Chapter 21: Buying Securities in Bulk

CHAPTER 21

Buying Securities in Bulk*

Methods for Acquisition of Common Stocks

Acquisition of Voting Equities through Exchanges of Securities

Acquisition of Control without Acquiring Securities by Using the Proxy Machinery

An active investor seeking control or elements of control over a publicly traded commercial entity through securities acquisition can follow several different courses of action. From a security holder’s point of view, all acquisitions of securities are either voluntary or mandatory. Voluntary refers to situations in which each individual security holder can make up his or her own mind as to whether to take certain actions. Mandatory refers to voting situations in which all security holders are forced to participate in some action once the requisite number of security holders of that class vote in favor of the action. Each of the methods under which control and quasi-control people acquire securities has advantages and disadvantages. This chapter discusses the advantages and disadvantages of each method in light of the following factors:

Pricing issues
Securities law issues
Income tax issues
Other regulations
Availability-of-information issues
Ability-to-finance issues
Financial commitment issues
Doability issues
Social issues
Speed
Rates of return

The methods reviewed below are not mutually exclusive. For example, in seeking control of a company, an activist limited by other regulations (e.g., the need for Hart-Scott-Rodino filings if more than $15 million is expended on common stock purchase) might still gain a toehold position by acquiring target company common stock for cash in the open market, then follow up by commencing a cash tender offer or by soliciting proxies seeking to elect a new slate of directors. Cash tender offers frequently are preludes to mop-up mergers.

METHODS FOR ACQUISITION OF COMMON STOCKS

There are four methods of acquiring common stock (or other securities) for cash:

1. In the open market

2. In private transactions

3. In tender offers

4. By use of proxy machinery (mergers, reverse splits, consents)

The first three are voluntary; the fourth is mandatory.

Cash Purchases in the Open Market

Pricing issues: Acquisition is possible at outside passive minority investor (OPMI) prices, which tend to be far more irrational and frequently far lower than can be obtained in negotiated transactions.
Securities law issues: No disclosure is required until the 5 percent ownership threshold is reached; no use of inside information is permitted. The Securities and Exchange Commission (SEC), though, is exceedingly tough on anything that smacks of manipulation of OPMI markets. The most important mandate of the SEC, ahead of providing disclosure and oversight of fiduciaries and quasi-fiduciaries, is protecting the integrity of OPMI market places.
Income tax issues: These are not a consideration.
Other regulations: Hart-Scott-Rodino applies when investing over $15 million.
Availability-of-information issues: These are pretty much restricted to public information.
Financial commitment issues: Buy as little or as much as desired. Margin rules may restrict the ability to borrow.
Doability issues: To gain control, investors probably need to acquire common stock by another—perhaps supplementary—method. (It may sometimes be possible, however, to “Tisch” a company, as in the takeover of control of CBS Corporation by Laurence Tisch solely by purchases of common stock in the OPMI market.) Also, owning cheap stock acquired as a toehold in OPMI market may afford very good returns for having put a company into play even if the acquirer never attains any element of control. On the other hand, if prices rise in an OPMI market, future prices to acquire control by other methods tend to become more expensive than they otherwise would have been.
Social issues: No social issues are involved.
Speed: If the object is to obtain elements of control, the timing involved is likely to be long and indeterminate.
Rates of return: The rates of return are usually plain vanilla.

Cash Purchases in Private Transactions

Pricing issues: Prices reached in negotiated transactions are often far more rational, from a control point of view, than prices in OPMI markets. (From time to time, however, there are anxious or even desperate sellers—for example, the sale of Tejon Ranch common stock by the Times Mirror Company at a 25 percent discount from OPMI market price in 1997.)
Securities law issues: Disclosure issues depend on privacy. Under Section 10(b) of the Securities Exchange Act, Rule 10b-5 is always a factor in terms of implied remedies: when do courts decide that private transactions, market sweeps of OPMI markets, or a combination of the two are mere masquerades for cash tender offers? Also, does the acquirer obtain restricted common or securities freely tradable in OPMI markets?
Income tax issues: Purchases of common stocks for cash are almost always straightforward taxable capital transactions for the sellers.
Availability-of-information issues: Privacy governs; the buyer can seek to know what the seller knows.
Ability-to-finance issues: There is the possibility of seller finance; margin rules may be a factor when there is no change of control.
Financial commitment issues: What issues there are depend on the size of the block being acquired privately. Deal expense may or may not be minimal.
Doability issues: Tying up large blocks tends to make obtaining control easier, whether the source of control is friendly, neutral, or hostile.
Social issues: Sometimes as part of a purchase, there are agreements about board representation and protection of incumbent management.
Speed: Purchase can be pretty fast—days to weeks.
Rates of return: The rates of return are usually plain vanilla.

