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FEDERAL SECURITIES LAWS

The federal securities laws consist mainly of eight statutes:

Securities Act of 1933 (SA)

Securities Exchange Act of 1934 (SEA)Public Utility Holding Company Act of 1935 (PUHCA)Trust Indenture Act of 1939 (TIA)Investment Company Act of 1940 (ICA)Investment Advisers Act of 1940 (IAA)Securities Investor Protection Act of 1970 (SIPA)Sarbanes-Oxley Act of 2002 (SOA)

We first summarize what each of the laws covers to provide an overview of the patternof legislation. We then develop some of the more important provisions in greater detail.The early major acts were enacted beginning in 1933. There is a reason for the timing. The

stock market crash of 1929 was followed by continued depressed markets for severalyears. Because so many investors lost money, both houses of Congress conducted lengthyhearings to find the causes and the culprits. The hearings were marked by sensationalismand wide publicity. The securities acts of 1933 and 1934 were the direct outgrowth of thecongressional hearings.

The Securities Act of 1933 regulates the sale of securities to the public. It provides forthe registration of public offerings of securities to establish a record of representations. Allparticipants involved in preparing the registration statements are subject to legal liabilityfor any mis-statement of facts or omissions of vital information.

The Securities Exchange Act of 1934 established the Securities and ExchangeCommission (SEC) to administer the securities laws and to regulate practices in thepurchase and sale of securities.

The purpose of the Public Utility Holding Company Act of 1935 was to correct abusesin the financing and operation of electric and gas public utility holding company systemsand to bring about simplification of the corporate structures and physical integration of theoperating properties. The SECs responsibilities under the act of 1935 were substantiallycompleted by the 1950s.

The Trust Indenture Act of 1939 applies to public issues of debt securities with a value

of $5 million or more. Debt issues represent a form of promissory note associated with along document setting out the terms of a complex contract and referred to as the indenture.The 1939 act sets forth the responsibilities of the indenture trustee (often a commercialbank) and specifies requirements to be included in the indenture (bond contract) for theprotection of the bond purchasers. In September 1987, the SEC recommended to Congressa number of amendments to establish new conflict-of-interest standards for indenturetrustees and to recognize new developments in financing techniques.

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The Investment Company Act of 1940 regulates publicly owned companies engaged inthe business of investing and trading in securities. Investment companies are subject torules formulated and enforced by the SEC. The act of 1940 was amended in 1970 to placeadditional controls on management compensation and sales charges.

The Investment Advisers Act of 1940, as amended in 1960, provides for registrationand regulation of investment advisers, as the name suggests.

The Securities Investor Protection Act of 1970 established the Securities InvestorProtection Corporation, (SIPCO). This corporation is empowered to supervise theliquidation of bankrupt securities firms and to arrange for payments to their customers.

The Securities Act Amendments of 1975 were passed after 4 years of research andinvestigation into the changing nature of securities markets. The study recommended theabolition of fixed minimum brokerage commissions. It called for increased automation oftrading by utilizing data processing technology to link markets. The SEC was mandated to

work with the securities industry to develop an effective national market system toachieve the goal of nationwide competition in securities trading with centralized reportingof price quotations and transactions. It proposed a central order routing system to find thebest available price.

In 1978, the SEC began to streamline the securities registration process. Large, well-known corporations were permitted to abbreviate registration statements and to discloseinformation by reference to other documents that already had been made public. Beforethese changes, the registration process often required at least several weeks. After the1978 changes, a registration statement could be approved in as little as 2 days.

In March 1982, Rule 415 provided for shelf registration. Large corporations canregister the full amount of debt or equity they plan to sell over a 2-year period. After theinitial registration has been completed, the firm can sell up to the specified amount of debtor equity without further delay. The firm can choose the time when the funds are neededor when market conditions appear favorable. Shelf registration has been actively used inthe sale of bonds, with as much as 60% of debt sales utilizing shelf registration. Less than10% of the total issuance of equities have employed shelf registration.

In 1995, the Private Securities Litigation Reform Act (PSLRA) was enacted byCongress. This law placed restrictions on the filing of securities fraud class action suits. Itsought to discourage the filing of frivolous claims. In late 1998, the Securities LitigationUniform Standards Act (SLUSA) was signed into law. It had been found that some classaction plaintiffs had been circumventing the PSLRA by filing suits in state courts. SLUSAestablishes a uniform national standard to be applied to securities class actions and makesclear such suits will be the exclusive jurisdiction of the federal courts. SLUSA forces allclass action plaintiffs alleging securities fraud to provide greater detail on the basis fortheir claims. It enables defendant companies to delay the expenses of discovery ofevidence until the complaint has withstood a motion to dismiss. The 1998 act seeks toprotect companies against unfounded securities fraud class actions. This reduces the

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pressure on defendant companies to enter into a settlement to avoid the litigation expensesthat otherwise would be incurred.

In the wake of the recent allegations of fraud, insider trading, and questionableaccounting practices by large companies such as Adeiphia, Enron, Global Crossing,

ImClone, Qwest, and Tyco, President Bush signed into law on July 31, 2002, theSarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act is expected to have a huge impacton corporate governance, financial disclosures, auditing standards, analyst reports, insidertrading, and so forth. Observers view the Act as the most comprehensive reform ofsecurities laws since the 1933 and 1934 Acts. The Act contains eleven titles:

I. Public Accounting Oversight BoardII. Auditor IndependenceIII. Corporate ResponsibilityIV. Enhanced Financial DisclosuresV. Analyst Conflicts of Interest

VI. Commission Resources and AuthorityVII. Studies and ReportsVIII. Corporate and Criminal Fraud AccountabilityIX. White Collar Crime Penalty EnhancementsX. Corporate Tax ReturnsXI. Corporate Fraud Accountability

Below is a brief summary of some of the Titles. Title I establishes a five memberPublic Company Accounting Oversight Board to oversee audits, establish standards, andmonitor registered public accounting firms. Title II requires auditor independence byprohibiting auditors from performing certain non-audit services contemporaneous with anaudit, requires auditor rotation, and requires that auditors report detailed material to theaudit committee. Title III strengthens corporate responsibility by requiring each memberof the audit committee to be an independent member of the board, requires the CEO andCFO to certify financial reports, requires the CEO and CFO to forfeit bonus andcompensation if an accounting restatement is due to non-compliance of the firm, andrequires that attorneys appearing before the SEC to report violations of securities by afirm or its management. Title IV provides for greater financial disclosures such asrequiring financial reports to reflect all material adjustments and off- balance sheet items,prohibits loans to executives, requires insiders to disclose insider trans actions within 2business days of the transaction, and requires that at least one member of the auditcommittee be a financial expert. Title V attempts to separate analyst conflicts of interestby restricting the ability of investment bankers to pre-approve research reports, restrictsemployers from firing analysts for having written negative reports, and requires analyststo disclose any potential conflicts such as having owned stock in the company covered.Titles VIII, IX, and XI provide stringent penalties for corporate and financial fraud andother white-collar crimes by corporations and management.

