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Chapter 2
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The Legal and Regulatory Framework
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Federal Securities Law
• Seven main pieces of federal legislation
– Securities Act of 1933
– Securities Exchange Act of 1934
– Public Utility Holding Company Act of 1935
– Trust Indenture Act of 1939
– Investment Company Act of 1940
– Investment Advisers Act of 1940
– Securities Investor Protection Act of 1970
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• More recent developments
– Securities Act Amendments of 1975
– Shelf registration (Rule 415) [1982] — allows
registration of total amount of securities
planned over two-year period; actual issuance
date(s) chosen by firm according to its needs
for funds or to market conditions
– Private Securities Litigation Reform Act (1995)
– Securities Litigation Uniform Standard Act of
1998
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Operation of Securities Acts
• Securities Act of 1933 — recording of
information
• Securities Exchange Act of 1934 —
basis of later amendments applicable to
takeover activities
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Tender Offer Regulation —
The Williams Act of 1968
• Section 13(d) [amended 1970] — must file
Schedule 13D with SEC within 10 days of
acquiring 5% or more of the stock of any
public corporation
• Public tender offer for ownership of more than
5% must file Schedule 14D
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• Acquiring firms must disclose in Schedule
14D-1 intentions/business plans for target
• Section 14(d)(4)-(7) — regulates terms of
tender offer
• Target management — as advisors to target
shareholders must file Schedule 14D-9 with
recommendations
• Section 14(e) prohibits misrepresentation or
deceptive practices in connection with tender
offers
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Insider Trading
• Three broad categories of insider
trading regulation
– Rule 10b-5 — defines fraud, deceit
– Rule 14e-3 — insider trading in context of
tender offer
– Insider Trading Sanctions Act of 1984 —
more general
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• Traditional insider trading rules
– Section 16(a) — insiders and 10% owners
must report transactions
– Section 16(b) — can bring suit to return
profits of insider trades completed within a
six-month period
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The Racketeer Influenced and
Corrupt Organization Act of 1970
(RICO)
• Requirements: Conspiracy and repeated
acts
• Allows seizure of assets of accused
when suit is filed
• Provides for treble damages for winning
plaintiffs
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Court Cases and SEC Rules
• Liability under Rule 10b-5 (fraud, deceit)
• Two principles of insider trading
– Illegal for insiders to trade on basis of
inside information
– Illegal for outsiders to trade on basis of
information which they have
"misappropriated"
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Other Disclosure Requirements
• Notification of stock exchanges of any
material development
• Disclosure of merger talks
– Management must inform investors of
material developments affecting stock price
– Boards may not deny substantive merger
talks
– Either keep information secret so none
leaks or fully disclose accurate information
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State Regulation of Takeover
Activity
• States are primary regulators of
corporate activity
• Limitation — states cannot restrict
interstate commerce
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• State legislation
– Illinois antitakeover law [1982] — struck
down as too favorable to target
management over shareholders, bidders
– Indiana act [1987] — upheld that majority
of shareholders must approve transfer of
voting rights
– New York/New Jersey act — five-year
moratorium on second-step transactions
– Delaware law [1988] — three-year
moratorium on second-step transactions
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• Rationale — to permit more considered
response to two-tier and partial tender
offers
• Antitakeover laws have negative effects
on share prices of firms
• Laws should balance shareholder
protection and competition between
bidders vs. discouraging "abusive"
takeovers
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Antitrust Policy
• Antitrust regulations reflect two opposing
views
– Merger activity as anticompetitive
– Merger activity as an expression of
competitive processes
• Main regulatory bodies
– Department of Justice (DOJ)
– Federal Trade Commission (FTC)
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Antitrust Statutes
• Sherman Act of 1980
– Section 1 — prohibits mergers that would
tend to create monopoly or market control
– Section 2 — directed against firms that have
already become dominant in the view of the
government
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• Clayton Act of 1914
– Original Act
• Created the Federal Trade Commission (FTC)
• Section 5 — Gives FTC power to prevent firms
from engaging in harmful business practices
• Section 7 — Illegal for a company to acquire
the stock of another company if competition
could be adversely affected
• Loophole — companies circumvent by using
asset acquisitions
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– 1950 amendment
• Federal Trade Commission (FTC) has power to
block asset purchases as well as stock
purchases
• Incipiency doctrine — FTC could block mergers
if it judges there is a tendency toward increased
concentration
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• Hart-Scott-Rodino Act of 1976
– Title I — Department of Justice (DOJ) has
power to issue civil investigative demands
(CIDs) in antitrust investigation
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– Title II — premerger notification provision
• Applies to acquiring firms with sales or assets
of $100 million or more and acquired firms with
sales or assets of $10 million or more, or vice
versa
• Information submitted to DOJ and FTC to
determine legality
• Thirty-day waiting period for mergers and 15
days for tender offers
• Either agency may request 20-day extension of
waiting period for mergers and 10 days for
tender offers
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– Title III — Parens Patriae Act
• Each state is the parent or protector of
consumers and competitors
