Exam 2: The Regulatory Environment

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.

Which of the following are true about the Sherman Antitrust Act?

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

The Importance of Timing: The Express Scripts and Medco Merger • While important, industry concentration is only one of many factors antitrust regulators use in investigating proposed M&As. • The timing of the proposed Express Scripts–Medco merger could have been the determining factor in its receiving regulatory approval. ______________________________________________________________________________________ Following their rejection of two of the largest M&As announced in 2011 over concern about increased industry concentration, U.S. antitrust regulators approved on April 2, 2012, the proposed takeover of pharmacy benefits manager Medco Health Solutions Inc. (Medco) by Express Scripts Inc., despite similar misgivings by critics. Pharmacy benefit managers (PBMs) are third-party administrators of prescription drug programs responsible for processing and paying prescription drug claims. More than 210 million Americans receive drug benefits through PBMs. Their customers include participants in plans offered by Fortune 500 employers, Medicare Part D participants, and the Federal Employees Health Benefits Program. The $29.1 billion Express Scripts–Medco merger created the nation’s largest pharmacy benefits manager administering drug coverage for employers and insurers through its mail order operations, which could exert substantial influence on both how and where patients buy their prescription drugs. The combined firms will be called Express Scripts Holding Company and will have $91 billion in annual revenue and $2.5 billion in after-tax profits. Including debt, the deal is valued at $34.3 billion. Together the two firms controlled 34% of the prescription drug market in the first quarter of 2012, processing more than 1.4 billion prescriptions; CVS-Caremark is the next largest, with 17% market share. The combined firms also will represent the nation’s third-largest pharmacy operator, trailing only CVS Caremark and Walgreen Co. The Federal Trade Commission’s approval followed an intensive eight-month investigation and did not include any of the customary structural or behavioral remedies that accompany approval of mergers resulting in substantial increases in industry concentration. FTC antitrust regulators voting for approval argued that the Express Scripts–Medco deal did not present significant anticompetitive concerns, since the PBM market is more susceptible to new entrants and current competitors provide customers significant alternatives. Furthermore, the FTC concluded that Express Scripts and Medco did not represent particularly close competitors and that the merged firms would not result in monopolistic pricing power. In addition, approval may have reflected the belief that the merged firms could help reduce escalating U.S. medical costs because of their greater leverage in negotiating drug prices with manufacturers and their ability to cut operating expenses by eliminating overlapping mail-handling operations. The FTC investigation also found that most of the large private health insurance plans offer PBM services, as do other private operators. Big private employers are the major customers of PBMs and have proven to be willing to switch PBMs if another has a better offer. For example, Medco lost one-third of its business during 2011, primarily to CVS Caremark. In addition, to CVS Caremark Corp, PBM competitors include UnitedHealth, which has emerged as a recent entrant into the business. Having been one of Medco’s largest customers, UnitedHealth did not renew its contract, which expired in 2012, with Medco, which covered more than 20 million of its pharmacy benefit customers. Other competitors include Humana, Aetna, and Cigna, all of which have their own PBM services competing for managing drug benefits covered under Medicare Part D. With the loss of UnitedHealth’s business, Express Script–Medco’s share dropped from 34% in early 2012 to 29% at the end of that year. Critics of the proposed merger argued that smaller PBM firms often do not have the bargaining power and data-handling capabilities of their larger competitors. Moreover, benefit managers can steer health plan participants to their own pharmacy-fulfillment services, and employers have little choice but to agree, due to their limited leverage. Opponents argue that the combination will reduce competition, ultimately raising drug prices. As the combined firms push for greater use of mail-ordering prescriptions instead of local pharmacies, smaller pharmacies could be driven out of business, for mail-order delivery is far cheaper for both PBMs and patients than dispensing drugs at a store. -Speculate as to how the Express Scripts-Medco merger might influence the decisions of their competitors to merge? Be specific.

Case Study Short Essay Examination Questions Regulatory Challenges in Cross-Border Mergers Such mergers entail substantially greater regulatory challenges than domestic M&As. Realizing potential synergies may be limited by failure to receive support from regulatory agencies in the countries in which the acquirer and target firms have operations. ______________________________________________________________________________________ European Commission antitrust regulators formally blocked the attempted merger between the NYSE Group and Deutsche Borse on February 4, 2012, nearly one year after the exchanges first announced the deal. The stumbling block appeared to be the inability of the parties involved to reach agreement on divesting their derivatives trading markets. The European regulators argued that the proposed merger would result in the combined exchanges obtaining excessive pricing power without the sale of the derivatives trading markets. The disagreement focused on whether the exchange was viewed as primarily a European market or a global market. The NYSE Group is the world’s largest stock and derivatives exchange, as 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 in 2011. The slight improvement in market share was due more to an increase in technology spending than any 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 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 cheaper, 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. The cross-border mergers also should make it easier and cheaper for individual investors to buy and sell foreign shares. 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. 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. In the United States, the SEC still oversees the NYSE but does not have a direct say over Europe, except in that it would oversee 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 the anticipated synergies are realized. -Who should or could regulate global financial markets?