The Sarbanes-Oxley Act went through Congress at a rapid pace without anyopposition in the Senate and minimal opposition in the House of Representatives.

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Subsequent to President Bushs signing of the Act into law on July 31,2002, the SEC andthe stock exchanges have been proposing and implementing rules in accordance with theAct. Some of the provisions were effective immediately, whereas in other cases, the SEChas 180 and 270 days, in some instances longer, to implement the rules. There is noquestion that the Act will have an enormous impact on corporate governance. However,

since the timing is so recent, it remains to be seen as to the effectiveness of the Act incurtailing corporate and financial fraud and providing greater financial disclosure toinvestors, while at the same time not impeding corporations from maximizing profits onbehalf of shareholders.

OFFER REGULATION THE WILLIAMS ACT

Prior to the late 1960s, most inter-corporate combinations were represented by mergers.This typically involved friendly negotiations by two or more firms. When they mutuallyagreed, a combination of some form might occur. During the conglomerate mergermovement of the 1960s, corporate takeovers began to occur. Some were friendly and not

much different from mergers. Others were hostile and shook up the business community.

In October 1965, Senator Harrison Williams introduced legislation seeking toprotect the target companies. These initial efforts failed, but his second effort, initiated in1967, succeeded. The Williams Act, in the form of various amendments to the SecuritiesExchange Act of 1934, became law on July 29, 1968. Its stated purpose was to protecttarget shareholders from swift and secret takeovers in three ways: (1) by generating moreinformation during the takeover process that target shareholders and management coulduse to evaluate outstanding offers; (2) by requiring a minimum period during which atender offer must be held open, thus delaying the execution of the tender offer; and (3) byexplicitly authorizing targets to sue bid ding firms.

SECTION 13

Section 13(d) of the Williams Act of 1968 required that any person who had acquired 10%or more of the stock of a public corporation must file a Schedule 13D with the SEC within10 days of crossing the 10% threshold. The act was amended in 1970 to increase the SECpowers and to reduce the trigger point for the reporting obligation under Section 13(d)from 10% to 5%. Basically, Section 13(d) provides management and the shareholders withan early notification system.

The filing requirement does not apply to those persons who purchased less than2% of the stock within the previous 12 months. Due to this exemption, a substantialamount of stock can be accumulated over several years without having to file Schedule13D. Institutional investors (registered brokers and dealers, banks, insurance companies,and so forth) can choose to file Schedule 13G instead of Schedule 13D if the equitysecurities were acquired in the ordinary course of business. Schedule 13G is anabbreviated version of Schedule 13D.

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The insider trading scandals of the late 1980s produced calls for a reduction below5% and a shortening of the 10-day minimum period for filing. However, shortening theperiod would not stop the practice of parking violations that was uncovered in theBoesky investigation. Under parking arrangements, traders attempt to hide the extent oftheir ownership to avoid the 5% disclosure trigger by parking purchased securities with

an accomplice broker until a later date. A related practice is to purchase options on thestock of the target: this is equivalent to ownership because the options can be exercisedwhenever the holder wishes to take actual ownership.

SECTION 14

Section 13(d) and 13(g) of the Williams Act apply to any large stock acquisitions, whetherpublic or private (an offering to less than 25 people). Section 14(d) applies only to publictender offers but applies whether the acquisition is small or large, so its coverage isbroader. The 5% trigger rule also applies under Section 14(d). Thus, any group makingsolicitations or recommendations to a target group of shareholders that would result in

owning more than 5% of a class of securities registered under Section 12 of the SecuritiesAct must first file a Schedule 14D with the SEC. An acquiring firm must disclose in aTender Offer Statement (Schedule 14D-1) its intentions and business plans for the targetas well as any relationships or agreements between the two firms. The schedule must befiled with the SEC as soon as practicable on the date of the commencement of the tenderoffer; copies must be hand delivered to the target firm and to any competitive bidders;and the relevant stock exchanges (or the National Association of Securities Dealers,NASD, for over-the-counter stocks) must be notified by telephone (followed by a mailingof the schedule).

Note, however, that the language of Section 14(d) refers to any group makingrecommendations to target shareholders. This includes target management, which isprohibited from advising target shareholders as to how to respond to a tender offer until ittoo has filed with the SEC. Until target management has filed a Schedule 14D-9, a TenderOffer Solicitation/Recommendation Statement, they may only advise shareholders to defertendering their shares while management considers the offer. Companies that considerthemselves vulnerable often take the precaution of preparing a fill-in-the-blanks scheduleleft with an agent in Washington to be filed immediately in the event of a takeoverattempt, allowing target management to respond swiftly in making publicrecommendations to shareholders. Thus, Section 14(d) (1) provides the early notificationsystem and information that will help target shareholders deter mine whether or not totender their shares. SEA Sections 14(d) (4)(7) regulate the terms of a tender offer,including the length of time the offer must be left open (20 trading days), the rightshareholders to withdraw shares that they may have tendered previously, the manner inwhich tendered shares must be purchased in oversubscribed offers, and the effect of thebidder changing the terms of the offer. The delay period also gives shareholders time toevaluate the offer, but, more importantly, it enables management to seek competing bids.

Also, SEA Section 14(e) prohibits misrepresentation; nondisclosure; or anyfraudulent, deceptive or manipulative acts or practices in connection with a tender offer.