• State attorneys general are given power to
initiate triple damage suits
• State itself does not need to be injured by
violation
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Antitrust Guidelines
• Merger guidelines of 1968
– Mechanical application of concentration
tests
– Antitrust could be triggered if share of the
top four firms exceeded 10-20%
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• Merger guidelines of 1982 and later
years
– Quantitative test shifted to HerfindahlHirschman Index (HHI)
• Concentration measure based on the sum of
the squared market shares of each firm in the
industry
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• Examples
– 10 firms each with 10% market share:
HHI = 10 (102) = 1,000
– 10 firms each with 1% market share, 1 firm with 90%:
HHI = 902 + 10 (1) = 8,110
• Critical concentration levels:
– HHI less than 1,000 — no challenge
– Postmerger HHI between 1,000 and 1,800 —
investigation if HHI increased by 100
– Postmerger HHI more than 1,800 — challenge if HHI
increased by 50
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– Theory that high concentration results in
tacit collusion is invalid because:
•
•
•
•
•
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Product differences — heterogeneity
Frequency of quality changes
Frequency of new products
Technological changes
Contract complexities and variations
Cost differences among suppliers
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• Nonhorizontal mergers — less likely to
cause competitive problems
• State antitrust activity
– Increased power of states granted by HartScott-Rodino Act of 1976
– National Association of Attorneys General
(NAAG) — active in lawsuits
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Private Antitrust Suits
• Business competitors have strong
influence on antitrust policy
• Business firms can sue other firms
under antitrust laws
• Private antitrust suits may be used as
blackmail
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Regulatory Bodies
• Railroads
– Surface Transportation Board (STB)
established in 1995
– STB replaced Interstate Commerce
Commission
– STB must file notices to DOJ
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• Commercial banks
– Agencies
• Comptroller of the Currency — national banks
• Board of Governors of the Federal Reserve
System — state banks
• Federal Deposit Insurance Corporation (FDIC)
– Bank mergers subject to Section 7 of
Clayton Act of 1914
• Clayton Act modified by the Bank Merger Act of
1966
• Attorney General has 30 days to challenge any
merger approved by one of the three agencies
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• Telecommunications
– Federal Communications Commission
(FCC)
– Mergers are subject to FCC review, but
FCC defers to DOJ and FTC
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International Antitrust
• International Competition Policy
Advisory Committee — recommends
explicit antitrust policies
• United Kingdom
– Director General of Office of Fair Trading
– Secretary of State for Trade and Industry
– Monopolies and Mergers Commission
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• Japan
– Japanese government has 30 days (can
extend by 60 days) to review transaction
– Review not required in stock for stock
deals
• Europe
– Premerger notification to Minister of
Competition of European Union
– European Union renders decision within
five months
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Regulation by Publicity
• Pressure on government regulators to limit
and penalize use of junk bonds
• Managers feared their use in takeovers
• Junk bonds fulfill several beneficial roles
– Finance the takeover of underperforming firms
– Fill financing gap for new risky growth firms
– Use in takeovers lead to value enhancement
for shareholders
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Illustrative Examples of
Application of HHI
1a. Assume an industry dominated by a
single large firm which controls 50%
of the market. The remaining 50% of
the market is controlled by five firms
each with a 10% market share.
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What is the 4-firm concentration ratio?
50 + 10 + 10 + 10 = 80%
What is the HHI?
1(50)2 + 5(10)2 = 2,500 + 500 = 3,000
Whatever the measure of concentration,
this market would be classified as highly
concentrated.
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1b. Now suppose that two of the smaller
firms in this industry merge.
What would be the effect on the
4-firm concentration ratio?
50 + 20 + 10 + 10 = 90%
What would be the effect on the HHI?
1(50)2 + 1(20)2 + 3(10)2
= 2,500 + 400 + 300 = 3,200
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Both measures of concentration have
increased. The market was already
highly concentrated, and the increase
in the HHI is 200 points. A challenge
of the merger between two of the
smaller firms would occur based on
the HHI tests.
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1c. Suppose that the merger in 1b
increases the ability of the merged firm
to compete with the dominant firm. For
example, suppose the merged firm is
able to take away 10% of the market
from the larger firm.
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What is the effect of this on the
4-firm concentration ratio?
40 + 30 + 10 + 10 = 90%
(no change from 1b)
What is the effect on HHI?
1(40)2 + 1(30)2 + 3(10)2
= 1,600 + 900 + 300 = 2,800
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The HHI has declined by 400 points,
reflecting reduction in market share
of the dominant firm.
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2a. Now consider an unconcentrated
industry (defined in the 1982 merger
guidelines as an industry with an HHI
below 1,000). Twenty-five firms in an
industry each have a market share of
4%.
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What is the 4-firm concentration
ratio?
4 + 4 + 4 + 4 = 16%
What is the HHI?
25(4)2 = 400
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2b. Two of the firms in the industry
propose to merge.
What is the effect on the 4-firm
concentration ratio?
8 + 4 + 4 + 4 = 20%
What is the effect on the HHI?
23(4)2 + 1(8)2 = 368 + 64 = 432
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Using the 4-firm ratio, antitrust action
might be taken. Using the HHI, the
industry would still be classified as
unconcentrated.
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