation, including the Multi-Employer Pension Plan Amendments Act of 1980, the Retirement Equity Act of 1984, the Single Employer Pension Plan Amendments Act of 1986, the Tax Reform Act of 1986, and the Omnibus Budget Reconciliation Acts of 1987, 1989, 1990, and 1993. Buyers and sellers also must be aware of the Unemployment Compensation Act of 1992, the Retirement Protection Act of 1994, and Statements 87, 88, and 106 of the Financial Accounting Standards Board.²¹

The Pension Protection Act of 2006 places a potentially increasing burden on acquirers of targets with underfunded pension plans. The new legislation requires employers with defined benefit plans to make sufficient contributions to meet a 100% funding target and erase funding shortfalls over seven years. Furthermore, the legislation requires employers with so-called “at-risk” plans to accelerate contributions. At-risk plans are those whose pension fund assets cover less than 70% of future pension obligations.

Cross-border transactions

Transactions involving firms in different countries are complicated by having to deal with multiple regulatory jurisdictions in specific countries or regions such as the European Union. The number of antitrust regulatory authorities globally has grown to over 100 from 6 in the early 1990s.²² More antitrust agencies mean more international scrutiny, potentially conflicting philosophies among regulators, and substantially longer delays in completing all types of business combinations.

The collapse of the General Electric and Honeywell transaction in 2001 underscores how much philosophical differences in the application of antitrust regulations can jeopardize major deals (see Case Study 2.6). The GE–Honeywell deal was under attack from the day it was announced in October 2000. Rival aerospace companies, including United Technologies, Rockwell, Lufthansa, Thales, and Rolls Royce, considered it inimical to their ability to compete. U.S. antitrust regulators focus on the impact of a proposed deal on customers; in contrast, EU antitrust regulators were more concerned about maintaining a level playing field for rivals in the industry. Reflecting this disparate thinking, U.S. antitrust regulators approved the transaction rapidly, concluding that it would have a salutary impact on customers. EU regulators refused to approve the transaction without GE making major concessions, which it was unwilling to do.

While the demise of the GE–Honeywell transaction reflects the risks of not properly coordinating antitrust regulatory transactions, the 2007 combination of information companies Thomson and Reuters highlights what happens when regulatory authorities are willing to work together. The transaction required approval from antitrust regulators in U.S., European, and Canadian agencies. Designing a deal that was acceptable to each country's regulator required extensive cooperation and coordination.

Antitrust law also can restrict the formation of other types of business combinations, such as joint ventures, when the resulting entity is viewed as limiting competition. Despite the potential for huge cost savings, regulators would not approve the creation of a mammoth JV between BHP Billiton and Rio Tinto in 2010. See Case Study 2.4.

Case Study 2.4

BHP Billiton and Rio Tinto Blocked by Regulators in an International Iron Ore Joint Venture

The revival in demand for raw materials in many emerging economies fueled interest in takeovers and joint ventures in the global mining and energy sectors in 2009 and 2010. BHP Billiton (BHP) and Rio Tinto (Rio), two global mining powerhouses, had hoped to reap huge cost savings by combining their Australian iron ore mining operations when they announced their JV in mid-2009. However, after more than a year of regulatory review, BHP and Rio announced in late 2010 that they would withdraw their plans to form an iron ore JV corporation valued at $116 billion after regulators in a number of countries indicated that they would not approve the proposal due to antitrust concerns.

BHP and Rio, headquartered in Australia, are the world's largest producers of iron ore, an input critical to the production of steel. Together, these two firms control about one-third of the global iron ore output. The estimated annual synergies from combining the mining and distribution operations of the two firms were estimated to be $10 billion. The synergies would come from combining BHP's more productive mining capacity with Rio's more efficient distribution infrastructure, enabling both firms to eliminate duplicate staff and redundant overhead and enabling BHP to transport its ore to coastal ports more cheaply.

The proposal faced intense opposition from the outset from steel producers and antitrust regulators. The greatest opposition came from China, which argued that the combination would concentrate pricing power further in the hands of the top iron ore producers. China imports about 50 million tons of iron ore monthly, largely from Australia, due to its relatively close proximity.

