Question
January 13, 2005
Marian R. Bruno, Esq.
Assistant Director
Federal Trade Commission
Premerger Notification Office
Bureau of Competition
600 Pennsylvania Avenue, N.W.
Washington D.C. 20580
Dear Ms. Bruno:
The purpose of this letter is to request a formal interpretationof Section 7A(a)(2) of the Hart-Scott-Rodino Antitrust Improvements Act of1976, as amended (the "Act") and 17 C.F.R. 801.13 as theseprovisions apply to "Rollover Shares" (as defined below).
We represent a number of private equity funds (each, a "Sponsor"),which often use a newly-formed acquisition entity ("Newco") toacquire all of the voting securities of a privately-held entity (a"Target") by either (a) purchasing all of the equity securities ofTarget or (b) merging a wholly-owned subsidiary of Newco with Target (each, an"Acquisition"). As a result of an Acquisition, Target becomesa wholly-owned subsidiary of Newco, and the sole asset of Newco following theAcquisition is the equity securities of Target held by Newco. Newco typicallyis capitalized immediately prior to the Acquisition by (i) cash contributed bySponsor in exchange for voting securities of Newco, and (ii) certain votingsecurities of Target contributed by certain existing shareholders of Target(the "Rollover Shareholders"), who are typically managementemployees of Target; in exchange for voting securities of Newco (the "RolloverShares"). After the Acquisition, voting securities of Newco are heldby Sponsor and the Rollover Shareholders.
The question has repeatedly arisen as to whether the RolloverShares should be deemed "voting securities held as a result of theacquisition" in the transaction described above. We believe that, for thepurposes of Section 7A(a)(2) of the Act and 17 C.F.R. 801.13, the term"voting securities" should be construed to specifically exclude anysecurity which an existing equityholder of a privately held acquired personexchanges for any security of a newly-formed acquisition entity (formed solelyfor the purpose of effecting an acquisition of such acquired person) if thesole asset of such newly-formed acquisition entity following the acquisition isthe securities of the acquired person.
The reason for this request is to clarify the rules set forth inSection 7A(a)(2) of the Act and 17 C.F.R. 801.13 in light of the economiceffect of the Acquisition transaction described above. Specifically, the changeof control effected by the Acquisition could have alternatively been effectedthrough a recapitalization of Target by Target's redemption of substantiallyall securities of Target held by existing equityholders and Sponsor'ssimultaneous purchase of newly issued voting securities of Target from Target(a "Recapitalization"). After the Recapitalization, inaddition to the voting securities held by Sponsor, certain existingshareholders (the "Continuing Shareholders") would continue toown voting securities of Target (the "Retained Shares"). In aRecapitalization, the Retained Shares are not transferred, exchanged orconverted, and would not constitute voting securities held by the acquiringperson under Section 7A(a)(2) of the Act and 17 C.F.R. 801.13.
Although there may be differing rationales that would lead aSponsor to choose between an Acquisition structure and a Recapitalizationstructure (including, without limitation, business, tax or accounting reasons),the economic effect of both the Acquisition and the Recapitalization is thesame. In each case, the effective result of the transaction is that certainexisting shareholders directly or indirectly maintain their ownership in theTarget, and Sponsor directly or ` indirectly acquires a controlling interest inTarget.
It is an anomalous result, in our view, that Retained Shares heldby Continuing Shareholders in a Recapitalization are not "votingsecurities held as a result of the acquisition" but that Rollover Sharesheld by Rollover Shareholders in an Acquisition are "voting securitiesheld as a result of the acquisition" simply because, in the latter case,the Rollover Shareholders physically exchange shares of Target votingsecurities for voting securities of Newco. In an Acquisition, Newco is merely aholding company whose only asset following the Acquisition is securities ofTarget. The Acquisition does not change the operations or value of Target,rather it only creates a holding company in which the securities of Target areheld. After the Acquisition, Newco's equity value is equivalent to the equityvalue of Target. Therefore, in our view, the Rollover Shares in an Acquisitionshould be analyzed in the same manner as the Retained Shares in aRecapitalization for Hart-Scott-Rodino purposes.
