Exam 2: The Regulatory Environment

Regulators often consider market concentration when determining whether an M&A will drive up prices and reduce consumer choice and product/service quality. What is an acceptable level of concentration often is difficult to determine. Concentration may be an outgrowth of the high capital requirements of the industry. Attempts to limit concentration may actually work to the detriment of some consumers. ______________________________________________________________________________________ United States antitrust regulators have moved aggressively in recent years to block horizontal mergers (i.e., those involving direct or potential competitors) while being more lenient on vertical deals (i.e., those in which a firm buys a supplier or distributor). These actions foreshadowed the likely outcome of the deal proposed by telecommunications giant AT&T to acquire T-Mobile for $39 billion in cash in early 2011. Despite the unfavorable regulatory environment for horizontal deals, AT&T expressed confidence that it could get approval for the deal when it accepted a sizeable termination fee as part of the agreement if it did not complete the transaction by March 2012. However, the deal would never be completed, as U.S. antitrust regulators made it clear that a tie-up between number two, AT&T (behind Verizon), and number four, T-Mobile (behind Sprint), would not be permitted. On December 20, 2011, AT&T announced that it would cease its nine-month fight to acquire T-Mobile. AT&T was forced to pay T-Mobile’s parent, Deutsche Telekom, $3 billion in cash and a portion of its wireless spectrum (i.e., cellular airwaves) valued at as much as $1 billion. T-Mobile and AT&T did agree to enter into a seven-year roaming agreement that could cost AT&T another $1 billion. The announcement came shortly after AT&T had ceased efforts to fight the Justice Department’s lawsuit filed in August 2011 to block the merger. The Justice Department would not accept any combination of divestitures or other changes to the deal, arguing that the merger would raise prices to consumers and reduce both choice and service quality. Instead, the Justice Department opted to keep a “strong” fourth competitor rather than allow increased industry concentration. But T-Mobile’s long-term viability was in doubt. The firm’s parent, Deutsche Telekom, had made it clear that it wants to exit the mature U.S. market and that it has no intention of investing in a new high-speed network. T-Mobile is the only national carrier that does not currently have its own next-generation high-speed network. Because it is smaller and weaker than the other carriers, it does not have the cash or the marketing clout with handset vendors to offer exclusive, high-end smartphones to attract new customers. While competitors Verizon and AT&T gained new customers, T-Mobile lost 90,000 customers during 2011. In response to these developments, T-Mobile announced a merger with its smaller rival MetroPCS on October 3, 2012, creating the potential for a stronger competitor to Verizon and AT&T and solving regulators’ concerns about increased concentration. However, it creates another issue by reducing competition in the prepaid cell phone segment. MetroPCS’s low-cost, no-contract data plans and cheaper phones brought cellphones and mobile Internet to millions of Americans who could not afford major-carrier contracts. While T-Mobile announced the continuation of prepaid service, it has an incentive not to make it so attractive as to cause its own more profitable contract customers to shift to the prepaid service as their contracts expire. While T-Mobile also announced plans to develop a new high-speed network, it will be late to the game. Some industries are more prone to increasing concentration because of their high capital needs. Only the largest and most financially viable can support the capital outlays required to support national telecom networks. While the U.S. Justice Department has sent a clear signal that mergers in highly concentrated industries are likely to be disallowed, it is probable that the U.S. cellular industry will become increasingly concentrated despite disallowing the AT&T/T-Mobile merger due to the highly capital-intensive nature of the business. Justice Department Requires VeriFone Systems to Sell Assets before Approving Hypercom Acquisition • Asset sales commonly are used by regulators to thwart the potential build-up of market power resulting from a merger or acquisition. • In such situations, defining the appropriate market served by the merged firms is crucial to identifying current and potential competitors. ______________________________________________________________________________ In late 2011, VeriFone Systems (VeriFone) reached a settlement with the U.S. Justice Department to acquire competitor Hypercom Corp on the condition it sold Hypercom’s U.S. point-of-sale terminal business. Business use point-of-sale terminals are used by retailers to accept electronic payments such as credit and debit cards. The Justice Department had sued to block the $485 million deal on concerns that the combination would limit competition in the market for retail checkout terminals. The asset sale is intended to create a significant independent competitor in the U.S. The agreement stipulates that private equity firm Gores Group LLC will buy the terminals business. San Jose, California-based VeriFone is the second largest maker of electronic payment equipment in the U.S. and Hypercom, based in Scottsdale, Arizona, is number three. Together, the firms control more than 60 percent of the U.S. market for terminals used by retailers. Ingenico SA, based in France, is the largest maker of card-payment terminals. The Justice Department had blocked a previous attempt to sell Hypercom’s U.S. point-of-sale business to rival Ingenico, saying that it would have increased concentration and undermined competition. VeriFone will retain Hypercom’s point-of-sale equipment business outside the U.S. The acquisition will enable VeriFone to expand in the emerging market for payments made via mobile phones by giving it a larger international presence in retail stores and the opportunity to install more terminals capable of accepting mobile phone payments abroad. -Do you believe requiring consent decrees that oblige the acquiring firm to dispose of certain target company assets is an abuse of government power? Why or why not?

