Exam 2: The Regulatory Environment

U.S.and European Union antitrust law are virtually identical.

Antitrust authorities may approve a proposed takeover even if the resulting combination will substantially increase market concentration if the target from would go bankrupt if the takeover does not occur.

Efficiencies rarely are considered by antitrust regulators in determining whether to accept or reject a proposed merger.

Horizontal mergers are rarely rejected by antitrust regulators.

U.S.antitrust regulators in determining if a proposed business combination is likely to be anti-competitive consider only domestic competitors or foreign competitors with domestic operations.

U.S.antitrust regulators are most concerned about what types of transaction?

The Sherman Act makes illegal all contracts,combinations,and conspiracies that "unreasonably" restrain trade.

Federal antitrust laws exist to prevent individual corporations from assuming too much market power such that they can limit their output and raise prices without concern for any significant competitor reaction.

Which of the following is among the least regulated industries in the U.S.?

Case Study Short Essay Examination Questions 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?

Case Study Short Essay Examination Questions Exxon and Mobil Merger-The Market Share Conundrum Following a review of the proposed $81 billion merger in late 1998, the FTC decided to challenge the Exxon-Mobil transaction on anticompetitive grounds. Options available to Exxon and Mobil were to challenge the FTC's rulings in court, negotiate a settlement, or withdraw the merger plans. Before the merger, Exxon was the largest oil producer in the United States and Mobil was the next largest firm. The combined companies would create the world's biggest oil company in terms of revenues. Top executives from Exxon Corporation and Mobil Corporation argued that they needed to implement their proposed merger because of the increasingly competitive world oil market. Falling oil prices during much of the late 1990s put a squeeze on oil industry profits. Moreover, giant state-owned oil companies are posing a competitive threat because of their access to huge amounts of capital. To offset these factors, Exxon and Mobil argued that they had to combine to achieve substantial cost savings. After a year-long review, antitrust officials at the FTC approved the Exxon-Mobil merger after the companies agreed to the largest divestiture in the history of the FTC. The divestiture involved the sale of 15% of their service station network, amounting to 2400 stations. This included about 1220 Mobil stations from Virginia to New Jersey and about 300 in Texas. In addition, about 520 Exxon stations from New York to Maine and about 360 in California were divested. Exxon also agreed to the divestiture of an Exxon refinery in Benecia, California. In entering into the consent decree, the FTC noted that there is considerably greater competition worldwide. This is particularly true in the market for exploration of new reserves. The greatest threat to competition seems to be in the refining and distribution of gasoline. : -How do the divestitures address perceived anti-competitive problems?

