The filing by the DOJ of a complaint in federal court on April 4, 2016 against ValueAct — claiming that ValueAct’s purchase of shares of two public companies violated the HSR Act’s notification and waiting period requirements and seeking $19 million in civil penalties (based on the $16,000 per day penalty provisions of the HSR Act) – has the potential to have an immediate impact on the tactics used by brand name “activist hedge funds,” such as ValueAct, to accumulate shares without prior notice to either the issuers in question or the market generally.
As some of the activism advocates from academia have observed, the imposition of any limitations on the ability of these hedge funds to accumulate shares without prior public disclosure that these accumulations are or will be occurring “can be expected to reduce the returns to [activist] blockholders and thereby reduce the incidence and size of outside [activist] blocks as well as [activist] blockholders’ investments in monitoring and engagement.” In other words, impediments to the ability to buy shares “under the radar” will hit activist hedge funds where it counts most –i.e., by increasing their upfront investment costs.
The ValueAct complaint has the potential to force activists into alternative approaches to avoiding advance disclosure of future accumulations in ways that prior enforcement actions, most notably DOJ’s complaint against Third Point in 2015, have not necessarily done. Moreover, the ValueAct complaint may give rise to a tightening by the SEC staff of a loophole in the SEC’s beneficial ownership reporting regime of which high profile activists regularly take advantage.
The HSR Act requires that in most circumstances, before any entity accumulates more than $78.2 million of a company’s stock, the prospective purchaser must notify the issuer, file a notification with the U.S. antitrust agencies and wait for the expiration or early termination of the 30-day waiting period. These notices to the issuer, as well as the HSR filings and waiting period expirations may all be kept nonpublic (although a grant of a request for early termination is made public by the government). However, when issuers receive these advance notices of intentions of an activist to accumulate shares in excess of the HSR threshold, these issuers regularly elect to disclose promptly this development so that they may get out in front of media reports about the activists’ accumulations and cleanse themselves of what may constitute possession by the issuer of material non-public information.
Moreover, since the disclosure of an initial investment by an activist typically leads to a short-term stock price pop, the disclosure by the issuer of the receipt of an HSR notice may prevent the activist from being able to book a quick profit simply by watching the value of its investment rise immediately following the announcement of its accumulation. Increasing the activist’s upfront costs is likely to limit the size of the accumulation and activist’s influence.
As a result, activists have been creative to avoid HSR filings. Among the tactics they employ are buying shares through multiple funds that purport to be different purchasers for HSR purposes and by acquiring options (sometimes at a high upfront cost that leaves little to be paid as the exercise price) that cement their right to own the shares upon exercise, but that do not count as beneficial ownership for HSR purposes until the exercise has occurred. The former approach is of limited viability and the latter approach means that the activist may not exercise any voting power while the HSR process is ongoing. A third approach is to purport to qualify for the passive investor exemption from HSR notification. The well-known activist fund, Third Point, apparently tried this approach in connection with its investment in Yahoo and ended up settling a civil complaint last year. The allegations against Third Point were that, at the same time that Third Point was accumulating shares without prior HSR clearance, the fund was taking concrete steps to change the composition of the senior management and board of Yahoo.
The ValueAct complaint may be taking the tightening of the passive investor exemption to a new level. ValueAct is not alleged to have engaged in any of the bold moves to replace officers and directors that characterized the allegations in the Third Point complaint. Indeed, the alleged actions by ValueAct consist primarily of the communication of views and opinions to the issuers in question, something that institutional holders, which regularly rely on the passive investor exemption from the HSR Act, have done increasingly in recent years, including to advocate in favor of the views of hedge fund activists, governance reforms, compensation plan reforms, and changes to approaches to core strategic matters such as capital allocation. On the one hand, one may read the ValueAct complaint as putting all opinion-conveying institutional holders on notice that they may be treading into territory that requires HSR notification whenever they pick up the phone to call the heads of IR at those companies where they hold in excess of $78.2 million of voting securities. That may be overreading the implications of the DOJ’s action, however. Another take is that ValueAct’s allegedly self-promoted reputation as an effective activist was the vital ingredient that, when added to the mix, led the DOJ to conclude that ValueAct failed to qualify as a passive investor. Indeed, the complaint highlights the ways that ValueAct allegedly portrays itself to the market as an activist fund that will use resources and tactics to cause change in the strategy and operations of companies. The implication of the ValueAct complaint thus may be that hedge funds that market themselves out as “well-known . . . activists” are going to be held to a higher standard when it comes to the availability of the HSR Act’s passive investor exemption.