An Example of Disparate Hart-Scott-Rodino Treatment
of a Recapitalization Compared to an Acquisition
Assume for thepurposes of this section that (a) Sponsor intends to directly or indirectlyacquire voting securities of Target in exchange for cash of $40 million, (b)existing equityholders of Target will continue to hold $15 million in votingsecurities of Target (either directly as Retained Shares or indirectly asRollover Shares), (c) Target is a privately-held entity, (d) Newco is anewly-formed acquisition entity formed solely for the purpose of effecting theacquisition of Target, and (e) the Act's "Size-of-Parties" and"commerce" tests are met.
If thetransaction is structured as a Recapitalization, Sponsor would purchase sharesof Target from Target in exchange for $40 million in cash. The Recapitalizationwould have no effect on the Retained Shares and the Continuing Shareholderswould continue to hold voting securities in Target having a value of $15million. Under this structure, no Notification Filing would be required becausethe Size-of-Transaction test set forth in Section 7A(a)(2) of the Act would notbe met.
If thetransaction is structured as an Acquisition, immediately prior to theAcquisition Sponsor would contribute cash in the amount of $40 million to Newcoin exchange for voting securities of Newco, and the Rollover Shareholders wouldcontribute their Rollover Shares of Target to Newco in exchange for shares ofvoting securities of Newco. Newco would acquire the remaining voting securitiesof Target (by purchase or merger). Following the Acquisition, Target would be awholly-owned subsidiary of Newco and the only asset held by Newco would be thesecurities of Target.
17 C.F.R.801.13 requires that "all voting securities of an issuer held by theacquiring person after the consummation of an acquisition . . . be deemedvoting securities held as a result of the acquisition." Because theRollover Shareholders contribute their Rollover Shares of Target to Newco inexchange for shares of voting securities of Newco, a literal reading of this provisionwould seem to require that the Rollover Shares would be considered "votingsecurities held as a result of the acquisition." Applying this literalreading of 17 C.F.R. 801.13 to the Rollover Shares would result in theSize-of-Transaction test set forth in Section 7A(a)(2) of the Act being met anda Notification Filing being required.
This disparatetreatment under the Act of the Acquisition and the Recapitalizationtransactions results solely from a structural difference in the transactions.Moreover, since the Rollover Shareholders and the Continuing Shareholders inboth transactions effectively continue to hold a direct or indirect equityinterest in Target, the structural difference does not seem to warrantdifferent treatment under the Act. Under the foregoing facts, the RolloverShares in the Acquisition should be construed as a continuing equity interestin Target (since Newco has no other assets) by the Rollover Shareholders ratherthan a new investment in Newco
The Need for Issuance of a Formal Interpretation
We believe thatRollover Shares should be excluded from "voting securities held as aresult of the acquisition" for the purposes of Section 7A(a)(2) of the Actand 17 C.F.R. 801.13 in the following, narrowly-tailored set ofcircumstances: (a) Target is a privately-held entity, (b) Newco is a newlyformed entity formed for the purposes of effecting an acquisition of Target,and (c) as a result of such acquisition, Target will be a wholly-ownedsubsidiary of Newco and Newco's sole asset will be the securities of Targetheld by it.
A literalapplication of Section 7A(a)(2) of the Act and 17 C.F.R. 801.13 resultsin different treatment for the Acquisition transaction solely due to astructural difference in how the transaction was effected. This disparatetreatment places onerous and costly filing requirements on Sponsor which wouldnot be necessary if Sponsor structured the transaction as a Recapitalization.As the structural differences between the Acquisition and the Recapitalizationdo not appear to warrant different treatment under the Act, it seems importantto have clear guidelines as to how Section 7A(a)(2) of the Act and 17 C.F.R.801.13 should be applied as to Rollover Shares.