A diligent buyer must ensure that the target is in compliance with the labyrinth of labor and benefit laws, including those covering all of the following except for

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 levered 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. 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 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. A Federal Judge Reprimands Hedge Funds in their Effort to Control CSX Investors 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 would disclose 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 percent 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 percent of the target firm’s shares. The funds together could effectively gain control of a combined 19.6 percent of the firm’s stock (i.e., each fund would own 4.9 percent of the target firm’s shares and have the right to acquire via an equity swap another 4.9 percent). 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 percent 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 percent of CSX stock and had access to an additional 11.5 percent 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. -Do you agree or disagree with the federal court's ruling? Defend your position.

Insider trading involves buying or selling securities based on knowledge not available to the general public.

The U.S. Securities Act of 1933 requires that all securities offered to the public must be registered with the government.

Justice Department Blocks Microsoft’s Acquisition of Intuit In 1994, Bill Gates saw dominance of the personal financial software market as a means of becoming a central player in the global financial system. Critics argued that, by dominating the point of access (the individual personal computer) to online banking, Microsoft believed that it may be possible to receive a small share of the value of each of the billions of future personal banking transactions once online banking became the norm. With a similar goal in mind, Intuit was trying to have its widely used financial software package, Quicken, incorporated into the financial standards of the global banking system. In 1994, Intuit had acquired the National Payment Clearinghouse Inc., an electronic bill payments system integrator, to help the company develop a sophisticated payments system. By 1995, Intuit had sold more than 7 million copies of Quicken and had about 300,000 bank customers using Quicken to pay bills electronically. In contrast, efforts by Microsoft to penetrate the personal financial software market with its own product, Money, were lagging badly. Intuit’s product, Quicken, had a commanding market share of 70% compared to Microsoft’s 30%. In 1994 Microsoft made a $1.5 billion offer for Intuit. Eventually, it would increase its offer to $2 billion. To appease its critics, it offered to sell its Money product to Novell Corporation. Almost immediately, the Justice Department challenged the merger, citing its concern about the anticompetitive effects on the personal financial software market. Specifically, the Justice Department argued that, if consummated, the proposed transaction would add to the dominance of the number-one product Quicken, weaken the number two-product (Money), and substantially increase concentration and reduce competition in the personal finance/checkbook software market. Moreover, the DoJ argued that there would be few new entrants because competition with the new Quicken would be even more difficult and expensive. Microsoft and its supporters argued that government interference would cripple Microsoft’s ability to innovate and limit its role in promoting standards that advance the whole software industry. Only a Microsoft–Intuit merger could create the critical mass needed to advance home banking. Despite these arguments, the regulators would not relent on their position. On May 20, 1995, Microsoft announced that it was discontinuing efforts to acquire Intuit to avoid expensive court battle with the Justice Department. -Explain how Microsoft's acquisition of Intuit might limit the entry of new competitors into the financial software market.

U.S. antitrust regulators are most concerned about what types of transaction?

Some state anti-takeover laws contain so-called "fair price provisions" requiring that all target shareholders of a successful tender offer receive the same price as those who actually tendered their shares.

Market share is usually easy to define.

Whenever an investor accumulates 5% or more of a public company's stock, it must make a so-called 13(d) filing with the SEC.

All of the following are true of the U.S. Foreign Corrupt Practices Act except for which of the following:

Whenever an investor acquires 5% or more of public company, it must disclose its intentions, the identities of all investors, their occupation, sources of financing, and the purpose of the acquisition.

The Sarbanes-Oxley bill is intended to achieve which of the following:

Case Study Short Essay Examination Questions Regulatory Challenges in Cross-Border Mergers Such mergers entail substantially greater regulatory challenges than domestic M&As. Realizing potential synergies may be limited by failure to receive support from regulatory agencies in the countries in which the acquirer and target firms have operations. ______________________________________________________________________________________ European Commission antitrust regulators formally blocked the attempted merger between the NYSE Group and Deutsche Borse on February 4, 2012, nearly one year after the exchanges first announced the deal. The stumbling block appeared to be the inability of the parties involved to reach agreement on divesting their derivatives trading markets. The European regulators argued that the proposed merger would result in the combined exchanges obtaining excessive pricing power without the sale of the derivatives trading markets. The disagreement focused on whether the exchange was viewed as primarily a European market or a global market. The NYSE Group is the world’s largest stock and derivatives exchange, as 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 in 2011. The slight improvement in market share was due more to an increase in technology spending than any 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 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 cheaper, 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. The cross-border mergers also should make it easier and cheaper for individual investors to buy and sell foreign shares. 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. 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. In the United States, the SEC still oversees the NYSE but does not have a direct say over Europe, except in that it would oversee 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 the anticipated synergies are realized. -In your opinion, will the merging of financial exchanges increase or decrease international financial stability?

Acquisitions involving companies of a certain size cannot be completed until certain information is supplied to the federal government and until a specific waiting period has elapsed.

Employee benefit plans seldom create significant liabilities for buyers.