The European Commission, the Australian Competition and Consumer Commission, the Japan Fair Trade Commission, the Korea Fair Trade Commission, and the German Federal Cartel Office all advised the two firms that their proposal would not be approved in its current form. While some regulators indicated that they would be willing to consider the JV if certain divestitures and other “remedies” were made to alleviate concerns about excessive pricing power, others such as Germany said that they would not approve the proposal under any circumstances.

Discussion Questions

1. A “remedy” to antitrust regulators is any measure that would limit the ability of parties in a business combination to achieve what is viewed as excessive market or pricing power. What remedies do you believe could have been put in place by the regulators that might have been acceptable to both Rio and BHP? Be specific.

2. Why do you believe that the antitrust regulators were successful in this instance but so unsuccessful limiting the powers of cartels such as the Organization of Petroleum Exporting Countries (OPEC), which currently controls more than 40% of the world's oil production?

Some Things to Remember

The Securities Acts of 1933 and 1934 established the SEC and require that all securities offered to the public must be registered with the government. The Williams Act consists of a series of amendments to the 1934 Securities Exchange Act intended to provide target firm shareholders with sufficient information and time to adequately assess the value of an acquirer's offer. Federal antitrust laws exist to prevent individual corporations from assuming too much market power. Numerous state regulations affect M&As, such as state antitakeover and antitrust laws.

A number of industries also are subject to regulatory approval at the federal and state levels. Considerable effort must be made to ensure that a transaction is in full compliance with applicable environmental and employee benefit laws. Finally, gaining regulatory approval in cross-border transactions can be nightmarish because of the potential for the inconsistent application of antitrust laws, as well as differing reporting requirements, fee structures, and legal jurisdictions.

Discussion Questions

2.1 What were the motivations for the Federal Securities Acts of 1933 and 1934?

2.2 What was the rationale for the Williams Act?

2.3 What factors do U.S. antitrust regulators consider before challenging a transaction?

2.4 What are the obligations of the acquirer and target firms according to the Williams Act?

2.5 Discuss the pros and cons of federal antitrust laws.

2.6 Why is premerger notification (HSR filing) required by U.S. antitrust regulatory authorities?

2.7 When is a person or firm required to submit a Schedule 13(D) to the SEC? What is the purpose of such a filing?

2.8 What is the rationale behind state antitakeover legislation?

2.9 Give examples of the types of actions that may be required by the parties to a proposed merger subject to a FTC consent decree.

2.10 How might the growth of the Internet affect the application of current antitrust laws?

2.11 Having received approval from the DoJ and the FTC, Ameritech and SBC Communications received permission from the FCC to combine to form the nation's largest local telephone company. The FCC gave its approval of the $74 billion transaction, subject to conditions requiring that the companies open their markets to rivals and enter new markets to compete with established local phone companies, in an effort to reduce the cost of local phone calls and give smaller communities access to appropriate phone service. SBC had considerable difficulty in complying with its agreement with the FCC. Between December 2000 and July 2001, SBC paid the U.S. government $38.5 million for failing to provide rivals with adequate access to its network. The government noted that SBC failed repeatedly to make available its network in a timely manner, meet installation deadlines, and notify competitors when their orders were filled. Comment on the fairness and effectiveness of using the imposition of heavy fines to promote government-imposed outcomes rather than free market determined outcomes.

2.12 In an effort to gain approval of their proposed merger from the FTC, top executives from Exxon Corporation and Mobil Corporation argued that they needed to merge because of the increasingly competitive world oil market. Falling oil prices during much of the late 1990s put a squeeze on oil industry profits. Moreover, giant state-owned oil companies pose a competitive threat because of their access to huge amounts of capital. To offset these factors, Exxon and Mobil argued that they had to combine to achieve substantial cost savings. Why were the Exxon and Mobil executives emphasizing efficiencies as a justification for this merger?

2.13 How important is properly defining the market segment in which the acquirer and target companies compete in determining the potential increase in market power if the two firms are permitted to combine? Explain your answer.

2.14 Comment on whether antitrust policy can be used as an effective means of encouraging innovation. Explain your answer.

2.15 The Sarbanes-Oxley Act has been very controversial. Discuss the arguments for and against the act. Which side do you find more convincing and why?