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. Case Study Short Essay Examination Questions 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. Discussion Questions 1. Do you agree or disagree with the federal court's ruling? Defend your position. 2. 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? Case Study Short Essay Examination Questions 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. Discussion Questions 1. In what way might the Justice Department's actions result in increased concentration in the online search business in the future? 2. What are the arguments for and against regulators permitting "natural monopolies"? BHP Billiton and Rio Tinto Blocked by Regulators in an International Iron Ore Joint Venture The revival in demand for raw materials in many emerging economies fueled interest in takeovers and joint ventures in the global mining and energy sectors in 2009 and 2010. BHP Billiton (BHP) and Rio Tinto (Rio), two global mining powerhouses, had hoped to reap huge cost savings by combining their Australian iron ore mining operations when they announced their JV in mid-2009. However, after more than a year of regulatory review, BHP and Rio announced in late 2010 that they would withdraw their plans to form an iron ore JV corporation valued at $116 billion after regulators in a number of countries indicated that they would not approve the proposal due to antitrust concerns. BHP and Rio, headquartered in Australia, are the world's largest producers of iron ore, an input critical to the production of steel. Together, these two firms control about one-third of the global iron ore output. The estimated annual synergies from combining mining and distribution operations of the two firms were estimated to be $10 billion. The synergies would come from combining BHP's more productive mining capacity with Rio's more efficient distribution infrastructure, enabling both firms to eliminate duplicate staff and redundant overhead and BHP to transport its ore to coastal ports more cheaply. The proposal faced intense opposition from the outset from steel producers and antitrust regulators. The greatest opposition came from China, which argued that the combination would concentrate pricing power further in the hands of the top iron ore producers. China imports about 50 million tons of iron ore monthly, largely from Australia, due to its relatively close proximity. The European Commission, the Australian Competition and Consumer Commission, the Japan Fair Trade Commission, the Korea Fair Trade Commission, and the German Federal Cartel Office all advised the two firms that their proposal would not be approved in its current form. While some regulators indicated that they would be willing to consider the JV if certain divestitures and other "remedies" were made to alleviate concerns about excessive pricing power, others such as Germany said they would not approve the proposal under any circumstances. Discussion Questions 1. A "remedy" to antitrust regulators is any measure that would limit the ability of parties in a business combination from achieving what is viewed as excessive market or pricing power. What remedies do you believe could have been put in place by the regulators that might have been acceptable to both Rio and BHP? Be specific. 2. Why do you believe the antitrust regulators were successful in this instance but so unsuccessful limiting the powers of cartels such as the Organization of Petroleum Exporting Countries (OPEC), which currently controls more than 40 percent of the world's oil production? Case Study Short Essay Examination Questions Justice Department Approves Maytag/Whirlpool Combination Despite Resulting Increase in Concentration When announced in late 2005, many analysts believed that the $1.7 billion transaction would face heated anti-trust regulatory opposition. The proposed bid was approved despite the combined firms' dominant market share of the U.S. major appliance market. The combined companies would control an estimated 72 percent of the washer market, 81 percent of the gas dryer market, 74 percent of electric dryers, and 31 percent of refrigerators. Analysts believed that the combined firms would be required to divest certain Maytag product lines to receive approval. Recognizing the potential difficulty in getting regulatory approval, the Whirlpool/Maytag contract allowed Whirlpool (the acquirer) to withdraw from the contract by paying a "reverse breakup" fee of $120 million to Maytag (the target). Breakup fees are normally paid by targets to acquirers if they choose to withdraw from the contract. U.S. regulators tended to view the market as global in nature. When the appliance market is defined in a global sense, the combined firms' share drops to about one fourth of the previously mentioned levels. The number and diversity of foreign manufacturers offered a wide array of alternatives for consumers. Moreover, there are few barriers to entry for these manufacturers wishing to do business in the United States. Many of Whirlpool's independent retail outlets wrote letters supporting the proposal to acquire Maytag as a means of sustaining financially weakened companies. Regulators also viewed the preservation of jobs as an important consideration in its favorable ruling. -What factors other than market share should be considered in determining whether a potential merger might result in an increased pricing power?

Employee benefit plans seldom create significant liabilities for buyers.

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

Market share is usually easy to define.