Cash Tender Offers

Pricing issues: A premium above OPMI market price must be offered. The basic rules are as follows: Immediately after the commencement of a tender offer, the bidder must file a tender offer statement with the SEC and the issuer identifying the bidder and setting forth the source of funds, the bidder’s purpose in making the tender (free advertising?), the ownership of other securities of the issuer, and appropriate financial statements for those bidders that are not natural people if the bidders are material to a decision by security holders of the target. The tender offer has to be open at least 20 days—10 days after an increase in price. Nobody of any consequence in the OPMI market tenders until just before a tender offer is to expire. If the tender is for less than all the shares, pro-rata shares must be accepted. The announcement is made promptly and payment is made within 10 days or so after acceptance of shares tendered. If a tender offer is extended, there must be an announcement of the approximate numbers of shares tendered.
Securities law issues: With this method, securities law issues are considerably more onerous than open-market and private purchases but considerably less onerous than using proxy machinery or issuing new securities, which virtually always requires registration under the highly onerous Securities Act of 1933 as amended. Portions of the Securities Exchange Act of 1934, also known as the Williams Act, primarily govern here. In hostile takeovers, state court litigation, especially in Delaware, may take center stage. Even in a friendly takeover, there is likely the need to contend with the plaintiffs’ bar representing OPMIs in both federal and state courts. These suits are usually easy to settle, as fee awards primarily drive plaintiffs’ counsel.
Income tax issues: These are, as for other purchases, for cash.
Availability-of-information issues: In hostile takeovers, only public information is available; in friendly takeovers, there is a prior opportunity to conduct due-diligence research.
Ability-to-finance issues: Conventional finance may be readily available, starting with secured lenders and working south. Since a bidder can never obtain 100 percent acceptance for a tender offer, however, financing opportunities may be limited unless the bidder announces plans for a mop-up merger that would result in 100 percent ownership of the equity. It tends to be far easier to finance a friendly takeover than a hostile one.
Financial commitment issues: There is almost always a multimillion-dollar commitment to purchase shares. Administrative expenses, including lawyers’ fees, printing costs, information agent fees, dealer-manager/investment banker fees, corporate trustee fees, and transfer service fees, are also large.
Doability issues: The key to doability is to offer a price premium above OPMI market price. During the pendency of a cash tender offer, shares are likely to gravitate into the hands of risk arbitrageurs, who toward the conclusion of the tender-offer period will make market decisions (based on the current premiums over OPMI market prices) rather than investment decisions (based on perceptions of fundamental values). In hostile takeovers, there are always uncertainties about doability. There is a huge advantage (or sometimes disadvantage) over soliciting proxies or exchanging securities, in that tender offers are much quicker.
Social issues: If the deal is friendly or the bidder wants to make a hostile or neutral takeover, it is frequently necessary to give terms that reward incumbent managements or other control people with clout.
Speed: Making a cash tender offer is infinitely faster than using proxy machinery or issuing securities. Issuing securities requires registration under the Securities Act of 1933. In using the proxy machinery, there is an additional delay of, say, 20 to 60 days after effectiveness of a proxy statment or a registration statement so that shareholder meetings can be held.
Rates of return: If the cash tender offer is successful, the present value of control becomes important.

Although cash tender offers are classified here as voluntary (each shareholder makes up his or her own mind whether to tender), a cash tender offer becomes mandatory (i.e., coercive) when the offeror can present a meaningful threat that if enough shares are tendered, the company will deregister with the SEC and there will no longer be a public market for the shares. This can happen when there are fewer than 300 shareholders of record.