Answers to these Chapter Discussion Questions are available in the Online Instructor's Guide for instructors using this book.

Chapter Business Cases

Case Study 2.5

Global Financial Exchanges Pose Regulatory Challenges

The year 2010 marked a turnaround for the NYSE Group, the world's largest stock and derivatives exchange measured by market capitalization. A product of the combination of the New York Stock Exchange and Euronext NV (the European exchange operator), the NYSE Group reversed the three-year slide in both its U.S. and European market share. Albeit modest, the improvement in market share was attributable largely to the decision to increase information technology spending rather than to any significant change in the regulatory environment. The key to unlocking the full potential of the international exchange remained the willingness of countries to harmonize the international regulatory environment for trading stocks and derivatives.

Valued at $11 billion, the mid-2007 merger created the first transatlantic stock and derivatives market. Organizationally, the NYSE Group operates as a holding company, with its U.S. and European operations run largely independently. The combined firms trade stocks and derivatives through the New York Stock Exchange, on the electronic Euronext Liffe Exchange in London, and on the stock exchanges in Paris, Lisbon, Brussels, and Amsterdam.

In recent years, most of the world's major exchanges have gone public and pursued acquisitions. Before this 2007 deal, the NYSE merged with electronic trading firm Archipelago Holdings, while NASDAQ Stock Market Inc. acquired the electronic trading unit of rival Instinet. This consolidation of exchanges within countries and between countries is being driven by declining trading fees, improving trading information technology, and relaxed cross-border restrictions on capital flows and in part by increased regulation in the United States. U.S. regulation, driven by Sarbanes-Oxley, contributed to the transfer of new listings (IPOs) overseas. The strategy chosen by U.S. exchanges for recapturing lost business is to follow these new listings overseas.

Larger companies that operate across multiple continents also promise to attract more investors to trading in specific stocks and derivatives contracts, which could lead to less expensive, faster, and easier trading. As exchange operators become larger, they can more easily cut operating and processing costs by eliminating redundant or overlapping staff and facilities and, in theory, pass the savings along to investors. Moreover, by attracting more buyers and sellers, the gap between prices at which investors are willing to buy and sell any given stock (i.e., the bid and ask prices) should narrow. The presence of more traders means more people are bidding to buy and sell any given stock. This results in prices that more accurately reflect the true underlying value of the security because of more competition. Furthermore, the cross-border mergers also should make it easier and cheaper for individual investors to buy and sell foreign shares. Finally, corporations now can sell their shares on several continents through a single exchange.

Before these benefits can be fully realized, numerous regulatory hurdles have to be overcome. Even if exchanges merge, they must still abide by local government rules when trading in the shares of a particular company, depending on where the company is listed. Generally, companies are not eager to list on multiple exchanges worldwide because that subjects them to many countries' securities regulations and a bookkeeping nightmare.

At the local level, little has changed in how markets are regulated. European companies list their shares on exchanges owned by the NYSE Group. These exchanges still are overseen by individual national regulators, which cooperate but are technically separate. In the United States, the Securities and Exchange Commission continues to oversee the NYSE but does not have a direct say over Europe, except in that it oversees the parent company, the NYSE Group, since it is headquartered in New York.

EU member states continue to set their own rules for clearing and settlement of trades. If the NYSE and Euronext are to achieve a more unified and seamless trading system, regulators must reach agreement on a common set of rules. Achieving this goal seems to remain well in the future. Consequently, it may be years before much of the anticipated synergies are realized.

Discussion Questions

1. What key challenges face regulators resulting from the merger of financial exchanges in different countries? How do you see these challenges being resolved?

2. In what way are these regulatory issues similar to or different from those confronting the SEC and state regulators and the European Union and individual country regulators?

3. Who should or could regulate global financial markets? Explain your answer.

4. In your opinion, would the merging of financial exchanges increase or decrease international financial stability?

Answers to these case study questions are found in the Online Instructor's Manual available to instructors using this book.