Case Study Short Essay Examination Questions The Legacy of GE's Aborted Attempt to Merge with Honeywell Many observers anticipated significant regulatory review because of the size of the transaction and the increase in concentration it would create in the markets served by the two firms. Most believed, however, that, after making some concessions to regulatory authorities, the transaction would be approved, due to its perceived benefits. Although the pundits were indeed correct in noting that it would receive close scrutiny, they were completely caught off guard by divergent approaches taken by the U.S. and EU antitrust authorities. U.S regulators ruled that the merger should be approved because of its potential benefits to customers. In marked contrast, EU regulators ruled against the transaction based on its perceived negative impact on competitors. Honeywell's avionics and engines unit would add significant strength to GE's jet engine business. The deal would add about 10 cents to GE's 2001 earnings and could eventually result in $1.5 billion in annual cost savings. The purchase also would enable GE to continue its shift away from manufacturing and into services, which already constituted 70 percent of its revenues in 2000. The best fit is clearly in the combination of the two firms' aerospace businesses. Revenues from these two businesses alone would total $22 billion, combining Honeywell's strength in jet engines and cockpit avionics with GE's substantial business in larger jet engines. As the largest supplier in the aerospace industry, GE could offer airplane manufacturers "one-stop shopping" for everything from engines to complex software systems by cross-selling each other's products to their biggest customers. ^{BusinessWeek, 2000b} Honeywell had been on the block for a number of months before the deal was consummated with GE. Its merger with Allied Signal had not been going well and contributed to deteriorating earnings and a much lower stock price. Honeywell's shares had declined in price by more than 40 percent since its acquisition of Allied Signal. While the euphoria surrounding the deal in late 2000 lingered into the early months of 2001, rumblings from the European regulators began to create an uneasy feeling among GE's and Honeywell's management. Mario Monti, the European competition commissioner at that time, expressed concern about possible "conglomerate effects" or the total influence a combined GE and Honeywell would wield in the aircraft industry. He was referring to GE's perceived ability to expand its influence in the aerospace industry through service initiatives. GE's services offerings help differentiate it from others at a time when the prices of many industrial parts are under pressure from increased competition, including low-cost manufacturers overseas. In a world in which manufactured products are becoming increasingly commodity-like, the true winners are those able to differentiate their product offering. GE and Honeywell's European competitors complained to the EU regulatory commission that GE's extensive services offering would give it entrée into many more points of contact among airplane manufacturers, from communications systems to the expanded line of spare parts GE would be able to supply. This so-called range effect or portfolio power is a relatively new legal doctrine that has not been tested in transactions of this size. ^{Murray, 2001} On May 3, 2001, the U.S. Department of Justice approved the buyout after the companies agreed to sell Honeywell's helicopter engine unit and take other steps to protect competition. The U.S. regulatory authorities believed that the combined companies could sell more products to more customers and therefore could realize improved efficiencies, although it would not hold a dominant market share in any particular market. Thus, customers would benefit from GE's greater range of products and possibly lower prices, but they still could shop elsewhere if they chose. The U.S. regulators expressed little concern that bundling of products and services could hurt customers, since buyers can choose from among a relative handful of viable suppliers. To understand the European position, it is necessary to comprehend the nature of competition in the European Union. France, Germany, and Spain spent billions subsidizing their aerospace industry over the years. The GE-Honeywell deal has been attacked by their European rivals from Rolls-Royce and Lufthansa to French avionics manufacturer Thales. Although the European Union imported much of its antitrust law from the United States, the antitrust law doctrine evolved in fundamentally different ways. In Europe, the main goal of antitrust law is to guarantee that all companies be able to compete on an equal playing field. The implication is that the European Union is just as concerned about how a transaction affects rivals as it is consumers. Complaints from competitors are taken more seriously in Europe, whereas in the United States it is the impact on consumers that constitutes the litmus test. Europeans accepted the legal concept of "portfolio power," which argues that a firm may achieve an unfair advantage over its competitors by bundling goods and services. Also, in Europe, the European Commission's Merger Task Force can prevent a merger without taking a company to court. The EU authorities continued to balk at approving the transaction without major concessions from the participants-concessions that GE believed would render the deal unattractive. On June 15, 2001, GE submitted its final offer to the EU regulators in a last-ditch attempt to breathe life into the moribund deal. GE knew that if it walked away, it could continue as it had before the deal was struck, secure in the knowledge that its current portfolio of businesses offered substantial revenue growth or profit potential. Honeywell clearly would fuel such growth, but it made sense to GE's management and shareholders only if it would be allowed to realize potential synergies between the GE and Honeywell businesses. GE said it was willing to divest Honeywell units with annual revenue of $2.2 billion, including regional jet engines, air-turbine starters, and other aerospace products. Anything more would jeopardize the rationale for the deal. Specifically, GE was unwilling to agree not to bundle (i.e., sell a package of components and services at a single price) its products and services when selling to customers. Another stumbling block was the GE Capital Aviation Services unit, the airplane-financing arm of GE Capital. The EU Competition Commission argued that that this unit would use its influence as one of the world's largest purchasers of airplanes to pressure airplane manufacturers into using GE products. The commission seemed to ignore that GE had only an 8 percent share of the global airplane leasing market and would therefore seemingly lack the market power the commission believed it could exert. On July 4, 2001, the European Union vetoed the GE purchase of Honeywell, marking it the first time a proposed merger between two U.S. companies has been blocked solely by European regulators. Having received U.S. regulatory approval, GE could ignore the EU decision and proceed with the merger as long as it would be willing to forego sales in Europe. GE decided not to appeal the decision to the EU Court of First Instance (the second highest court in the European Union), knowing that it could take years to resolve the decision, and withdrew its offer to merge with Honeywell. On December 15, 2005, a European court upheld the European regulator's decision to block the transaction, although the ruling partly vindicated GE's position. The European Court of First Instance said regulators were in error in assuming without sufficient evidence that a combined GE-Honeywell could crush competition in several markets. However, the court demonstrated that regulators would have to provide data to support either their approval or rejection of mergers by ruling on July 18, 2006, that regulators erred in approving the combination of Sony BMG in 2004. In this instance, regulators failed to provide sufficient data to document their decision. These decisions affirm that the European Union needs strong economic justification to overrule cross-border deals. GE and Honeywell, in filing the suit, said that their appeal had been made to clarify European rules with an eye toward future deals, since they had no desire to resurrect the deal. In the wake of these court rulings and in an effort to avoid similar situations in other geographic regions, coordination among antitrust regulatory authorities in different countries has improved. For example, in mid-2010, the U.S. Federal Trade Commission reached a consent decree with scientific instrument manufacturer Agilent in approving its acquisition of Varian, in which Agilent agreed to divest certain overlapping product lines. While both firms were based in California, each has extensive foreign operations, which necessitated gaining the approval of multiple regulators. Throughout the investigation, FTC staff coordinated enforcement efforts with the staffs of regulators in the European Union, Australia, and Japan. The cooperation was conducted under the auspices of certain bilateral cooperation agreements, the OECD Recommendation on Cooperation among its members, and the European Union Best Practices on Cooperation in Merger Investigation protocol. Discussion Questions -Do you think that competitors are using antitrust to their advantage? Explain your answer.

