APPLICATION OF THE HART-SCOTT-RODINO
ACT TO VENTURE FUND TRANSACTIONS
BY MICHELE S. HARRINGTON
HOGAN & HARTSON L.L.P.
August 30, 2000
This article discusses in general terms the circumstances under
which investment funds might have to file a Hart-Scott-Rodino (“HSR”)
notification report and observe a waiting period before making certain
investments. By necessity this memorandum is very general and is not a
substitute for consulting HSR counsel on a transaction-by-transaction basis.
Part I describes the HSR Act and the three threshold tests for reportability.
Part II describes certain exemptions that are commonly applicable to venture
fund investments.
I. THE HSR ACT
The Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the
“HSR Act” or "the Act”) applies to certain acquisitions of assets or voting
securities 1/ and requires that both the “acquiring person” and the “acquired
person” file a premerger notification if the transaction satisfies each of the
three tests set forth below (the commerce test, the size-of-person test, and the
size-of-transaction test) and is not otherwise exempt. A $45,000 HSR filing
fee must accompany the acquiring person’s HSR notification.2 In addition,
the parties cannot close on a reportable transaction until the 30-day HSR
waiting period expires or is terminated.
For purposes of the Act, the acquired and acquiring persons are
not only the parties to the transaction, but include each party’s ultimate
1/
Voting securities are defined as “any securities which at present or
upon conversion entitle the owner or holder thereof to vote for the election of
directors of the issuer, or an entity included within the same person as the
issuer, . . . ." 16 C.F.R. § 801.1(f)(1). Under certain circumstances debentures
and other interests (such as convertible promissory notes) to which the right
to select directors is attached may be considered voting securities for HSR
purposes. While options, warrants, and securities convertible into common
stock are considered voting securities, the acquisition of such instruments is
exempt from the Act until the exercise or conversion of such instruments into
securities with present voting rights. 16 C.F.R. § 802.31.
2
See n.4, infra.
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parent entity (“UPE”) and all entities which its UPE controls directly or
indirectly. 16 C.F.R. § 801.1(a)(1). The term “ultimate parent entity” means
an entity which is not “controlled” by any other entity. 16 C.F.R.
§ 801.1(a)(3). Federal Trade Commission (“FTC”) regulations define “control”
as holding 50% or more of the voting securities of a corporation or having the
contractual right to designate 50% or more of its directors. Control of a
partnership or limited liability company ("LLC") is defined as having the
right to 50% or more of the profits of the partnership or LLC or the right, in
the event of dissolution, to 50% or more of the assets of the partnership or
LLC. 16 C.F.R. § 801.1(b). Thus, in order to determine the UPE of each
party to the transaction, one looks “upstream” to determine what entity
ultimately controls each party. One then looks “downstream” to all entities
which that UPE controls, either directly or indirectly, to determine what
entities are included within the “person” of which the UPE is a part. 3/
The Three Threshold Tests 4/
The Commerce Test. The HSR Act applies only if the acquiring
or acquired person is engaged in “commerce.” As used in the Act, the term
“commerce” means trade or commerce among the states, with foreign nations,
or between the District of Columbia or any territory of the United States and
any state, territory, or foreign nation. Generally the commerce test would be
satisfied with respect to investments contemplated by investment funds.
3/
Thus, for example, a group of six limited partnerships (“LPs”), with a
common general partner and a common group of investors, may be considered
different “persons” under the HSR Act so long as such LPs are not under
common control (e.g. the same entity is not entitled to at least 50% of the
profits of assets of such LPs). If no one (after aggregating the holdings of
spouses and their minor children and after aggregating the holdings of
entities that are themselves under common control) is entitled to at least 50%
of the profits or assets of the six LPs, each would be its own UPE. In this
example, when the LPs invest, as directed by their common general partner,
in the voting securities of a corporation, one would apply the threshold tests
and the exemptions to each LP separately to determine whether there is any
HSR reporting requirement with respect to that LP.
