Private equity sponsors contemplating a minority investment are accustomed to assuming that they need not be concerned with substantive antitrust compliance simply by reason of the investment itself. If they secure rights to designate board seats with companies that may compete, however, that assumption needs to be revisited.
A recent decision in a federal court in New York has breathed new life into a virtually unknown and rarely used provision of the antitrust laws. Clayton Act Section 8, the obscure antitrust prohibition on interlocking directorates, has become a trap for the unwary private equity investor.
Antitrust has been around since 1890, when Congress adopted the Sherman Act to bust trusts that had eliminated competition in basic industries like sugar, oil and steel. In 1914, Congress beefed it up with the Clayton Act, which added several significant features to the antitrust arsenal. Since then, the Sherman Act has proven itself to be a powerful tool to protect the equalizing effect of competition in commerce.
One of these add-ons, called Clayton Act Section 8, prohibits an end-run around the Sherman Act’s bans on monopolization and agreements in restraint of trade by prohibiting the same “person” from serving on the boards of competitive companies. It states that, “No person shall, at the same time, serve as a director or officer in any two corporations . . . that are . . . competitors so that the elimination of competition by agreement between them would constitute a violation of the antitrust laws.” Unlike most of the other provisions of the antitrust laws, Clayton Act Section 8 ignores whether the interlock has any impact on competition-if two companies meet the size requirements, are direct competitors and share a board member, Clayton Act Section 8 is violated. End of inquiry.
Since its 1914 enactment, Clayton Act Section 8 has rarely been enforced, either by private litigants or by the federal government, doubtless because of its lack of linkage with real anticompetitive effects. By contrast, the Sherman Act has been extremely effective in forcing competitors to avoid collusion and aggressively compete. Sherman’s success, coupled with a director’s fiduciary obligation to the entity on whose board he serves, has created an atmosphere where individuals shy away from serving on the boards of two companies that are direct competitors. Similarly, competitors avoid sharing a board member if there is any risk that proprietary information and business secrets would be exposed. Clayton Act Section 8 has proven to be unnecessary and until very recently has sunk into obscurity.
With the growth of private equity funds as an important source of financing for business ventures, particularly for startups, later-stage companies or companies emerging from bankruptcy, Clayton Act Section 8 may be about to find new life. A typical investment involves a non-controlling equity position, coupled with the right of the Fund to a designated board seat. This structure has caused vast sums of necessary capital to be invested for business innovation and growth. At the same time, the venture capital funds have grown substantially in size and number. As a result, the likelihood that a single venture capital sponsor will hold a non-controlling investment in two entities that are, or may become, competitors is more and more probable.
For decades, except for the government, anyone who thought about Section 8 compliance assumed that a “person” meant a natural person because only a natural person can serve as a member of a board of directors. While both the FTC and Department of Justice have long taken the view that a “person” can be an entity that places two different investing principals on two different boards, the government simply has not cared enough to flex its enforcement muscles. As a result, until recently, no court has accepted this interpretation.
A recent shift in the meaning of “person” has brought this moribund statute back to the forefront for private equity firms. In late 2003, the Southern District of New York issued an opinion that, for the first time, definitively interpreted “person” as used in Clayton Act Section 8. It held that a “person” can be the entity, such as a private equity firm, that deputizes two different natural persons to serve on competing boards.
Reading v. Oaktree
In Reading International, Inc. v. Oaktree Capital Management, LLC, the owner, operator and landlord of an independent movie theater in Manhattan brought suit under federal and New York antitrust laws against the Loews and Regal theater chains, which competed with each other as well as with the plaintiff. The suit claimed that Loews and Regal monopolized that market for top commercial films, for the purpose of driving plaintiffs’ independent theater out of business.
So far Reading sounds like a pretty typical antitrust case. The case becomes important because the plaintiff also sued the asset management companies and investment firms with equity positions in Loews and Regal. One of them, Oaktree Management, held a minority equity position in both Loews (40%) and Regal (17%). Oaktree had assigned one principal, its president, Bruce Karsh, to serve on Loew’s board and another principal, Stephen Kaplan, to serve on Regal’s board. Plaintiffs challenged this arrangement as an interlock prohibited by Clayton Act Section 8 and demanded an injunction and treble damages, as well as the attorneys fees automatically awarded to any victim of an antitrust violation.
Oaktree sought dismissal of the Clayton Act Section 8 claim, arguing that it only prohibits “direct” interlocks in which the same individual serves on the boards of two competing corporations. Oaktree also argued that an entity like Oaktree cannot violate Clayton Act Section 8 because only a natural person can serve as a director. But the Court rejected these arguments and held that an entity like Oaktree is a “person,” so that Oaktree’s decision to deputize two different individuals to serve on the boards of two competitive companies in which it held a minority equity position potentially violates Clayton Act Section 8. The remaining question is whether Mr. Karsh and Mr. Kaplan in fact were deputized to act for Oaktree. The Court held that plaintiffs must prove that they served on the two boards, not in their individual capacities, but as the deputies of Oaktree:
“[A]cting as the puppets or instrumentalities of [Oaktree]’s will, such that it can legitimately be said that it is Oaktree as an entity and not Kaplan and Karsh as separate persons, which serve[s] as a director’ of both Loews and Regal.”
If a judge or jury finds that the two board members acted as “deputies” of the Fund, Clayton Act Section 8 is violated.
While the Reading case is still pending, the claims against Oaktree and its principals were dismissed on Dec. 6, 2004. Nevertheless, the opinion interpreting Clayton Section 8 cannot be ignored. Private equity sponsors invest at their peril if they ignore the prohibition of Clayton Act Section 8.