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INSIDER TRADING OVERVIEW

The SEC has three broad categories under which insider trading, fraud, or illegal profitscan be attacked. Rule 10b-5 is a general prohibition against fraud or deceit in securitytransactions. Rule 14e-3 prohibits trading in nonpublic information in connection with

tender offers. The Insider Trading Sanctions Act of 1984 applies to insider trading moregenerally. It states that those who trade on information not available to the general publiccan be made to give back their illegal profits and pay a penalty of three times as much astheir illegal activities produced. To date, the term insider trading has not been clearlydelineated by the SEC. The ambiguity of the three sources of power that may be used bythe SEC in the regulation of insider trading gives the SEC considerable discretion in itschoice of practices and cases to prosecute. Also, the SEC is empowered to offer bountiesto informants whose information leads to the recovery of illegal gains and payment of acivil penalty.

It should be noted also that the traditional regulation of insider trading was

provided for under SEA Sections 16(a) and 16(b). Section 16(a) applies to officers,directors, and any persons who own 10% or more of any class of securities of a company.Section 16(a) provides that these corporate insiders must report to the SEC all transactionsinvolving their purchase or sale of the corporations stock on a monthly basis. Section16(a) is based on the premise that a corporate insider has an unfair advantage by virtue ofhis or her knowledge of information that is generated within the corporation. Thisinformation is available on a privileged basis because the insider is an officer, a director,or a major security holder who is presumed to have privileged communications with topofficers in the company. Section 16(b) provides that the corporation or any of its securityholders may bring suit against the offending corporate insider to return the profits to thecorporation because of insider trading completed within a 6-month period.

The Sarbanes-Oxley Act of 2002 amended Section 1(a) of the 1934 Act byrequiring that insiders disclose any changes in ownership within 2 business days of thetransaction, sharply decreasing the time between the insider transaction and disclosure. Inaddition, the Act requires that change in ownership be filed electronically, rather than onpaper as was done prior, and that the SEC post the filing on the internet within 1 businessday after the filing is made.

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TABLE 1

Summary of Securities Laws and Regulations

Rule 10b-5: Prohibits fraud, misstatements, or omission of material facts inconnection with the purchase or sale of any security.

Section 13(d): Provides early warning to target firms of acquisitions of their stockby potential acquirers: 5% threshold, 10-day filing period. Appliesto all large stock acquisitions.

Section 14(d) (1): Requirements of Section 13(d) extended to all public tender offers.Provides for full disclosure to SEC by any group makingrecommendations to target shareholders.

Section 14(d) (4)-(7): Regulates terms of tender offers: length of time offer must be heldopen (20 days), right of shareholders to withdraw tendered shares,and so on.

Section 14(e): Prohibits fraud and misrepresentation in context of tender offers.Rule 14e-3 prohibits trading on nonpublic information in tenderoffers.

Section 16(a): Provides for reporting by corporate insiders on their transactions intheir corporations' stocks.

Section 16(b): Allows the corporation or its security holders to sue for return of profits on transactions by corporate insiders completed within a 6-month period.

Insider Trading SanctionsAct of 1984:

Provides for triple damages in insider trading cases.

Racketeer Influenced and

Corrupt Organizations Actof 1970 (RICO):

Provides for seizure of assets upon accusation and triple damages

upon conviction for companies that defraud consumers, investors,and so on.

COURT CASES AND SEC RULES

To this point we have described the main statutory provisions that specify the variouselements of fraud and insider trading in connection with trading in securities and takeoveractivities. The full meaning of these statutes is brought out by the subsequent courtinterpretations and SEC rules implementing the powers granted the SEC by the variousstatutes.

LIABILITY UNDER RULE 10B-5 OF THE 1934 ACT

As we have indicated, Rule 10b-5, issued by the Securities and Exchange Commissionunder the powers granted to it by the 1934 act, is a broad, powerful, and general securitiesantifraud provision. In general, for Rule 10b-5 to apply, a security must be involved.Technical issues have arisen regarding what constitutes a security. If securities areinvolved, all transactions are covered, whether on one of the securities exchanges or over

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the counter. A number of elements for a cause of action have been set forth in connectionwith Rule 10b-5, as follows.

1. There must be fraud, misrepresentation, a material omission, or deception inconnection with the purchase or sale of securities.

2. The misrepresentation or omission must be of a fact as opposed to an opinion.However, inaccurate predictions of earnings may be held to be misrepresentations,and failure to disclose prospective developments may be challenged.

3. The misrepresentation or omission must be material to an investor's decision in thesense that there was a substantial likelihood that reasonable investors wouldconsider the fact of significance in their decision.

4. There must be a showing that the plaintiff believed the misrepresentation andrelied upon it and that it was a substantial factor in the decision to enter thetransaction.

5. The plaintiff must be an actual purchaser or an actual seller to have standing.6. Defendant's deception or fraud must have a sufficiently close nexus to the

transaction so that a court could find that the defendant's fraud was "in connectionwith" the purchase or sale by plaintiff.7. Plaintiff must prove that the defendant had scienter. Scienter literally means

"knowingly or willfully." It means that the defendants had a degree of knowledgethat makes the individual legally responsible for the consequences of their act andthat they had an actual intent to deceive or defraud. Negligence is not sufficient.

These elements represent requirements for a successful suit under Rule 10b-5. Someof the elements were developed in a series of court decisions. The main thrust of Rule10b-5 concerns fraud or deceit. The Supreme Court set forth the scienter requirement intwo cases:Ernst and Ernst v. Hochfelder, 425 US 185 (1976); and Aaron v. SEC,446US680 (1980).

In addition to its use in fraud or deceit cases, a number of interesting cases havebrought out the meaning and applicability of Rule 10b-5 in connection with insidertrading, For the present, we refer to insider trading merely as purchases or sales bypersons who have access to information that is not available to those with whom they dealor to traders generally. However, many court decisions address what constitutes insidertrading and a continual stream of proposals in Congress attempt to clarify the meaning ofthe term.

An early case was Cady, Roberts & Company, 40 SEC 907 (1961). In this case, a partner in a brokerage firm received a message from a director of the Curtiss-WrightCorporation that the board of directors had voted to cut the dividend. The brokerimmediately placed orders to sell the Curtiss-Wright stock for some of his customers. Thesales were made before news of the dividend cut was generally disseminated. The brokerwho made the transactions was held to have violated Rule 10b-5.