Cash Mergers through the Use of Proxy Machinery

Pricing issues: Cash mergers through the proxy machinery almost always offer a premium over OPMI market price, but there is nowhere near the same pressure as in a cash tender, because all that is needed here is the requisite vote of stockholders (e.g., anywhere from 50 percent of those voting to two thirds of outstanding holders once a 50 percent quorum votes) to bind 100 percent of the common stock to the transaction. Outside passive minority investors are a lot more attentive to sale situations at premiums over market than they are to voting situations. The price paid will be reviewed in state court, especially in Delaware, where sometimes there can be a requirement for “entire fairness.” The court will be heavily influenced, however, by OPMI market prices in determining entire fairness. Insiders control timing; they are free to pick depressed OPMI markets as the time for cash mergers.
Securities law issues: It is much more difficult to comply with the provisions of the Securities Exchange Act in soliciting merger proxies than it is in a cash tender offer. The legal liabilities here, however, are far less onerous than when common stocks are acquired for securities rather than for cash. Issuing securities publicly gives rise to strictures existing under the Securities Act of 1933. The SEC clears proxy materials before they are mailed. Lawsuits by the plaintiffs’ bar, both state and federal, are automatic in merger transactions, whether for cash or for securities. (Do insiders in merger transactions sometimes hold back some consideration initially so that they have reserve ammunition to settle stockholder suits?) In force-out mergers, state blue-sky laws, as they exist in California and Wisconsin, for example, can be a problem. In part because of time-consuming delays, it tends to be more difficult to use the cash-merger technique in hostile takeovers than to use a cash-tender offer to be followed by a mop-up merger.
Income tax issues: These are as for other cash deals. After the investor owns 100 percent of target, however, it is easier to do subsequent tax planning on behalf of the surviving companies.
Availability-of-information issues: Control people can do due- diligence research. Disclosure to OPMIs, including making admissions against interest (e.g., providing rosy forecasts), becomes crucially important.
Ability-to-finance issues: Generally, it is more easy to finance here than with any other cash purchase of common stocks.
Financial commitment issues: Usually, these involve megabucks both for the investment and for deal expenses.
Doability issues: Cash mergers are very doable if the investor controls the proxy machinery, but see securities law issues above.
Social issues: It is probably necessary to make a deal with the incumbent management and other control groups with clout.
Speed: Cash mergers are much slower than cash tender offers.
Rates of return: These can be huge, including premiums for control. In the case of the use of proxy machinery for a hostile takeover, the expenditures incurred are probably better analyzed as an investment rather than as an expense. If the investor does fairly well in a hostile proxy solicitation—even if the investor loses—incumbents mostly will pay good-size amounts to get rid of the hostile solicitor. If the hostile solicitor wins, there is no doubt that he, she, or it will be reimbursed for expenditures.

ACQUISITION OF VOTING EQUITIES THROUGH EXCHANGES OF SECURITIES

There are two methods of acquiring voting equities—common and preferred—by way of exchanges of securities:

1. The voluntary method, in which each shareholder makes up his, her, or its own mind about whether to exchange.

2. The mandatory method, in which the proxy machinery is used and in which, except for those who might perfect rights of appraisal, each shareholder has to participate in the proposed exchange provided the requisite vote of shareholders is obtained even those who perfect rights to dissent cease to be shareholders.

Voluntary

Pricing issues: It is necessary to offer a premium over the OPMI market price in terms of the consideration to be received, whether that consideration is cash, debt, preferred stock, common stock of some issuer other than the target, or combinations thereof.
Securities law issues: It is necessary to register under the relatively onerous Securities Act of 1933 (except for a Section 3(a)9 exemption, which involves different securities of the same issuer when no sales compensation is involved). Voluntary exchanges sometimes take a long time to clear the SEC, they are expensive, and their potential liabilities are large. The same problems with state lawsuits and plaintiffs’ bar exist as for cash tender offers and cash mergers.
Income tax issues: There are opportunities for tax planning. For example, the exchange of voting securities for voting securities might qualify for a tax-deferred reorganization under Section 368(b) of the Securities Act of 1933, and an exchange of voting common stock for net assets might qualify as a Section 368(c) reorganization.
Availability-of-information issues: The amount of information needed for Securities Act of 1933 registrations sometimes makes voluntary exchanges a difficult tool to use in hostile takeovers. Sometimes voluntary exchanges can be used, however, when the investor is competing against a friendly exchange offer, because then the hostile bidder can clone the friendly bidder’s registration papers in describing the target.
Ability-to-finance issues: Exchanging securities means that the initiator is getting target companies’ shareholders to finance, at least in part, the bid for control (e.g., the Worldcom bid for MCI in 1997).
Financial commitment issues: Usually, megabucks are involved for both investment and deal expenses.
Doability issues: Voluntary exchanges are okay for friendly takeovers, but they usually are harder than buying for cash.
Social issues: These tend to be huge, especially when the investor wants a friendly takeover and is willing to make a deal with the incumbents.
Speed: Voluntary exchanges are often slow, although the SEC has been speeding up the clearance of registration statements. If clearance is required from other regulators (e.g., the Federal Communications Commission [FCC] or the Federal Trade Commission [FTC]), the process can be long.
Rates of return: These can be off the charts, especially against the background that company A will trade two of its $60 million of funny money common stocks or junk bonds for $100 million of company B’s solid underlying value, giving OPMIs a 20 percent premium over market.