4/
At the time of the writing of this article, there is pending in both
Houses of Congress proposed legislation that would increase the HSR filing
thresholds. If enacted, such legislation would afford relief to the venture
fund community because, at least in the near term, fewer HSR filings would
be required. However, if enacted the legislation could also increase the HSR
filing fees (depending upon the value of the transaction).
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The Size-of-Transaction Test. The “size-of-transaction” test is
satisfied if an acquiring person would hold, as a result of the acquisition,
either (A) 15% or more of the voting securities or assets of the acquired
person, or (B) an aggregate amount of voting securities and assets of the
acquired person that exceeds $15 million. To determine if the size-oftransaction test is satisfied, an acquiring person would have to aggregate the
voting securities of the acquired issuer (including the voting securities of any
other issuer under common control with the acquired issuer) it currently
holds with the voting securities or assets it is acquiring in the present
transaction. Thus in many cases, while an investment fund does not have to
make a filing at the time of an initial investment, it may need to do so at the
time of a "follow-on" investment.
The Size-of-Person Test. The “size-of-person” test essentially
requires that (i) one person have annual net sales or total assets of at least
$10 million and (ii) the other person have annual net sales or total assets of
at least $100 million. Annual net sales are as stated in the most recent
regularly prepared annual statement of income and expense, and total assets
are as stated in the most recent regularly prepared balance sheet. 16 C.F.R.
§ 801.11. 5/ Under the Act, the annual net sales and total assets of all
entities under common control are aggregated with those of the UPE to
determine whether the size-of-person test is satisfied. 16 C.F.R. § 801.11. In
situations where a $100 million person is acquiring assets or voting securities
from a person not engaged in manufacturing, 6/ the size-of-person test would
not be satisfied if the acquired person had annual net sales less than $100
million and total assets of less than $10 million. 15 U.S.C. § 18A(a)(2)(B).
If any one of the three threshold tests is not satisfied with
respect to an investment contemplated by an investment fund, no HSR
notification would be required with respect to that investment.
1.
Measuring the Value of Voting Securities
In a voting securities transaction, the value of the securities in
question depends on whether those securities are publicly traded. If the
5/
The regularly prepared financials must be “of a date not more than 15
months prior to the date of [the HSR] filing . . . or the date of consummation
of the acquisition.” 16 C.F.R. § 801.11(b)(2).
6/
For HSR purposes, a “person” is engaged in manufacturing if “it
produces and derives annual net sales or revenues in excess of $1 million
from products within” SIC Codes 2000-3999. 16 C.F.R. § 801.1(j). Software,
for instance, is outside the manufacturing SIC Codes.
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securities to be acquired are publicly traded, their value is the greater of
“market price” or acquisition price. “Market price” is the lowest closing
quotation for the securities within 45 or fewer days preceding consummation
of the transaction (but not earlier than the day prior to execution of the
contract or agreement). 16 C.F.R. § 801.10(c). If the securities to be acquired
are not publicly traded, the price the parties have set is conclusive as to the
value of the securities. If the parties have not set a price, or the price is
contingent on future events, the acquiring person has an obligation to make a
good faith evaluation of the securities’ fair market value. 7/
When an acquiring person already holds voting securities of an
issuer and plans to acquire additional voting securities of that issuer (or an
entity under common control with that issuer), the acquiring person must
aggregate the value of the voting securities it will acquire (as determined
pursuant to the preceding paragraph) with the value of the voting securities
it already holds to determine if the size-of-transaction test is met. If it
already holds publicly traded securities, the value of such securities is the
“market price” (see above). If the securities already held are not publicly
traded, the value is the fair market value as determined by the acquiring
person. 16 C.F.R. § 801.13.
2.