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The Texas Gulf Sulphur Corporation case of 1965 was classic [SEC v. Texas GulfSulphur Company,401 F.2d 833 (2d. Cir. 1968)]. A vast mineral deposit consisting ofmillions of tons of copper, zinc, and silver was discovered in November 1963. However,far from publicizing the discovery, the company took great pains to conceal it for more

than 5 months, to the extent of issuing a false press release In April 1964 labelingproliferating rumors as unreliable premature and possibly misleading." Meanwhile,certain directors, officers, Gulf Sulphur who knew of the find bought up quantities of thefirms stock (and options on many more shares) before any public announcement. Thefalse press release was followed only 4 days later by another that finally revealed publiclythe extent of the find. In the companys defense, it was alleged that secrecy was necessaryto keep down the price of the neighboring tracts of land that they had to acquire in order tofully exploit the discovery. However, the SEC brought and won a civil suit based on Rule10b-5.

The next case is Investors Management Company, 44 SEC 633 (1971). An aircraft

manufacturer disclosed to a broker-dealer, acting as the lead underwriter for a proposeddebenture issue, that its earnings for the current year would be much lower than it hadpreviously publicly announced. This information was conveyed to the members of thesales department of the broker-dealer and passed on in turn to major institutional clients.The institutions sold large amounts of the stock before the earnings revisions were madepublic. Again, the SEC won the suit.

In the next two cases we cover, the SEC lost. The first case involved one of the leadinginvestments banking corporations, Morgan Staley. The Kennecott Copper Corporationwas analyzing whether or not to buy Olinkraft, a paper manufacturer. Morgan Stanleybegan negotiations with Olinkraft on behalf of Kennecott. Later Kennecott decided it didnot wish to purchase Olinkraft. The knowledge that Morgan Stanley had gained in itsnegotiations led it to believe that one of its other clients, Johns-Manville, would findOlinkraft attractive. In anticipation of this possibility, Morgan Stanley bought largeamounts of the common stock of Olinkraft. When Johns-Manville subsequently made abid for Olinkraft, Morgan Stanley realized large profits. A suit was brought againstMorgan Stanley. However, the court held that Morgan Stanley had not engaged in anyimproper behavior under Rule 10b-5.

In the next case, Raymond Dirks was a New York investment analyst who wasinformed by a former officer of Equity Funding of America that the company had beenfraudulently overstating its income and net assets by large amounts. Dirks conducted hisown investigation, which corroborated the information he had received. He told the SECand a reporter at the Wall Street Journal to follow up on the situation and advised hisclients to sell their Equity Funding shares. The SEC brought an action against Dirks on thegrounds that if tippees have material information knowingly obtained from a corporateinsider, they must either disclose it or refrain from trading. However, the U.S. SupremeCourt found that Dirks had not engaged in improper behavior[Dirks v. SEC, 463 US 646(1983)]. In Texas Gulf Sulphur, the law made it clear that trading by insiders in shares oftheir own company using insider knowledge is definitely illegal. However, the court held

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that it was not illegal for Raymond Dirks to cause trades to be made on the basis of whathe learned about Equity Funding because the officer who conveyed the information wasnot breaching any duty and Dirks did not pay for the information.

Therefore, the first principle is that it is illegal for insiders to trade on the basis of

inside information. A second principle that has developed is that it is illegal for an outsiderto trade on the basis of information that has been "misappropriated." The misappropriationdoctrine began to develop in the famous Chiarella case [United States v. Chiarella 445 US222 (1980)]. United States v. Chiarella was a criminal case. Vincent Chiarella was the"markup man " in the New York composing room of Pandick Press, one of the leadingU.S. financial printing firms. In working on documents, he observed five announcementsof corporate takeover bids in which the targets' identities had presumably been concealedby blank spaces and false names. However, Chiarella made some judgments about thenames of the targets, bought their stock, and realized some profits. Chiarella was suedunder Rule 10b-5 on the theory that, like the officers and directors of Texas Gulf Sulphur,he had defrauded the uninformed shareholders whose stock he had bought. Chiarella was

convicted in the lower courts, and his case was appealed to the Supreme Court. In arguingits case before the Supreme Court, the government sought to strengthen its case. It arguedthat even if Chiarella did not defraud the persons with whom he traded, he had defraudedhis employer, Pandick Press, and its clients, the acquiring firms in the documents he hadread. He had misappropriated information that had belonged to Pandick Press and itsclients. As a result, he had caused the price of the targets' stock to rise, thereby injuring hisemployer's clients and his employer's reputation for reliability. The Supreme Courtexpressed sympathy with the misappropriation theory but reversed Chiarella's convictionbecause the theory had not been used in the lower court.

However, in the next case that arose, the SEC used its misappropriation theory fromthe beginning and won in a criminal case. A stockbroker named Newman was informed byfriends at Morgan Stanley and Kuhn Loeb about prospective acquisitions. He bought thetargets' shares and split the profits with his friends who had supplied the information. Hewas convicted under the misappropriation theory on grounds that he had defrauded theinvestment banking houses by injuring their reputation as safe repositories of confidentialinformation from their clients. He had also defrauded their clients, because the stockpurchases based on confidential information had pushed up the prices of the targets.

The misappropriation theory also won in a case similar to Chiarella. Materia was aproofreader at the Bowne Printing firm. Materia figured out the identity of four takeovertargets and invested in them. This time the SEC applied the misappropriation theory fromthe start and won [SECv. Materia, 745 F.2d.197 (2d. Cir.1984)].

The SEC also employed the misappropriation theory in its criminal cast against a WallStreet Journalreporter, R. Foster Winans, the author of the newspaper's influential "Heardon the Street" column. Along with friends, Winans traded on the basis of what they knewwould appear in the paper the following day. Although his conviction was upheld by theSupreme Court, the 4-4 vote could not be mistaken for a resounding affirmation of themisappropriation doctrine, and some suspect that without the mail and wire fraud involved

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ISSUES WITH REGARD TO STATE TAKEOVER LAWS

One reason put forth for state takeover laws is that they permit shareholders a moreconsidered response to two-tier and partial tender offers. The other argument is that theWilliam Act provides that tender offers remain open for only 20 days. It is argued that a

longer time period may be needed when the target is large to permit other bidders todevelop information to decide whether or not to compete for the target.

However, in practice it has been found that 70% of the tender offers during theyear 1981 to 1984 were for all outstanding shares. The other 30% of the offers were splitbetween two-tier and partial offers. The proportion of two-tier offers declined over theperiod of the study (Office of the Chief Economist, SEC April 1985). Today, virtually alltender offers are outstanding shares.