Case Study 2.6

The Legacy of GE's Aborted Attempt to Merge with Honeywell

Many observers anticipated significant regulatory review because of the size of the transaction and the increase in concentration it would create in the markets served by the two firms. Most believed, however, that, after making some concessions to regulatory authorities, the transaction would be approved due to its perceived benefits. Although the pundits were indeed correct in noting that it would receive close scrutiny, they were completely caught off guard by divergent approaches taken by the U.S. and EU antitrust authorities. U.S regulators ruled that the merger should be approved because of its potential benefits to customers. In marked contrast, EU regulators ruled against the transaction based on its perceived negative impact on competitors.

Honeywell's avionics and engines unit would add significant strength to GE's jet engine business. The deal would add about 10 cents to General Electric's 2001 earnings and could eventually result in $1.5 billion in annual cost savings. The purchase also would enable GE to continue its shift away from manufacturing and into services, which already constituted 70% of its revenues in 2000.23 The best fit was clearly in the combination of the two firms' aerospace businesses. Revenues from these two businesses alone would total $22 billion, combining Honeywell's strength in jet engines and cockpit avionics with GE's substantial business in larger jet engines. As the largest supplier in the aerospace industry, GE and Honeywell could offer airplane manufacturers “one-stop shopping” for everything from engines to complex software systems by cross-selling each other's products to their biggest customers.

Honeywell had been on the block for a number of months before the deal was consummated with GE. Its merger with Allied Signal had not been going well and contributed to deteriorating earnings and a much lower stock price. Honeywell's shares had declined in price by more than 40% since its acquisition of Allied Signal. While the euphoria surrounding the deal in late 2000 lingered into the early months of 2001, rumblings from the European regulators began to create an uneasy feeling among GE's and Honeywell's management.

Mario Monti, the European competition commissioner at that time, expressed concern about possible “conglomerate effects” or the total influence a combined GE and Honeywell would wield in the aircraft industry. He was referring to GE's perceived ability to expand its influence in the aerospace industry through service initiatives. General Electric's service offerings help to differentiate it from others at a time when the prices of many industrial parts are under pressure from increased competition, including low-cost manufacturers overseas. In a world in which manufactured products are becoming increasingly commodity-like, the true winners are those able to differentiate their product offerings. GE and Honeywell's European competitors complained to the European Union regulatory commission that GE's extensive services offering would give it entrée into many more points of contact among airplane manufacturers, from communications systems to the expanded line of spare parts GE would be able to supply. This so-called range effect or portfolio power is a relatively new legal doctrine that has not been tested in transactions of this size.²⁴

On May 3, 2001, the U.S. Department of Justice approved the buyout after the companies agreed to sell Honeywell's helicopter engine unit and take other steps to protect competition. The U.S. regulatory authorities believed that the combined companies could sell more products to more customers and therefore could realize improved efficiencies, although it would not hold a dominant market share in any particular market. Thus, customers would benefit from GE's greater range of products and possibly lower prices, but they still could shop elsewhere if they chose. The U.S. regulators expressed little concern that the bundling of products and services could hurt customers, since buyers can choose from among a relative handful of viable suppliers.

In order to understand the European position, it is necessary to comprehend the nature of competition in the European Union. France, Germany, and Spain spent billions subsidizing their aerospace industry over the years. The GE–Honeywell deal has been attacked by their European rivals, from Rolls-Royce and Lufthansa to French avionics manufacturer Thales. Although the European Union imported much of its antitrust law from the United States, the antitrust law doctrine evolved in fundamentally different ways. In Europe, the main goal of antitrust law is to guarantee that all companies are able to compete on an equal playing field. The implication is that the European Union is just as concerned about how a transaction affects rivals as it is about how it affects consumers. Complaints from competitors are taken more seriously in Europe, whereas in the United States it is the impact on consumers that constitutes the litmus test. Europeans accepted the legal concept of “portfolio power,” which argues that a firm may achieve an unfair advantage over its competitors by bundling goods and services. Also, in Europe, the European Commission's Merger Task Force can prevent a merger without taking a company to court.

