Focused on speed and anonymity in making investments, hedge funds are often constrained by the Hart-Scott-Rodino Act (HSR Act). Hedge fund managers frequently seek to make quick, secret acquisitions of voting securities before other investors became aware of an opportunity. However, if the investments are substantial and result in holdings of voting securities valued above $56.7 million (unless certain exemptions apply), the HSR Act requires disclosure and a 15- to 30-day waiting period before completing the transaction. HSR-notified transactions are disclosed to the U.S. Federal Trade Commission (FTC) and Department of Justice (DOJ)—and possibly the public—depending on whether the acquiring party requests early termination.
While these constraints may be frustrating for hedge fund managers, failure to comply with HSR notification regulations can result in substantial penalties. In September 2005, the FTC fined a hedge fund (controlled by manager Scott Sacane) $350,000 for failing to report two separate acquisitions, including a purchase of $100 million in voting securities of a target corporation.
The FTC has not announced additional enforcement actions since September 2005, but it is actively monitoring hedge funds’ HSR compliance. A recent letter to the editor of The Daily Deal (published in June 2006) from Marian Bruno, director of the FTC Pre-Merger Notification Office, confirmed that the FTC is closely examining the application of HSR rules to hedge funds, aiming to emphasize enforcement and facilitate compliance.
Despite the obstacles the HSR Act imposes, certain transactions that exceed the basic HSR filing thresholds may be free from filing notification if specific rules or exemptions apply. Hedge fund clients considering the possibility of making substantial investments may benefit from consultation with the McDermott Antitrust and Competition Practice Group to determine if exemptions are available. For example, HSR regulations permit the following types of transactions to proceed without notification:
Investment Only: Acquisitions that result in holdings of less than 10 percent of an issuer’s voting securities may qualify for the “investment-only” exemption under HSR regulations. The investment must be purely passive, and the acquirer must not have the intent or means to influence the activities of the issuer. Hedge funds are often deemed activist investors and may struggle to meet the requirements of this exemption. However, in certain situations where the investment is truly passive, the investment-only exemption may apply.
This is an area of concern to the FTC, and it is expected that the FTC may soon challenge funds that have claimed the exemption for investments that were not truly passive.
Independent Investment Vehicle: An entity that is not “controlled” by any superior fund entity (as defined under HSR regulations) may be free to acquire voting securities or interests valued at less than $226.8 million if that entity falls below the “size-of-person” threshold (holding assets valued below $11.3 million) and has no regularly prepared balance sheet. Logistical constraints and the capital structure of a fund may preclude the utility of this exemption, but complex funds set up with a series of related entities may be able to take advantage of this special exemption.
Acquisition of Derivatives: In lieu of an acquisition of voting securities, a fund may contract to purchase financial derivatives tied to the market price of a target company stock. Under HSR rules, this type of contract is exempt from reporting requirements as long as the derivative does not convey beneficial ownership of the target company stock. However, the derivative contract allows the fund to wager on the future price of a stock with an independent third party, such as an investment bank, and then collect—or pay—the difference when the derivative matures. This type of investment requires some level of disclosure (to an invest-ment bank as opposed to the government), but may nonetheless allow a fund to take a financial position tied to a promising stock without acquiring the stock (and without having another party acquire the stock on its behalf).
Whether exemptions will render a given investment free from HSR notification requirements is a complex and fact-intensive question. And in all events, HSR compliance must be carefully managed with the guidance of counsel. However, hedge fund clients may, under certain circumstances, be able to take advantage of valid exemptions to rapidly acquire securities without observing HSR waiting periods.