Furthermore, many companies have adopted fair price amendments that require the bidder to pay a fair price for all shares acquired. Under the laws of Delaware,

Massachuset, and certain other states, dissenting shareholders may request court appraisalof the value of their shares. To do so, however, they must file a written demand forappraisal before the shareholders meeting to vote on the merger. Tendering shareholdersmust not vote for the merger if they wish to preserve the right to an appraisal.

Critics also point out that state antitakeover laws have hurt shareholders. Studiesby the Office of the Chief Economist of the SEC found that when New Jersey placedrestrictions on takeovers in 1986, the prices for 87 affected companies fell by 11.5%(Bandow, 1988). Similarly, an SEC study found that stock prices for 74 companieschartered in Ohio declined an average of 3.2%, a $1.5 billion loss, after that state passedrestrictive legislation. Another study estimated that the New York antitakeover rulesreduced equity values by 1%, costing shareholders $1.2 billion (Bandow, 1988).

For these reasons, critics argue that the state laws protect parochial state interestsrather than shareholders. They argues that the states act to protect employment andincrease control over companies in local areas. Furthermore, they argue that state laws arenot needed. If shareholder protection were needed, it could be accomplished by simplyamending the Williams Act by extending the waiting period from 20 to 30 days, forexample. It is argued further that that securities transactions clearly represent interstatecommerce. Thus, it is difficult to argue that the state laws are not unconstitutional. Bylimiting securities transactions, they impede interstate commerce.

ANTITRUST POLICIES

When firms announce plans to merge, a great outcry often arises from consumer groups,suppliers, and other stakeholders that the merger will lead to less competition.Consequently, the U.S. government scrutinizes every merger in which the transactionvalue exceeds $50 million. In most cases, antitrust policy is handled by the Department ofJustice (DOJ) and the Federal Trade Commission (FTC). Although the DOJ and the FTChave overlapping jurisdictions regarding antitrust policy, they generally coordinate the

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merger cases and decide which agency should handle each deal. In early 2002, theyreleased plans to overhaul the merger review process whereby the DOJ would beresponsible for mergers in certain industries, such as media and entertainment, and theFTC would be responsible for other industries, such as health care and automanufacturing. The plan would eliminate duplicative efforts and eliminate 'potential

conflict over which group is responsible for handling a specific merger. However, in May2002, the DOJ and the FTC dropped their proposal due to threats from Senator ErnestHollings (democrat, South Carolina) that he would cut the budgets of the respectiveagencies if they moved forward with the plan. Senator Hollings's objection was based onthe argument that the Justice Department under President Bush would be less likely tochallenge certain mergers, especially mergers in the media industry.

THE BASIC ANTITRUST STATUTES

The two basic antitrust laws are the Sherman Act of 1890 and the Clayton Act of 1914.

SHERMAN ACT OF 1890

This law was passed in response to the heightened merger activity around the turn of thecentury. It contains two sections. Section 1 prohibits mergers that would tend to create amonopoly or undue market control. This was the basis on which the FTC stopped themerger between Staples and Office Depot in 1997. This merger would have combined twoof the top three office supply superstore chains in the United States. These two chainscompeted in numerous metropolitan areas and in some cases were the only two superstorecompetitors. The key issue in the case was defining the relevant product market. The FTCheld that the relevant market for office supplies was "office supply superstores." Becauseonly one other major superstore existed, namely Office Max, this definition eliminatedany potential competition that could arise from nonsuperstores, Internet, fax, mail order,warehouse clubs, and so forth. As evidence, the FTC used internal documents obtainedfrom the merging parties, which suggested that raising prices was easier in the marketswith only two superstores as opposed to three. Section 2 is directed against firms thatalready had become dominant in their markets in the view of the government. This wasthe basis for actions against IBM and AT &T in the 1950s. Both firms were required tosign consent decrees in 1956 restricting AT&T from specified markets and requiring thatIBM sell as well as lease computer equipment. Under Section 2, IBM and AT&T weresued again in the 1970s. The suit against IBM, which had gone on for 10 years, wasdropped in 1983. The suit against AT&T resulted in divestiture of the operatingcompanies, effective in 1984.

A recent landmark Section 2 case is United Stares v. Microsoft. The Microsoft casedates back to 1990 when the FTC opened an antitrust investigation to see whetherMicrosofts pricing policies illegally thwarted competition and whether Microsoft hadwritten its operating system source code to hinder competing applications. Throughout the1990s, Microsoft was continually. Involved in litigation with the FTC, the DOJ, andvarious state governments regarding the antitrust allegations. At one juncture in 2000, a

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federal court issued a judgment requiring Microsoft to split the company into an operatingsystems business and an applications business. This judgment eventually was reversed onappeal, and in late 2001 Microsoft reached a settlement with the U.S. government. Underthe consent decree, Microsoft agreed to restrictions on how it develops and licensessoftware, works with independent software providers, and communicates about its

software with competitors and partners. Microsoft had not cleared all suits from someindividual states as of March 4,2003. Possible action by the EU has also been rumored.

CLAYTON ACT OF 1914

The Clayton Act created the Federal Trade Commission for the purpose of regulating thebehavior of business firms. Among its sections two are of particular interest. Section givesthe FTC power to prevent firms from engaging in harmful business practices. Section 7involves mergers. As enacted in 1914, Section 7 made it illegal for a company to acquirethe stock of another company if competition could be adversely affected. Companiesmade asset acquisitions to avoid the prohibition against acquiring stock. The 1950

amendment gave the FTC the power to block asset purchases as well as stock purchases.The amendment also added an incipiency doctrine The FTC can block mergers if itperceives a tendency toward increased concentration - meaning the share of industry salesof the largest firms appears to be increasing

HART-SCOTT-RODINO ACT OF 1970

The Hart-Scott-Rodino Act of 1976 (HSR) consists of three major parts. Its objective wasto strengthen the powers of the DOJ and the FFC by requiring approval before a mergercould take place Before HSR, antitrust actions usually were taken after completion of atransaction. By the time a cart decision was made, the merged firms had been operatingfor several years, so it was difficult to unscramble the omelet.