The consequence of the ValueAct complaint may be more activist hedge funds using American-style, stock-settled options to accumulate shares and thereby avoid HSR Act risk. An important limitation on the effectiveness of this approach to permitting stealth accumulations, however, is that the SEC’s beneficial ownership reporting rules, in contrast to the HSR rules, will consider these options to constitute “beneficial ownership” even if the hedge funds do not have the right to control the vote over the underlying shares until after exercise of these options. Under the SEC regime, once an activist’s fund group has beneficially owned such options or outright shares representing in excess of 5% of the outstanding shares for at least 10 calendar days, the activist must publicly report the ownership on Schedule 13D and thereafter promptly update upon any material changes.
While the 10-calendar day period before the due date for publicly filing a Schedule 13D provides some cover for “under the radar” accumulations, there is an even better way for activists to avoid the Schedule 13D disclosure regime and thereby facilitate their accumulations: the exemption from Schedule 13D filings for passive investors, pursuant to which these passive shareholders, beneficially owning more than 5% but less than 10%, need only disclose their accumulation through a short-form public filing on Schedule 13G by as late as February 14 of the year following the calendar year in which they crossed the 5% threshold. As evidenced in the attached chart of “activist 13G filers”, there are a number of brand name activists, which do not have non-activist divisions and which regularly disclose their 5%+ holdings on Schedule 13G in reliance on the passive investor exemption from Schedule 13D that entitles the filer to delay filing until the 45th calendar day after the end of the calendar year in which the shares were purchased.
These “activist 13G-filers” are able to complete their accumulations after crossing the 5% threshold in a period exceeding the 10-day period that governs Schedule 13D filers and to avoid public disclosure potentially for several additional months depending on the point in the calendar year when their purchasing is occurring. After completing their accumulations, these activist 13G filers will engage in communications with the issuers and convey opinions, sometimes publicly and other times in private meetings with the issuer, on critical issues, such as whether the issuer should pursue a sale of itself or incur more leverage; but the activist 13G filer will typically not overtly threaten or launch efforts to change the composition of senior management or the board unless and until it switches to a Schedule 13D.
A take-away from the ValueAct complaint may be that such a course of conduct – communicating with the company to advocate for strategic courses of action without any references to threats to run proxy contests or to seek the removal of executives – is arguably per se non-passive if the party doing the communicating has a self-promoted reputation for being an activist who will run proxy contests and campaigns to change management when issuers do not comply with their opinions. The SEC is aware of what is going on at the antitrust agencies on this front. Indeed, at last year’s Annual Institute on Securities Regulation conference in New York, Michele Anderson, formerly Chief of the SEC’s Officer of Mergers and Acquisitions and currently an Associate Director in the SEC’s Division of Corporation Finance, speaking for herself and not the staff, remarked on the affinity between the interpretation by the antitrust agencies of the scope of the passive investor exemption from HSR notification and the interpretation by the SEC staff of the scope of the passive investor exemption from Schedule 13D filing.
The ValueAct complaint may drive more activist hedge funds to use options to avoid the impact of the HSR Act on their accumulation activities, but, to the extent those options cross the 5% threshold for SEC beneficial ownership reporting purposes, we may well see steps taken by the SEC staff, inspired by the DOJ’s precedent in the ValueAct complaint, to assure that well-known activist funds are not able to avoid detection by positioning themselves as passive investors for purposes of qualifying for the less timely and burdensome Schedule 13G filing regime in lieu of the tighter and more transparent Schedule 13D requirements. Moreover, in a mutually reinforcing cycle, it is not unreasonable to consider that the U.S. antitrust agencies may be scouring Schedule 13D filings to identify activist funds that have failed to make the requisite HSR notification.
 In addition, to any extent activist money managers rely on Exchange Act Rule 16a-1(a)(1)’s limited exemption for passive holders from Section 16’s short-swing profit and expedited beneficial ownership reporting regimes, the SEC staff may start to scrutinize more closely the use of this exemption by those who perennially hold themselves out as activists.