Alliances and joint ventures are likely to receive more intensive scrutiny by regulators because of their tendency to be more anti-competitive than M&As.

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. -How might the proliferation of Internet usage in the twenty-first century change your answer to question 1?

There are no state statutes affecting proposed takeovers.

All of the following factors are considered by U.S. antitrust regulators except for

Unlike the Sherman Act, which contains criminal penalties, the Clayton Act is a civil statute and allows private parties injured by the antitrust violations to sue in federal court for a multiple of their actual damages.

Google Thwarted in Proposed Advertising Deal with Chief Rival Yahoo! A proposal that gave Yahoo! an alternative to selling itself to Microsoft was killed in the face of opposition by U.S. government antitrust regulators. The deal called for Google to place ads alongside some of Yahoo!'s search results. Google and Yahoo! would share in the revenues generated by this arrangement. The deal was supposed to bring Yahoo! $250 million to $450 million in incremental cash flow in the first full year of the agreement. The deal was especially important to Yahoo!, due to the continued erosion in the firm's profitability and share of the online search market. The Justice Department argued that the alliance would have limited competition for online advertising, resulting in higher fees charged to online advertisers. The regulatory agency further alleged that the arrangement would make Yahoo! more reliant on Google's already superior search capability and reduce Yahoo!'s efforts to invest in its own online search business. The regulators feared this would limit innovation in the online search industry. On November 6, 2008, Google and Yahoo! announced the cessation of efforts to implement an advertising alliance. Google expressed concern that continuing the effort would result in a protracted legal battle and risked damaging lucrative relationships with their advertising partners. The Justice Department's threat to block the proposal is a sign that Google can expect increased scrutiny in the future. High-tech markets often lend themselves to becoming "natural monopolies" in markets in which special factors foster market dominance by a single firm. Examples include Intel's domination of the microchip business, as economies of scale create huge barriers to entry for new competitors; Microsoft's preeminent market share in PC operating systems and related application software, due to its large installed customer base; and Google's dominance of Internet search, resulting from its demonstrably superior online search capability. -What are the arguments for and against regulators permitting "natural monopolies"?

If the regulatory authorities suspect that a potential transaction may be anti-competitive, they will file a lawsuit to prevent completion of the transaction.

Why do you believe the regulators approved the deal despite the large increase in industry concentration and their awareness that historically increases in concentration would likely result in a further reduction in industry capacity?

Mergers and acquisitions are subject to federal regulation only.

The Herfindahl-Hirschman Index is a measure of industry concentration used by U.S. antitrust regulators in determining whether to accept or reject a proposed merger.

The Williams Act of 1968 consists of a series of amendments to the Securities Act of 1933, and it is intended to protect target firm shareholders from lighting fast takeovers in which they would not have enough time to adequately assess the value of an acquirer's offer.

Having received approval from the Justice Department and the Federal Trade Commission, Ameritech and SBC Communications received permission from the Federal Communications Commission to form the nation's largest local telephone company. The FCC gave its approval of the $74 billion transaction, subject to conditions requiring that the companies open their markets to rivals and enter new markets to compete with established local phone companies. SBC had considerable difficulty in complying with its agreement with the FCC. Between December 2000 and July 2001, SBC paid the U.S. government $38.5 million for failing to provide adequately rivals with access to its network. The government noted that SBC failed repeatedly to make available its network in a timely manner, to meet installation deadlines, and to notify competitors when their orders were filled. Comment on the fairness and effectiveness of using the imposition of heavy fines to promote government-imposed outcomes, rather than free market outcomes..

State "blue sky" laws are designed to

Antitrust regulators rarely consider the impact of a proposed takeover on product and technical innovation.

Which other types of legislation can have a significant impact on a proposed transaction?

All of the following are true about a consent decree except for

Foreign competitors are not relevant to antitrust regulators when trying to determine if a merger of two domestic firms would create excessive pricing power.

The requirements to be listed on most major public exchanges far exceed the auditor independence requirements of the Sarbanes-Oxley Act.

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. -What criteria might have been used to prove collusion between TCI and 3G in the absence of signed agreements to coordinate their efforts to accumulate CSX voting shares?