Under Title I, the DOJ has the power to issue civil investigative demands in anantitrust investigation. The idea, here is that if the DOJ suspects a firm of antitrustviolations, it can require firms to provide internal records that can be searched forevidence. We have seen cases in which firms were required to provide literally boxcarloads of internal files for review by the DOJ under Title 1.

Title II is a premerger notification provision, Title acquiring firm has sales orassets of $100 million or more and the target firm has sales or assets of 15 million ormore, or vice versa, information must be submitted for review. Before the takeover can becompleted, a 30-day waiting period for mergers (15 days for tender offers) is required toenable the agencies to ender an opinion legality. Either agency may request a 20-dayextension of the waiting period for mergers or a 10-day extension for tender often.

Title III is the Parens Patriac Act - each state is the parent or protector ofConsumers and competitors. It expands the powers of state attorneys general to initiatetriple-damage suits on behalf of persons (in their states) injured by violations of theantitrust laws. The state itself does not need to be injured by the violation. This gives the

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the Economist had a lead article entitled, How Dangerous Is Microsoft? (pp. 1314).In an article on antitrust in the same issue, the Economist commented that Microsoft held80% of its market but advised that the trustbusters should analyze the economics of theindustry.

The guidelines sought to assure business firms that the older antitrust rules thatemphasize various measures of concentration would be replaced by consideration of therealities of the marketplace. Nevertheless, the guidelines start with measures ofconcentration. For many years, the antitrust authorities, following the academic literature,looked at the share of sales or value added by the top four firms. If this share exceeded20% (in some cases even lower), it might trigger an antitrust investigation.

Beginning in the 1982 guidelines, the quantitative test shifted to the Herfindahl-Hirschman index (Hill), which is a concentration measure based on the market shares ofall firms in the industry. It is simply the sum of the s4uares of market shares of each firmin the industry. For example; if there were 10 firms in the industry and each held a 10%

market share, the HHI would be 1000. If one firm held a 90% market share and the nineothers held a 1% market share, the HHI would be 8,109 (902 + 9 x 1). Notice how havinga dominant firm greatly increases the HHI. The HHI is applied as indicated by Table 2.

A merger in an industry with a resulting HHI of less than 1,000 is unlikely to beinvestigated or challenged by the antitrust authorities. An HHI between 1,000 and 1,800represents moderate concentration. Investigation and challenge depend on the amount bywhich the HHI increased over its premerger level. An increase of 100 or more may invitean investigation. An industry with postmerger HHI higher than 1,800 is considered aconcentrated market. Even a moderate increase over the premerger HHI is likely to resultin an investigation by the antitrust authorities.

But, beginning in 1982, the guidelines already had recognized the role of marketcharacteristics. Particularly important is the ability of existing and potential competitors toexpand the supply of a product if one firm tries to restrict output. On the demand side, it isrecognized that close substitutes usually can be found for any product, so a high marketshare of the sales of one product does not give the ability to elevate price. Qualitydifferences, the introduction of new products, and technologies change result in productproliferation and close substitutes. The result is usually fluctuating market shares. Forthese reasons, concentration measures alone are not a reliable guide to measure thecompetitiveness of an industry.

OTHER MARKET CHARACTERISTICS

Most important is whether entry is easy or difficult. If output can be increased byexpansion of non-cooperating firms already in the market or if new firms can constructnew facilities or convert existing ones, an effort by some firms to increase price would notbe profitable. The expansion of supply would drive prices down. Conditions of entry orother supply expansion potentials determine whether firms can collude successfullyregardless of market structure numbers.

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Table 2

Critical Concentration Levels

Postmerger HHI Antitrust Challenge to a Merger?

Less than 1.0 No challenge industry is unconcentrated.

Between 1,000 and 1,800 If HHI increased by 100, investigate.More than 1,800 If HHI increased by 50, challenge.

Next considered is the ease and profitability of collusion, because it is less likelythat firms will attempt to coordinate price increases if collusion is difficult or impossible.Here the factors to consider are product differences (heterogeneity), frequent qualitychanges, frequent new products, technological changes, contracts that involve complicatedterms in addition to price, cost differences among suppliers, and so on. Also, the DOJchallenges are more likely when firms in an industry have co in the past or use practicessuch as exchanging price or output information.

NONHORIZONTAL MERGERS

The guidelines also include consideration of non-horizontal mergers. Non-horizontalmergers include vertical and conglomerate mergers. The guidelines express the view thatalthough non-horizontal mergers are less likely than horizontal mergers to createcompetitive problems, they are not invariably innocuous. The principal theories underwhich non-horizontal mergers are like to be challenged are then set forth. Concern isexpressed over the elimination of potential entrants by non-horizontal mergers. The degreeof concern is greatly influenced by whether conditions of entry generally are easy ordifficult. If entry is easy, effects on potential entrants are likely to be small. If entry isdifficult, the merger will be examined more closely.

The guidelines set forth three circumstances under which vertical mergers mayfacilitate collusion and therefore be objectionable (1) If upstream firms obtain a high levelof vertical integration into an associated retail market, tins may facilitate collusion m theupstream market by monitoring retail prices. (2) The elimination by vertical merger of adisruptive buy in a downstream market may facilitate collusion in the upstream market.(3) Non-horizontal mergers by monopoly public utilities may be used to evade rateregulation.

PRIVATE ANTITRUST SUITS

The attitudes of business competitors have always had a strong influence on antitrustpolicy. Writers have pointed out that even when government was responsible for mostantitrust actions, the investigations usually followed complaints that were lodged bycompetitors against the behavior of other firms that were making life difficult for them inthe marketplace (Ellert, 1975, 1976).

It also is argued that the private lawsuit has always been a temptation to lawyers.The cost of litigation is so high that the threat of a private lawsuit can sometimes be used

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the tests the STB is required to consider are (1) the effect on adequacy of transportation,(2) the effect on competition among rail carriers, and (3) the interests of rail carrieremployees affected by the proposed transaction.

The Department of Justice strongly opposed the Un4on Pacific Southern Pacific

merger, but, after gaining the approval of the STB, the deal was completed in 1996. InOctober 1996, CSX offered $2.50 in cash for 40% of Conrail and stock for the remaining60% Norfolk Soutbexn Railroad shortly made an all-cash offer of $100 per share. Abidding war ensued. coupled with legal skirmishes. The STB urged the participants tonegotiate an agreement in which two balanced east-west lines would be created. In theresulting compromise, CSX acquired what was the old New York Central Railroad, andNorfolk Southern acquired the old Pennsylvania Railroad system. The two examplesdemonstrate the strong role of the STB.