The EU authorities continued to balk at approving the transaction without major concessions from the participants—concessions that GE believed would render the deal unattractive. On June 15, 2001, GE submitted its final offer to the EU regulators in a last-ditch attempt to breathe life into the moribund deal. GE knew that if it walked away, it could continue as it had before the deal was struck, secure in the knowledge that its current portfolio of businesses offered substantial revenue growth or profit potential. Honeywell clearly would fuel such growth, but it made sense to GE's management and shareholders only if it would be allowed to realize potential synergies between the GE and Honeywell businesses.

GE said it was willing to divest Honeywell units with annual revenues of $2.2 billion, including regional jet engines, air-turbine starters, and other aerospace products. Anything more would jeopardize the rationale for the deal. Specifically, GE was unwilling to agree not to bundle (i.e., sell a package of components and services at a single price) its products and services when selling to customers. Another stumbling block was the GE Capital Aviation Services unit, the airplane-financing arm of GE Capital. The EU Competition Commission argued that that this unit would use its influence as one of the world's largest purchasers of airplanes to pressure airplane manufacturers into using GE products. The commission seemed to ignore that GE had only an 8% share of the global airplane leasing market and would therefore seemingly lack the market power the commission believed it could exert.

On July 4, 2001, the European Union vetoed the GE purchase of Honeywell, marking the first time a proposed merger between two U.S. companies has been blocked solely by European regulators. Having received U.S. regulatory approval, GE could ignore the EU decision and proceed with the merger as long as it would be willing to forego sales in Europe. GE decided not to appeal the decision to the EU Court of First Instance (the second highest court in the European Union), knowing that it could take years to resolve the decision, and withdrew its offer to merge with Honeywell.

On December 15, 2005, a European court upheld the European regulator's decision to block the transaction, although the ruling partly vindicated GE's position. The European Court of First Instance said regulators were in error in assuming without sufficient evidence that a combined GE–Honeywell could crush competition in several markets. However, the court demonstrated that regulators would have to provide data to support either approval or rejection of mergers by ruling on July 18, 2006, that regulators erred in approving the combination of Sony BMG in 2004. In this instance, regulators failed to provide sufficient data to document their decision. These decisions affirm that the European Union needs strong economic justification to overrule cross-border deals. GE and Honeywell, in filing the suit, said that their appeal had been made to clarify European rules with an eye toward future deals, since they had no desire to resurrect the deal.

In the wake of these court rulings and in an effort to avoid similar situations in other geographic regions, coordination among antitrust regulatory authorities in different countries has improved. For example, in mid-2010, the U.S. Federal Trade Commission reached a consent decree with scientific instrument manufacturer Agilent in approving its acquisition of Varian, in which Agilent agreed to divest certain overlapping product lines. While both firms are based in California, each has extensive foreign operations, which necessitated gaining the approval of multiple regulators. Throughout the investigation, FTC staff coordinated enforcement efforts with the staffs of regulators in the European Union, Australia, and Japan. This cooperation was under the auspices of certain bilateral cooperation agreements, the OECD Recommendation on Cooperation among its members, and the European Union Best Practices on Cooperation in Merger Investigation protocol.

Discussion Questions

1. What are the important philosophical differences between U.S. and EU antitrust regulators? Explain the logic underlying these differences. To what extent are these differences influenced by political rather than economic considerations? Explain your answer.

2. This is the first time that a foreign regulatory body prevented a deal involving only U.S. firms from going through. What are the long-term implications, if any, of this precedent?

3. What were the major stumbling blocks between GE and the EU regulators? Why do you think these were stumbling blocks? Do you think the EU regulators were justified in their position?

4. Do you think that competitors are using antitrust to their advantage? Explain your answer.

5. Do you think the EU regulators would have taken a different position if the deal had involved a less visible firm than General Electric? Explain your answer.

Answers to these case study questions are found in the Online Instructor's Manual available to instructors using this book.

¹ Lehman temporarily moved as much as $50 billion of assets off its books in the months leading up to its financial collapse in September 2008. The firm used a version of a repo called repo 105 in which the firm paid $105 or more for each $100 they received if the counterparty agreed to hold onto the securities for several weeks. Because the counterparty agreed to hold the securities for a matter of weeks rather than the customary day or two, Lehman booked the transaction as a sale. It was viewed as a sale because Lehman did not own the securities for an extended period. While such transactions may be valid if done for sound business practices, the intent in this instance was to engage in massive deception.

