Dan Loeb's Hedge Fund Filed a Form Late
On Monday the Federal Trade Commission settled a sort-of-antitrust case with Third Point, Dan Loeb's activist hedge fund. In 2011, Third Point bought some shares of Yahoo! Inc. without filing a form that the FTC thinks it should have filed. Third Point agreed to pay a fine of zero dollars and not do this again for five years; coupled with the fact that two of the five FTC commissioners dissented from the enforcement action, that suggests that the FTC case wasn't particularly great. 1 But it's a weird little story that explains something important about financial regulation.
If you want to buy more than $76.3 million worth of stock in a company, you have to file a form with the Federal Trade Commission and wait about 30 days before crossing over that threshold. 2 This is an antitrust rule -- it's called the "Hart-Scott-Rodino Antitrust Improvements Act of 1976" -- and the idea is to stop a company from accumulating a big stake in its competitor before antitrust authorities have a chance to review and decide if there's a competitive threat. So there's an exemption for acquiring shares "solely for the purpose of investment." If you don't go above 10 percent of the company, and if you have "no intention of participating in the formulation, determination, or direction of the basic business decisions of the issuer," you don't have to file. 3 Because it's hard to see what antitrust threat you could pose.
This is at least in theory a problem for activist hedge funds, since sometimes they do have an interest in "participating in the formulation, determination, or direction of the basic business decisions of the issuer." So when they want to buy more than $76.3 million of a company's stock and run a proxy fight, they tend to file for HSR.
Four years ago, Third Point, the hedge fund ran by Dan Loeb, began buying shares of Yahoo. Three of its funds bought shares, and they each exceeded the HSR threshold (then $66 million -- it goes up every year) by the end of August 2011. Third Point kept buying shares until September 8, when it filed a Schedule 13D with the Securities and Exchange Commission disclosing a 5.15 percent stake and including a punchy letter to Yahoo's board criticizing the board's leadership and previewing "an All-Star team of potential Director candidates" that Third Point wanted to put on the board. (The SEC requires a Schedule 13D within 10 days after a fund acquires more than 5 percent of a company's stock.)
Third Point made its HSR filing on September 16, a few days after Yahoo hung up on a call with Third Point and relations became more hostile. The waiting period expired on October 17. The FTC thinks that Third Point should have filed in early August, before going over the $66 million threshold, and waited until September to finish its buying. Third Point seems to have thought that it bought the shares "solely for the purpose of investment," was allowed to talk to the company and didn't need to file until it decided to go hostile.
On the letter of the law, like I said, it's not a super strong case for enforcement, but on balance I'd probably give this one to the FTC. 4
As a matter of policy, the dissenting FTC commissioners clearly have the better of it. They don't really disagree that Third Point violated the rules 5 ; they just think that the rules weren't quite meant to apply to Third Point:
In our view, pursuing an enforcement action in this matter was not in the public interest because the stock acquisition at issue here presented absolutely no threat of competitive harm and the type of shareholder advocacy pursued by the respondent here often generates well-documented benefits to the market for corporate control.
The point of the HSR rules is to prevent anticompetitive behavior: You don't want one company to buy a big stake in its competitor and use that stake to influence the competitor's business in a way that reduces competition. No one -- certainly not the FTC 6 -- thinks that Dan Loeb was buying a stake in Yahoo to make it less competitive.
More broadly, if the FTC wants to encourage competition, it should probably encourage shareholder activism. We've talked before about the theory that diversified passive institutional shareholders make companies less competitive and should be banned. You might think that theory is crazy -- lots of people do! -- but there's some core of intuitive appeal to it. Concentrated activist equity hedge funds are a natural antidote to this sort of sleepy institutional investing: If you only own, say, one Internet company, you want that company to compete fiercely, not to back off and let Google pad its margins. The right antitrust thing to do would be to encourage Loeb, not to punish him for technical violations.
Obviously there are broader policy questions around whether the government should be encouraging or discouraging activist hedge funds, and around whether the HSR rules generally strike the right balance. The Financial Times says that the Third Point "settlement is likely to reignite calls for scrapping the HSR rules, which hedge funds argue are too expensive and therefore makes it costly for shareholders to voice their concerns against a company’s management."
But there is a simpler and in some ways more important thing to realize about these rules, which is: They don't matter. I mean, they matter a little: They are rules, and you can get in some nominal trouble for breaking them. But they do not actually limit activity. If you want to buy more than $76.3 million worth of stock in a company without filing for HSR and with plans to run a proxy fight, you totally can! It is easy! There is standard technology for it! It's called "synthetic ownership," and activists use it all the time! 7
The trick is that HSR limits acquisitions of voting securities. You can't buy stock without following the rules and waiting 30 days to cross over the threshold, which can be time-consuming and expensive if you want to launch an activist campaign. 8 But you can buy cash-settled swaps to your heart's content, and those swaps give you economic exposure to the stock without the vote. (Then, as you get closer to a vote, you can do your HSR filing, sell the swaps and buy the stock. 9 ) Or you can buy call options, or put/call combos, in which you buy calls and sell puts in a way that is economically identical to buying the stock. 10 (Again, when you actually want the stock, you just do the HSR filing, wait 30 days and exercise the options.) These synthetic approaches give you the same economics as buying the stock, only without the delay of HSR. They don't give you the vote, immediately, but proxy fights take forever, and there's plenty of time to change your economic ownership into voting ownership after you announce your stake and start agitating. 11
Obviously the FTC knows about this, which makes this week's enforcement action sort of strange. I mean, I get it: There's a rule, and the FTC thinks Loeb violated it, so it has to fine him some number of dollars, though that number happens to be zero. But the FTC's own commissioners admit that there's no real antitrust purpose in preventing Loeb from accumulating an activist stake, and everyone knows that the rule doesn't actually prevent him from doing that anyway. All it does is create, as it were, rulesiness: It adds complexity and opacity, makes it easier for less-well-advised hedge funds to mess up and gives some business to Wall Street derivatives desks. It hardly seems worth it.