COMMERCIAL BANKS

Ranking is another industry subject to regulation. The Board of Governors of the FederalReserve System (FED) has broad powers over economic matters as well as antitrust. Withregard to bank mergers, three agencies may be involved. The Comptroller of the Currencyhas jurisdiction when national banks are involved. The FED makes decisions for state banks are members of the Federal Reserve System. The Federal Deposit InsuranceCorporation (FDIC) reviews mergers for state-chartered banks that are not members of theFED but are insured by the FDIC. In conducting its reviews, each agency takes intoaccount a review provided by the Department of justice.

Bank mergers have long been subject to Section 7 of the Clayton Act of 1914.Modifications were enacted by the Bank Merger Act of 1966. Past bank mergers werelegalized. Any merger approved by one of the three regulatory agencies had fly hechallenged within 30 days by the Attorney General. The Act of 1966 provided thatanticompetitive effects could be out weighed by a finding that the transaction served theconvenience and needs of the community to be served. The convenience and needsdefense is not applicable to the acquisition banks of non-banking businesses. The reviewby one of the three agencies substitutes for under Hart-Scott-Rodino of 1976.

TELECOMMUNICATIONS

The Federal Communications Commission (FCC) has primary responsibility for the radioand television industries. Mergers in these areas are subject to approval by the FCC whichdefers to the Department of Justice and the FFC on antitrust aspects. The Federalcommunications of 1996 provided for partial deregulation of the telephone and relatedindustries, with rather complicated provisions affecting the role of the former operatingcompanies of the Bell System with their relatively strong monopoly positions in theirregional markets.

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INTERNATIONAL ANTITRUST

Most of the developed countries of the world have some form of merger control. Cross-border transactions will be subject to the multiple jurisdictions of the borne countries ofbidders and targets. At the end of February 2000, the International Competition Policy

Advisory Committee released its 2-year study. It recommended that the more than 80nations conducting antitrust enforcement make more explicit what their antitrust policiesare. They proposed faster approval of transactions that do not present obvious problems.They recommended that the U.S. second-request process, in which the U.S. antitrustagencies ask for more information about a merger, should be streamlined. The reportnoted that about half of the mergers reviewed by the U.S. Federal Trade Commission orJustice Department have an international component.

Although variations in statutes administrative bodies and procedures are observed,a central theme is market share percentages. The advisory committee report recommendedthat the merger-size threshold be raised to reduce the number of reviews It also

recommended more definite time lines for the review process be established. However,antitrust authorities may even take action when a purely foreign transaction is perceived tohave an impact in domestic markets.

CANADA

The Competition Act of 1976, amended in 1991 and 2002 is a federal statute that governsall aspects of Canadian competition. Unlike the United States, where merging parties dealwith separate agencies such as the SEC and the FTC the Competition Bureau providesone-stop shopping for the review and control of all merger. Waiting periods for mergerapproval range from 2 weeks for the straightforward cases to 6 weeks for morecomplicated cases and upto 5 months for complex cases. Mergers generally will not bechallenged on the basis of concerns relating to the exercise of market power where thepost-merger market share of the merged entity would be less than 35%.

UNITED KINGDOM

The Monopolies and Mergers Act of 1965 created the Monopolies and MergersCommission (MMC) (Gray and McDenuott, 1989). A new era in merger control wasestablished by the Fair Trading Act of 1973 in the United Kingdom (UK). The ad createdan Office of Fair trading (OFT) headed by a director general (DG). The DG of the OFT isrequired to review all mergers in which the combined firm would have a 25% marketshare or where the assets of the target exceed 30 million British pounds. Alter review bythe OFT, its DG advises the secretary of state for trade and industry whether a referralshould be made to the MMC. The secretary of state has discretion whether or not to makethe referral. If a referral is made to the MMC, the current bid lapses but may be renewed ifthe MMC approves. The MMC review may take as long as 6 months. Its report is made tothe OFT and the secretary of state. If the MMC recommends approval, the secretary ofstate cannot override. However, if the MMC recommends prohibition, the secretary ofstate is not required to accept its findings, but such instances are rare. As a practical

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matter, a referral to the MMC, which lapses the current bid and involves along time lag, islikely to kill the transaction. In 1999 its name was changed to the CompetitionCommission.

JAPAN

Immediately after the conclusion of World War II, the United States attempted to reducethe role of Japanese business groups (keiretsu). Also, a proposed merger requires a filingwith a Japanese FTC. The government has 30 days to review the antitrust implications andcan extend the review period another 60 days. However, in a stock-for-stock transaction,approval by the government is not required. The reasoning is that advanced review is notneeded in a stock transaction, which is more easily reversed. The government can,however, still make an antitrust challenge within 90 days after the transaction.

As in the United States, the review focuses on market share. A combined marketshare below 25% is not likely to be challenged. A market share above the critical level is

likely to be reviewed. The government is probably more flexible in reaching acompromise with the merging companies than are the U.S. antitrust agencies.

EUROPE

The European Union (EU) Merger Regulation grants the European Commission (EC)exclusive authority to review the antitrust implications of transactions that affect theeconomy of the European Community Transactions have a community impact if totalsales of the combined firm are greater than $4.5 billion annually and the EU sales of eachparty are greater than $250 million. However, if two thirds of the revenues of each firmare achieved in a single EU country, the EC will defer to that countrys antitrustauthorities.

Premerger notification is required. The minister of competition of the EU requiresa 3-week waiting period but can extend it. The commission is required to decide uponfurther investigation within the waiting period and must render an approval decisionwithin 5 months. The critical issue is whether the combination will create or strengthen adominant position.

A dramatic example of the international reach of the EU competition policy isprovided by the Boeing-McDonnell Douglas merger, announced m December 1996-USdefense procurement outlays between 1988 and 1996 had declined by more than 50%. Aseries of consolidating mergers had taken place among U.S. defense contractor. The EUcompetition commissioner was concerned that Boeings position in the commercialaviation market would be further strengthened. However, the main concern was Boeingsaggressive program of signing exclusive purchase contracts with major U.S. airlines thatwould have made it more difficult for Airbus to increase its share of the US commercialaviation market. On May 21, 1997, the EU issued its objections, requiring concessions toavoid its stopping the transaction. The EU had the authority to impose substantial fines,including the seizure of Boeing planes in Europe. Boeing made the requisite concessions

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to obtain approval from the EU competition commissioner. This case illustrates thepotentially far reach of international antitrust to a merger between two US firms.