All of the following are true of antitrust lawsuits except for

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. Case Study Short Essay Examination Questions 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. Discussion Questions 1. Do you agree or disagree with the federal court's ruling? Defend your position. 2. 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? Case Study Short Essay Examination Questions 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. Discussion Questions 1. In what way might the Justice Department's actions result in increased concentration in the online search business in the future? 2. What are the arguments for and against regulators permitting "natural monopolies"? BHP Billiton and Rio Tinto Blocked by Regulators in an International Iron Ore Joint Venture The revival in demand for raw materials in many emerging economies fueled interest in takeovers and joint ventures in the global mining and energy sectors in 2009 and 2010. BHP Billiton (BHP) and Rio Tinto (Rio), two global mining powerhouses, had hoped to reap huge cost savings by combining their Australian iron ore mining operations when they announced their JV in mid-2009. However, after more than a year of regulatory review, BHP and Rio announced in late 2010 that they would withdraw their plans to form an iron ore JV corporation valued at $116 billion after regulators in a number of countries indicated that they would not approve the proposal due to antitrust concerns. BHP and Rio, headquartered in Australia, are the world's largest producers of iron ore, an input critical to the production of steel. Together, these two firms control about one-third of the global iron ore output. The estimated annual synergies from combining mining and distribution operations of the two firms were estimated to be $10 billion. The synergies would come from combining BHP's more productive mining capacity with Rio's more efficient distribution infrastructure, enabling both firms to eliminate duplicate staff and redundant overhead and BHP to transport its ore to coastal ports more cheaply. The proposal faced intense opposition from the outset from steel producers and antitrust regulators. The greatest opposition came from China, which argued that the combination would concentrate pricing power further in the hands of the top iron ore producers. China imports about 50 million tons of iron ore monthly, largely from Australia, due to its relatively close proximity. The European Commission, the Australian Competition and Consumer Commission, the Japan Fair Trade Commission, the Korea Fair Trade Commission, and the German Federal Cartel Office all advised the two firms that their proposal would not be approved in its current form. While some regulators indicated that they would be willing to consider the JV if certain divestitures and other "remedies" were made to alleviate concerns about excessive pricing power, others such as Germany said they would not approve the proposal under any circumstances. Discussion Questions 1. A "remedy" to antitrust regulators is any measure that would limit the ability of parties in a business combination from achieving what is viewed as excessive market or pricing power. What remedies do you believe could have been put in place by the regulators that might have been acceptable to both Rio and BHP? Be specific. 2. Why do you believe the antitrust regulators were successful in this instance but so unsuccessful limiting the powers of cartels such as the Organization of Petroleum Exporting Countries (OPEC), which currently controls more than 40 percent of the world's oil production? Case Study Short Essay Examination Questions Justice Department Approves Maytag/Whirlpool Combination Despite Resulting Increase in Concentration When announced in late 2005, many analysts believed that the $1.7 billion transaction would face heated anti-trust regulatory opposition. The proposed bid was approved despite the combined firms' dominant market share of the U.S. major appliance market. The combined companies would control an estimated 72 percent of the washer market, 81 percent of the gas dryer market, 74 percent of electric dryers, and 31 percent of refrigerators. Analysts believed that the combined firms would be required to divest certain Maytag product lines to receive approval. Recognizing the potential difficulty in getting regulatory approval, the Whirlpool/Maytag contract allowed Whirlpool (the acquirer) to withdraw from the contract by paying a "reverse breakup" fee of $120 million to Maytag (the target). Breakup fees are normally paid by targets to acquirers if they choose to withdraw from the contract. U.S. regulators tended to view the market as global in nature. When the appliance market is defined in a global sense, the combined firms' share drops to about one fourth of the previously mentioned levels. The number and diversity of foreign manufacturers offered a wide array of alternatives for consumers. Moreover, there are few barriers to entry for these manufacturers wishing to do business in the United States. Many of Whirlpool's independent retail outlets wrote letters supporting the proposal to acquire Maytag as a means of sustaining financially weakened companies. Regulators also viewed the preservation of jobs as an important consideration in its favorable ruling. -What is anti-trust policy and why is it important?

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