² See the Securities and Exchange Commission website (www.sec.gov) and Coffee, Seligman, and Sale (2008) for a comprehensive discussion of federal securities laws.

³ According to the Insider Trading Sanctions Act of 1984, those convicted of engaging in insider trading are required to give back their illegal profits. They also are required to pay a penalty three times the magnitude of such profits. A 1988 U.S. Supreme Court ruling gives investors the right to claim damages from a firm that falsely denied it was involved in negotiations that subsequently resulted in a merger.

⁴ The Williams Act is vague as to what constitutes a tender offer so as not to construe any purchase by one firm of another in the open market as a tender offer. The courts have ruled that a tender offer generally is characterized by a bidder announcing publicly its desire to purchase a substantial block of another firm's stock with the intention of ultimately gaining control or if a substantial portion of another firm's shares are acquired in the open market or through a privately negotiated block purchase of the firm's shares.

⁵ Coates (2007)

⁶ Chaochharia and Grinstein (2007) conclude that large firms that are the least compliant with the rules around the announcement dates of certain rule implementations are more likely to display significantly positive abnormal financial returns. In contrast, small firms that are less compliant earn negative abnormal returns.

⁷ Grant, 2007

⁸ For excellent discussions of antitrust law, see the DoJ (www.usdoj.gov) and FTC (www.ftc.gov) websites and the American Bar Association (2006).

⁹ Truitt, 2006

¹⁰ In 2007, there were 2,201 HSR filings with the FTC (about one-fifth of total transactions) compared to 1,768 in 2006 (Barnett, 2008). Of these, about 4% typically are challenged and about 2% require second requests for information (Lindell, 2006). This represents a continuation of a longer-term trend. About 97% of the 37,701 M&A deals filed with the FTC between 1991 and 2004 were approved without further scrutiny (Business Week, 2008).

¹¹ Regulators filed a suit on February 27, 2004, to block Oracle's $26 per share hostile bid for PeopleSoft on antitrust grounds. On September 9, 2004, a U.S. District Court judge denied a request by U.S. antitrust authorities that he issue an injunction against the deal, arguing that the government failed to prove that large businesses can turn to only three suppliers (i.e., Oracle, PeopleSoft, and SAP) for business applications software.

¹² In a report evaluating the results of 35 divestiture orders entered between 1990 and 1994, the FTC concluded that the use of consent decrees to limit market power resulting from a business combination has proven to be successful by creating viable competitors (Federal Trade Commission, 1999b). The study found that the divestiture is likely to be more successful if it is made to a firm in a related business rather than a new entrant into the business.

¹³ The authorities recognized that neither firm would be financially viable if compelled to remain independent. The firms also argued successfully that other forms of media, such as conventional radio, represented viable competition, since they were free and XM and Sirius offered paid subscription services.

¹⁴ For example, in 2008, the FDIC agreed to pay for any losses incurred by JPMorgan Chase of up to $30 billion to induce the bank to buy the failing investment bank Bear Stearns.

¹⁵ For an excellent discussion of the state of antitakeover law in the various states, see Barzuza, 2009.

¹⁶ Following the public furor over the proposed Dubai Ports Worldwide deal, CFIUS was amended to cover investments involving critical infrastructure. The intention is to cover cross-border transactions involving energy, technology, shipping, and transportation. Some argue that it may also apply to large U.S. financial institutions in that they represent an important component of the U.S. monetary system.

¹⁷ Truitt, 2006

¹⁸ All studies show an increase in voluntary disclosure by firms (e.g., Heflin et al., 2003; Bailey et al., 2003; and Dutordoir et al., 2010). However, Bailey et al. (2003) report an increase in the variation of analysts' forecasts but no change in the volatility of share prices following the introduction of Regulation FD. In contrast, Heflin et al. (2003) finds no change in the variation of analysts' forecasts but a decrease in share price volatility.

¹⁹ Dutordoir et al., May 17, 2010.

²⁰ See the Federal Communications Commission website (www.fcc.gov).

²¹ Sherman, 2006

²² New York Times, 2001

²³ BusinessWeek, 2000b

²⁴ Murray, 2001