Section 8 Prohibitions
Clayton Act Section 8 prohibits a “person” from serving as a director or officer for two competing companies at the same time. While it ignores whether the overlap has any real or measurable anticompetitive effect, it does have a carve-out for interlocks between small companies or where the competitive overlap is de minimus.
Congress set two size thresholds below which Clayton Act Section 8 does not apply. The thresholds float up with the GNP and are reset annually by Jan. 31 of each year. Since Jan. 16, 2004, the size test is satisfied if both of the following two thresholds are met: (1) Each competitive corporation has capital, surplus and undivided profits aggregating more than $20.09 million, and (2) the competitive overlap between the two corporations is significant enough to satisfy one of the following three tests: (a) each corporation has competitive sales of at least $2.009 million; or (b) the competitive sales of either corporation are at least 2% of the corporation’s total; or (c) the competitive sales of each corporation are at least 4% of the corporation’s total.
A practical way to determine whether two companies compete so that there is a potential Clayton Act Section 8 problem looks to whether an agreement on price between two companies would be a price fixing agreement. If it would, the competition between them is also sufficient to trigger a Clayton Act Section 8 violation.
Ironically if the investment confers control, the Clayton Act Section 8 problem may be eliminated. If a parent company designates employees or agents to sit on the boards of competing subsidiaries, there is no violation: antitrust considers the parent and its controlled subsidiaries as a single entity, so that the competitors are not capable of reaching an agreement in restraint of trade.
It is worth noting that Clayton Act Section 8 does not apply to interlocking board membership or officers of competing banks, banking associations or trust companies. While interlocks involving banks are addressed in a different statute, unlike Clayton Act Section 8, the regulations governing banks do look at whether the interlock would have an anticompetitive effect.
What happens if a private equity sponsor places representatives on two different boards with no competitive overlap but, over time, one portfolio company enters a business in which another already competes? What happens if a private equity sponsor places representatives on two different boards of corporations that are below the operative size thresholds, but the portfolio companies grow and the thresholds are exceeded? The framers of Clayton Act Section 8 considered these questions and created a one-year buffer for the incipient violation to be fixed. There is no permanent safe harbor for board interlocks that were in compliance at the time the investment was made; a private equity investor that unintentionally or unknowingly drifts into a Clayton Act Section 8 violation has one year after the potential problem arose to cure or face the antitrust consequences.
A Clayton Act Section 8 violation can be even more difficult to detect because of what has been called the “attribution theory.” This theory applies when an investor designates board members for seats on the boards of Company A and Company B, neither of which compete; however, if B controls C and C competes with A, Clayton Act Section 8 might be violated. The only issue is the degree to which the board of B exercises substantial control over the business decisions of C. If it does, the interlocking directorship violates Clayton Act Section 8.
If a Clayton Act Section 8 violation is exposed, how serious is the problem? It depends. One unacceptable consequence arose in the Oaktree case where an antitrust suit brought by a business seeking damages exposed the interlock. In such a case, the plaintiff may recover attorney’s fees and damages automatically trebled under the antitrust laws. Even if the venture capital firm pulls one of the board members and there has been no competitive injury, it is still exposed to the antitrust requirement that it pay the plaintiff’s attorneys fees. There also is a risk, though remote, that a pattern of disregard of Clayton Act Section 8 could attract aggressive governmental enforcement or lead to an injunction that impairs the freedom of the Fund to protect its investments through board designations.
Given the risks of an inadvertent Clayton Act Section 8 violation, it is advisable to establish a compliance program to assure that each potential investment is evaluated for potential Clayton Act Section 8 problems. In addition, competitive data for the existing portfolio should be reviewed annually to detect a problem that has arisen since the last review. If the compliance review exposes a problem, the private equity investor should consult with counsel regarding how to avoid or minimize Clayton Act Section 8 risk while maximizing protection of its investment.
If a potential problem is identified, the most effective, but not necessarily attractive, method to cure a Clayton Section 8 problem is to remove one of the two Fund representatives from one of the boards. Another potential fix-but one that has never been blessed by any court-would be to wall the two board members off from each other so that their “independence” is assured. If a Clayton Section 8 problem means a Fund cannot have a board designee, the alternatives for maintaining the level of oversight essential to monitor an investment may include:
* The private equity firm may seek protective controls by contract, barring the portfolio company from taking specified actions without the private equity firm’s consent.
* The private equity firm may obtain board visitation rights, entitling the Fund’s designee to attend board meetings and to receive all financial and relevant corporate information that board members’ receive.
* Or, the private equity firm may participate on an advisory board that deals with strategy but lacks formal responsibility.
Of course, these alternatives to a board seat are still subject to the Sherman Act restrictions on anticompetitive conduct.
Rethinking Section 8
For 90 years, Clayton Act Section 8’s utility in supplementing the Sherman Act has been questionable. The dearth of reported decisions affirms that neither the government nor private litigants have bothered to enforce it. Now it may put at risk the availability of essential capital to innovative startup businesses by deterring equity investors from taking a position that has no adverse impact on competition. When a statute fails to satisfy the fundamental principle borrowed from the Law of Hippocrates, “at least do no harm,” it is time to start the debate whether it should be repealed.
Richard G. Small is a Partner and co-head of the Private Equity & Venture Capital practice group at Edwards & Angell. Patricia A. Sullivan is a Partner in the Antitrust practice group of Edwards & Angell. Small’s email is rsmall@EdwardsAngell.com. Sullivan’s email is psullivan@EdwardsAngell.com.