Mandatory

Pricing issues: These are much like those for cash merger, except that it is harder for the OPMI market to appraise the value of a securities package rather than cash. It is probable that premiums over OPMI market prices offered in exchanges are larger than for cash transactions, other things being equal. This may be especially true in voluntary exchanges.
Securities law issues: These are much like those for cash mergers, except—and this is a big exception—that the issuer has to comply with the Securities Act of 1933 (see the Worldcom S-4 red herring). The S-4 is a combination proxy statement for voting purposes and a prospectus registering securities that are being offered publicly.
Income tax issues: There is more certainty regarding the use of Section 368 under the Internal Revenue Service code to effect a tax-deferred reorganization than is the case for voluntaries. A Section 368(a) reorganization encompasses a merger transaction. Acquirers know they have 100 percent equity ownership at the conclusion of proxy solicitation.
Availability-of-information issues: These are as for a voluntary exchange.
Ability-to-finance issues: If senior debt is required from third-party lenders, it is easier to obtain here than for a voluntary exchange, in which the investor can never get 100 percent acceptance.
Financial commitment issues: Mandatory exchanges usually involve megabucks, both investment and deal expenses.
Doability issues: These are just like those for cash mergers and voluntary exchanges. Mandatory exchanges tend to be hard to use for hostile takeovers.
Social issues: These are likely to be highly important.
Speed: Mandatory exchanges are as slow as voluntary exchanges of securities, and additional time is required for a stockholder meeting after definitive materials are issued—perhaps another 20 to 60 days.
Rates of return: These are similar to the rates for voluntary exchanges, except here there may be less price sensitivity on part of the OPMI market, and as is stated above, it tends to be easier to get senior financing because acquirer will be a 100 percent holder of acquire common stock. Both these factors ought to improve returns over a pure voluntary exchange.

ACQUISITION OF CONTROL WITHOUT ACQUIRING SECURITIES BY USING THE PROXY MACHINERY

With the advent of the shark repellent, hostile contests for corporate control almost invariably end up in a proxy fight; that is, the use of the proxy machinery to get the requisite voting majorities to exercise control or elements of control. The advantages and disadvantages of the proxy machinery can be examined in light of the same factors used in the examination of security purchases.

Pricing issues: These are not relevant, but an outsider needs an issue or issues to obtain votes. The issue usually has to be the promise of improved future OPMI market prices.
Securities law issues: These are a problem. The investor needs SEC clearance and has to defend against lawsuits by incumbents in control. Incumbents have control of both the proxy machinery and the corporate treasury.
Income tax issues: Are proxy contest expenses always deductible for outsiders?
Availability-of-information issues: These are not relevant.
Ability-to-finance issues and financial-commitment issues: Securities are not acquired. The cost of hostile proxy solicitation usually runs well into seven figures for legal fees, printing costs (actual solicitation and fight letters), proxy solicitor fees, public relations (PR) costs, advertising costs, and the cost of courting large shareholders (e.g., Worldcom materials). If the attempt at the acquisition of control goes well, costs are likely to be recoverable because even if the hostile solicitor does not win, the incumbents are likely to pay to get rid of him or her. The situation may be different, however, if the outside solicitor is a strategic player in the industry rather than one engaged only in a financial transaction. Nonetheless, in terms of deal expense, the company finances all of the incumbents’ expenditures and none of the outsider’s expenditures.
Doability issues: Such acquisitions are almost always highly uncertain.
Social issues: These are usually extremely important, except when the raider can win without the necessity of making any deal with the incumbents.
Speed: The transaction speed varies. In most instances, outsiders cannot call a special meeting of shareholders; they have to do their thing at an annual meeting. Such meetings are supposed to be an annual occurrence for listed companies, but sometimes they can be postponed almost indefinitely.
Rates of return: This is an activity with a very high potential return.

SUMMARY

Active investors seeking control or elements of control over a publicly traded commercial entity through the acquisition of securities can follow several different courses of action to achieve that goal. All acquisitions of securities are either voluntary or mandatory. Voluntary refers to situations in which each individual security holder can make up his or her own mind as to whether to take certain actions. Mandatory refers to voting situations in which all security holders are forced to participate in some action once the requisite number of security holders of that class vote in favor of the action. This chapter discusses the advantages and disadvantages of each method in light of factors such as pricing issues, securities law issues, income tax issues, other regulations, availability-of-information issues, ability-to-finance issues, financial commitment issues, doability issues, social issues, speed, and rates of return.

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