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Third Point "could have faced millions of dollars in penalties under the rules," says the Wall Street Journal. It didn't in part because "the violation was inadvertent and short-lived." But actually the five years thing is the most telling part. If regulators find that you broke the law, part of your settlement is usually agreeing not to break the law any more. The fact that Third Point is only agreeing not to break this law for five years suggests that no one is quite sure that this was the law to begin with.
The waiting period is usually 30 days; it can sometimes be cut short, but that requires public notice which most activist funds probably want to avoid.
The exemption is 16 C.F.R. 802.9, and the definition of "solely for the purpose of investment" is 16 C.F.R. 801.1(i)(1). Under 16 C.F.R. 802.64, "certain institutional investors" can go up to 15 percent rather than 10 percent.
The argument turns on what "solely for the purpose of investment" means. Here's the FTC's statement on the case:
Since 1978, the Commission has consistently and narrowly defined the phrase “solely for the purpose of investment” to mean that an acquiring person must “not intend to participate in the formulation of the basic business decisions of an issuer.” To illustrate this definition, the Commission has set forth various actions inconsistent with an investment-only purpose such as “[n]ominating a candidate for the board of directors of the issuer.” In this case, we allege that Third Point was communicating with third parties to ascertain their interest in becoming a candidate for Yahoo!’s board of directors, taking other steps to assemble an alternate slate of board of directors, drafting correspondence to Yahoo! announcing Third Point’s interest in joining Yahoo!’s board, internally deliberating about the possible launch of a proxy battle for Yahoo! directors, and making public statements about proposing a slate of directors at Yahoo!’s next annual meeting.
So talking to potential board nominees and even "internally deliberating" over a proxy fight might, in the FTC's view, constitute an "intention" to participate in running the business. That seems pretty weird, and you can see why Third Point would object. The Wall Street Journal reports that "Third Point went as far as to argue the FTC’s interpretation was unconstitutional, saying it essentially forces investors to pay the government in order to speak," and surely it is odd to have to pay the HSR filing fees before you can have internal deliberations about whether to run a proxy fight. Do you have to file for HSR before you think about a proxy fight?
On the other hand, that letter to Yahoo urging that it replace its directors with new, Dan-Loeb-approved directors, does kind of seem like "participating" in Yahoo's business decisions? Like I don't know what "solely for the purpose of investment" really means, but in any case a critical public letter suggesting board changes is not the action of a purely passive investor. So you can see why the FTC would object.
The settlement prevents Third Point "from relying on the investment-only exemption if they have contacted third parties to gauge their interest in joining the board of the target company, communicated with the target company about proposed candidates for its board, or engaged in other specified conduct in the four months prior to acquiring voting securities above the HSR Act threshold," which seems like a pretty generous concession from Third Point; I wouldn't have thought that either of those named actions would be enough to disqualify it.
Well, they say that "the Commission’s interpretation of the investment-only exemption in the HSR Rules is neither unreasonable nor plainly contrary to the text of the statute and regulations at issue," which isn't quite the same as agreeing with the majority.
The majority's statement says: "Contrary to what Commissioners Ohlhausen and Wright suggest, the public interest does not hinge on whether Third Point’s acquisitions of Yahoo! stock were likely to produce any competitive harm."
I've written about it before in connection with Carl Icahn. Andrew Ross Sorkin complained about it in 2008. Third Point has notably used synthetic exposures in Sony, Sotheby's and Baxter International, its latest activist situation, though at least in Baxter Third Point filed for HSR and waited the 30 days before buying most of its stake and announcing.
A little fake math in the Loeb/Yahoo example: The stock closed at $12.085 on August 9, 2011, the last day before any Third Point fund crossed the threshold; on September 7, just under a month later and just before Third Point's announcement, it was at $13.61. Third Point bought 65 million shares, worth about $786 million at the August price. Had it bought only $66 million worth and then waited a month to buy the rest, it would have spent about $876 million for those 65 million shares. (That is, $66 million at $12.085 is 5.46 million shares; buy the other 59.54 million shares at $13.61 each for $810 million; the total is $876 million.) So roughly speaking the FTC's delay would have cost Third Point an extra $90 million.
Prices from Bloomberg, calculations mine. Obviously this is not a fair calculation at all; you can't isolate (1) general passage of time, (2) the effect of Third Point's buying, (3) the effect of Third Point's announcement, etc. But in round numbers, you can see why Third Point didn't want to wait a month.
If you do this right, it's like holding the stock all along: The price at which you sell the swaps should match the price at which you buy the stock, so that you have little or no economic friction in changing from swap to stock ownership. Henry Hu and Bernard Black notably called this strategy "hidden (morphable) ownership."
Or penny-strike call options, which are also more or less equivalent to stock. Or forwards. Et cetera.
And while you have to wait 30 days, there should be no antitrust hurdle to converting into voting ownership: As the FTC recognizes here, there's no antitrust reason not to let activist fund managers accumulate voting shares.
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