Another example of the international reach of the EU involves the General Electricand Honeywell merger announced in October 2000. When this deal was announced,

analysts believed that the DOJ and the FTC would likely issue an HSR second request dueto potential concerns about segment concentration and pricing power, especially in theaircraft engine segment. The view held at the time would be that perhaps somedivestitures would be required, but the merger would be permitted to go through. A secondrequest was issued, but the DOJ formally approved the merger in May 2001, with someminimal conditions such as requiring General Electric to divest a military helicopterengine unit and let a new company service some of Honeywells small commercial jetengines.

Whereas analysts and the merging parties had expected some resistance from theDOJ and the FFC, they exhibited little concern regarding the EU. After all, the EU had

never blocked a U.S.-based merger that had received the prior approval of the DOJ or theFTC. Indeed, Jack Welch, chairman and CEO of General Electric, believed that the dealwould easily obtain EU approval. General Electric waited until early February 2001before formally filing for EU approval. They delayed the EU filing until well after theUnited States in order to learn something from the US experience so as to make anynecessary adjustments to the EU filing. Even though they filed relatively late,representatives of the merging parties had spent considerable time in Brussels engaged indiscussions with the EU staff in preparation for the filing. The goal was to get it right thefirst time and obtain approval without any waiting period. However, in March of 2001, theEU announced a formal second-stage review, which is similar to the HSR second review.The second-stage review can last up to 4 months. The primary issue was with GeneralElectrics aircraft-engines business. The EU was concerned that with the addition ofHoneywell, General Electric would be able to bundle various product packages, and thushave the ability to hurt its competitors and to increase its price to consumers As a result ofthis possibility, Rolls Royce and Airbus Industries, two European aircraft-enginemanufacturers, lobbied heavily to prevent the merger. General Electric continued toremain optimistic that the merger would go through. In late May, Jack Welch indicatedthat he did not foresee major hurdles to completing the deal. Nonetheless, in early July,the EU formally voted against the merger as it believed the merger would create dominantpositions in several areas including the markets for avionics and jet engines.

The EU decisions with respect to the General Electric Honeywell merger resultedin great criticism from numerous groups in the United States, including analysts on WallStreet politicians in Washington. D.C., and business leaders throughout the country. Theperception was that the EUs dominance test as applied in-the Honeywell merger wouldresult in too many rejections of mergers. Moreover, many hold the view that thedominance test tends to benefit competitors, and in the case of the General Electric andHoneywell merger, tends to benefit Rolls Royce and Airbus Industries. The EU hasrejected this notion, indicating that if a merger results in cheaper or better services to thecustomer base, then it would consider allowing a merger even if it meant a reduction in

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FE. This adverse publicity gave John Garamendi, the insurance commissioner ofCalifornia, a basis for placing ELIC in conservatorship on April 11, 1991. This seizurecaused further policy surrender request. Ultimately, in March 1992, California regulatorssold $6.13 billions (par value) of ELICs junk bonds for $3.25 billions; this was at least $2billion below their then-current value.

Ironically, the more traditional insurers experienced declines in their real estateportfolios that were 23 times the decline in junk bonds. Furthermore, although junk bonds,real estate, and mortgages bottomed out toward the end of 1990, the value of junk bondsincreased in value by almost 60% by July 1992, but real estate and mortgages hadrecovered by less than 20%. Without regulatory intervention, FE and ELK would havebeen fully solvent within a year and a half after the junk bond market bottomed out.Insurance companies and S&Ls with heavy investments in real estate and mortgagesexperienced continued difficulties.

The story of First Capital Life is similar (DDG 1996). The seizure of That Capital

Life and its parent First Capital Holdings was related to the investment of 40% of itsportfolio in junk bonds. DDG state that their evidence suggests that regulatory seizurereflected the targeting of insurers that had invested in junk bonds. However, thesecompanies did not experience differentially poorer financial positions compared withother insurers.

THE HOSTILE TAKEOVER OR THE PACIFIC LUMBER COMPANY

In 1986, the Pacific Lumber Company (It), the largest private owner of old redwood trees,was acquired in a leveraged hostile takeover by the MAXXAM Group headed by CharlesHurwitz, regarded as a corporate raider. The event resulted in a dramatic barrage ofnegative media coverage linking junk bonds and takeover greed to the destruction of theredwoods.

In their careful analysis of the facts, DD (1998) reach a more balanced conclusion.They point out that basic limber economics explains the behavior of MAXXAM and thepredecessor owners of PL. Timber economics predict that old growth forests will beharvested first because they will yield virtually no further growth in harvestable limbervolume, limber economic principles predict that under any private ownerships, old growthforests will be harvested, a process that had been taking place for at least 100 years beforethe 1986 takeover of FL. Theft study presents evidence that shows that 91% of PLs oldgrowth redwoods had already been logged by the time of the takeover and that the old andnew managements had similar timetables for the remaining acreage. Junk bonds andtakeovers would have little effect on these timetables. DD outline the correct policies forsaving the redwoods. One is to raise hinds to purchase the old growth acreage for publicholding. The other is to raise funds to purchase previously logged land to grow newredwood forests. These eminently sensible prescriptions were lost in the hysteria over thechange of ownership of the Pacific Lumber Company.

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REGULATION BY THE POLITICS OF FINANCE

The clinical studies of ELIC, First Capital Life, and PL illustrate how the use of junkbonds resulted in regulation by the politics of finance, The ultimate explanation for thebad reputation of junk bonds is that potentially they could finance the takeover of any firm

that was not per forming up to its potential. Thus, junk bonds became a vigilantmonitoring instrument to pressure managements to achieve a high level of efficiency inthe companies under their steward ship. The junk bond takeover threat was unsettling tothe managers of the leading companies in the United States. Widespread animosity towardthe use of junk bonds developed. Junk bonds filled an important financing gap for newand risky growth companies. Their use in takeovers led to value enhancement forshareholders. However, these three studies illustrate how junk bond use became alightning rod for widespread hysteria, animosity, and pressures on government regulationsto limit and penalize their use.

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