Measuring the Percentage of Voting Securities
The size-of-transaction test turns in part on the percentage of
the issuer’s outstanding (not fully diluted) voting securities that will be held
by the acquiring person. In cases where the issuer has a charter or articles
that permit classes of voting securities to vote as a class for directors,
calculation of the outstanding voting securities must be made pursuant to a
formula descried in 16 C.F.R. § 801.12. Under this section:
[T]he percentage shall be the sum of the separate
ratios for each class of voting securities, expressed
as a percentage. The ratio for each class of voting
securities equals:
7/
The fair market value must be determined in “good faith by the board
of directors of the ultimate parent entity included within the acquiring
person, . . . or by an entity delegated that function by such board . . . . Such
determination must be made as of any day within 60 calendar days prior to
the filing of the notification required by the act, or, if such notification has
not been filed, within 60 calendar days prior to the consummation of the
acquisition.” 16 C.F.R. § 801.10(c)(3).
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(i)(A) The number of votes for directors of
the issuer which the holder of a class of voting
securities is presently entitled to cast, and as a
result of the acquisition, will become entitled to
cast, divided by,
(B)
The total number of votes for directors
of the issuer which presently may be cast by that
class, and which will be entitled to be cast by that
class after the acquisition, multiplied by,
(ii)(A) The number of directors that class is
entitled to elect, divided by (B) the total number of
directors.
See 16 C.F.R. § 801.12(b).
For example, assume that an investment fund holds 500 shares
of class A stock and no shares of class B stock of X. By virtue of its class A
holdings, the fund has 500 of the 1000 votes which may be cast by class A to
elect four of X's ten directors. Applying the formula, the fund holds 500/1000
x 4/10 or 20 percent of the voting securities of X. If, on the other hand, the
fund holds 500 shares of X's class A stock and 60 shares of X's class B stock,
the fund would hold 20 percent of the voting securities of X because of its
holdings of class A stock. As a result of its class B holdings, the fund has 60
of the 100 votes which may be cast by class B stock to elect six of X's ten
directors. Applying the formula, the fund calculates that it holds 60/100 x
6/10 or 36 percent of the voting securities of X because of its holdings of class
B stock. Since the formula requires that a person that holds different classes
of voting securities of the same issuer add together the separate percentages
calculated for each class, the fund holds a total of 56 percent (20 percent plus
36 percent) of the voting securities of X.
II.
EXEMPTIONS
While there are many exemptions to the filing requirements of
the HSR Act, only the most common exemptions in venture capital
transactions will be discussed below.
A.
The Minimum Dollar Value Exemption
In circumstances where the 15% but not the $15 million portion
of the size-of-transaction threshold test is satisfied, a “minimum dollar value”
exemption could apply. In voting securities transactions, the exemption
would apply if, as a result of the acquisition, the acquiring person would not
hold voting securities which confer control (i.e. at least 50% of the voting
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securities) of an issuer which, together with all entities which it controls, has
annual net sales or total assets of $25 million or more. 16 C.F.R. § 802.20(b).
B.
Acquisitions Not Exceeding A Greater Notification
Threshold
When a fund files a HSR notification to report its acquisition of
voting securities it must indicate what threshold it expects to cross -- $15
million worth of assets and voting securities or 15%, 25%, or 50% of the
outstanding voting securities of the acquired issuer. The fund would then
have one year from the date of the expiration or termination of that HSR
waiting period to cross the indicated threshold. 16 C.F.R. § 803.7. If the fund
crosses that threshold within a year, the fund may acquire additional voting
securities of the same issuer for five years after the expiration or termination
of the initial HSR waiting period without filing again so long as the fund does
not cross the next filing threshold. 16 C.F.R. § 802.21.
C.
Passive Investor Exemption
If the fund acquires and holds 10% or less of the outstanding
voting securities of an issuer, regardless of the value of such securities, and
the fund intends to be a “passive investor,” the fund would not have to report
its acquisition of such securities. 16 C.F.R. § 802.9. A fund would qualify as
a passive investor only if the fund acquires the voting securities “solely for
the purpose of investment.” Voting securities are held solely for the purpose
of investment “if the person holding or acquiring such voting securities has no
intention of participating in the formulation, determination, or direction of
the basic business decisions of the issuer.” 16 C.F.R. § 801.1(i)(1). 8/
8/
“Merely voting the stock” is not considered inconsistent with an intent
to be a passive investor. However, the following types of conduct could
possibly be considered inconsistent with an intent to be a passive investor:
“(1) [n]ominating a candidate for the board of directors of the issuer, (2)
proposing corporate action requiring shareholder approval; (3) soliciting
proxies; (4) having a controlling shareholder, director, officer or employee
simultaneously serving as an officer or director of the issuer; (5) being a
competitor of the issuer; or (6) doing any of the foregoing with respect to any
entity directly or indirectly controlling the issuer.” FTC Statement of Basis
and Purpose for the HSR Regulations, 43 Federal Register 33450, 33465 (July
31, 1978). Depending upon their terms, management rights agreements may
preclude an investor from invoking the passive investor exemption.
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D.
Transactions Which Do Not Directly Or Indirectly
Increase The Percentage Of Voting Securities Held
The Act also exempts from its filing requirements:
acquisitions of voting securities, if, as a result of
such acquisition, the voting securities acquired do
not increase, directly or indirectly, the acquiring
person's per centum share of outstanding voting
securities of the issuer.
15 U.S.C. § 18a(c)(10). When employing this exemption, it is important to
calculate the percentage of outstanding voting securities pre- and post- the
upcoming acquisition pursuant to the 16 C.F.R. § 801.12 formula, if
applicable, described at pages 4-5, supra. Under this exemption, depending
on the circumstances, even a substantial additional investment, if made pro
rata with other investors, may not increase the percentage held by the fund
and may thus not be reportable.
E.
The Intraperson Transaction Exemption
The intraperson transaction exemption applies to:
acquisitions of voting securities of an issuer at least
50 per centum of the voting securities of which are
owned by the acquiring person prior to such
acquisition.
15 U.S.C. § 18a(c)(3). Further, 16 C.F.R. § 802.30 provides that:
[a]n acquisition (other than the formation of a joint
venture . . . ) in which, by reason of holdings of
voting securities, the acquiring and acquired
persons are . . . the same person, shall be exempt
from the requirements of the act.
16 C.F.R. § 802.30. (emphasis added) Essentially, this exemption would
apply if the fund holds 50% or more of the outstanding voting securities of
Issuer X and intends to acquire additional shares of Issuer X voting
securities.
F.
The Institutional Investor Exemption
Certain types of institutional investors (listed in 16 C.F.R.
§ 802.64) do not have to report certain acquisitions of voting securities if:
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(1)
Made directly by an institutional investor in the ordinary
course of business and solely for the purpose of
investment;
(2)
As a result of the acquisition the acquiring person would
not control the issuer; and
(3)
As a result of the acquisition the acquiring person would
hold either
(i)
Fifteen percent or less of the outstanding voting
securities of the issuer; or
(ii)
Voting securities of the issuer valued at $25 million
or less.
16 C.F.R. § 802.64. The types of institutional investors eligible for the
institutional investor exemption include investment companies registered
under the Investment Company Act of 1940 (the “ICA”) and Small Business
Investment Companies regulated by the Small Business Administration.
However, because most venture funds are structured so as not to be an
“investment company” within the meaning of the ICA and are not licensed as
Small Business Investment Companies, the institutional investor exemption
is not likely to be available to them.
III. CONCLUSION
There are a number of published and unpublished regulations,
interpretations, and guidelines that may affect the outcome of a particular
HSR analysis. Moreover, HSR regulations and FTC interpretations of such
regulations change from time-to-time. Accordingly, this memorandum should
only be used as a generalized HSR guide, and advice should always be sought
from a HSR expert on a transaction-by-transaction basis.
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