Enforcing interlocking directorates

What stepped up enforcement of the prohibitions on interlocking directorates means for private equity firms. By Robert Bell

Section 8 of the Clayton Act provides that “[n]o person shall, at the same time, serve as a director or officer in any two [competing] corporations.”   For many years there were very few cases brought under section 8, but this is now changing.  A little over two years ago, the Department of Justice filed suit under section 8 to prevent a company from being able to appoint directors of a competitor.   In the past eight months, as a result of a Federal Trade Commission investigation into whether Apple and Google had violated section 8, two directors who sat on both boards resigned ? Google CEO Eric Schmidt from Apple’s board and Genentech CEO Arthur Levinson from Google’s board.   In addition, well-known venture capitalist John Doerr, who sits on Google’s board, will not seek re-election to Amazon.com’s board, reportedly as a result of the same FTC investigation.   Moreover, earlier this month Sears announced that in order to settle a shareholder lawsuit alleging a violation of section 8, one board member will vacate his seat and another will not participate in any discussions about the company’s women’s clothing business because she also sits on the board of a clothing manufacturer.   Finally, section 8 is currently being invoked by Genzyme in its fight with Carl Icahn.  Icahn is seeking to place himself and three associates on Genzyme’s board.  Genzyme has pointed out that two of Icahn’s nominees are directors of Biogen Idec, a competitor, and is urging investors to reject Icahn’s slate on the grounds that its election would violate section 8.

The Chairman of the FTC recently stated that “we will continue to monitor companies that share board members and take enforcement actions where appropriate;”  and another FTC Commissioner has endorsed using section 5 of the FTC Act  to challenge interlocks that do not violate section 8.   Moreover, the Department of Justice is actively investigating several potential section 8 violations.

Private Equity Firms, Hedge Funds, and Section 8

Private equity firms and hedge funds have been targets of section 8 litigation.  William Crowley, the Sears director who will vacate his seat in May, is President and Chief Operating Officer of ESL Investments, Inc., a hedge fund that owned 54 percent of the outstanding voting stock of  Sears, 45 percent of the outstanding voting stock of AutoNation, Inc., and 41 percent of the voting stock of AutoZone, Inc.,  when the section 8 suit was filed.  He sat on all three boards.  Plaintiffs alleged that AutoZone competes with Sears in the sale of automobile replacement parts and accessories, and AutoNation competes with Sears in automobile service and repair.  Oaktree Capital Management LLC, a private equity firm, was sued under section 8 when it acquired 40 percent of Loews Cineplex Entertainment Group and 17 percent of Regal Entertainment Group, both of which operate movie theatre chains, and placed representatives on both boards.

Although section 8 investigations and suits involving private equity firms, hedge funds, sector funds, and similar entities ? hereinafter referred to as “private equity firms” ? have been rare, until recently section 8 suits and investigations involving all types of entities have been infrequent.  Not only do many private equity funds invest in companies that compete against each other, even if only tangentially, which can be sufficient to create a section 8 issue, but they invest in companies in high tech industries where as a result of new product offerings, a company that is not a competitor today may become one tomorrow.  Accordingly, private equity firms need to understand and comply with section 8.

This article describes what section 8 prohibits, explains the key limitations on the reach of section 8, and notes when interlocks may be challenged under section 5 of the FTC Act.  It then suggests some steps private equity firms can take to reduce their exposure to investigations and lawsuits.

Section 8 of the Clayton Act

The purpose of section 8 is to prevent interlocking officers and directors from facilitating collusion between competing companies, such as price fixing and market division, by serving as a conduit for competitively sensitive information.  It prevents a single person from serving on the boards of two competing corporations, and it also prevents an entity such as a private equity firm from placing two different representatives or agents on the boards of competing companies.

Section 8 is violated if there is a prohibited interlock even if there is no proof of any harm to competition or any intent to coordinate prices, output, or other business decisions.  It can be enforced by the Department of Justice, the Federal Trade Commission, state attorneys general, and private parties.  The typical remedy under section 8 is an injunction prohibiting the offending interlock and future interlocks.  Treble damages are theoretically available to private plaintiffs, but no court has ever awarded damages under section 8.  Nevertheless, no company wants to be subject to a government investigation (or discovery in a private lawsuit) and possible litigation.  Both are expensive, time-consuming, and can create disclosure obligations.  Moreover, interlocking officers or directors can make a company more vulnerable to claims of price fixing, customer, territorial, or product allocation, or other agreements not to compete, all of which can have serious civil and criminal consequences.

Limitations on Section 8

There are three important limitations on the reach of section 8.  First, the statute does not apply if an agreement to eliminate competition between the two corporations that have common officers or directors would not “constitute a violation of any of the antitrust laws.”   Because the Supreme court has held that a corporation is not capable of conspiring with its wholly-owned subsidiary to violate the Sherman Act,  section 8 does not apply to interlocks involving wholly-owned subsidiaries.  However, the Court left open the question “under what circumstances, if any, a parent may be liable for conspiring with an affiliated corporation it does not completely own.”   The better-reasoned cases hold that where a parent controls a subsidiary, the parent and the subsidiary cannot conspire.   Those cases are in the majority, but there are a few cases holding that a parent can conspire with a majority-owned subsidiary.

Consistent with the case law on parent-subsidiary conspiracy, section 8 has been held to prohibit interlocks where a parent owns less than 50 percent of an affiliate,  but there are no cases addressing the application of section 8 where the parent owns more than 50 percent but less than 100 percent of the subsidiary.  Similarly, there are no cases addressing the situation where there is an interlock between two majority-owned subsidiaries of the same person, such as two portfolio companies of a private equity firm.  Nevertheless, where a private equity firm owns 80 to 85 percent of the equity of its portfolio companies and two or more of those companies compete against each other, the risk of an interlock being found to violate section 8 is very low.

The second limitation on section 8 is a set of de minimus exceptions.  The Act applies only where both companies have capital, surplus, and undivided profits in excess of $25,841,000, a figure that is revised annually.   Also exempted from section 8 are interlocks where the competitive sales of either corporation are less than $2,584,100 (also adjusted annually),  the competitive sales of either corporation are less than two percent of the corporation’s total sales,  or the competitive sales of each corporation are less than four percent of that corporation’s total sales.

A third limitation on the operation of section 8 is a one-year grace period.  If, as a result of a change in the capital, surplus, and undivided profits, or in the affairs of the company, a previously ineligible director becomes ineligible under the statute, he or she may continue to serve for one year following the date on which the event causing ineligibility occurred.

Section 5 of the FTC Act

Section 5 of the FTC Act  prohibits “unfair methods of competition” and it has been used by the FTC to challenge interlocks that violated the “spirit and policy” of section 8 but section 8 did not reach.  Going forward, the most likely use of section 5 will be to challenge interlocks involving entities other than corporations and interlocks between potential competitors.
Lessons for Private Equity Firms

The FTC in particular has clearly signaled that it is subjecting interlocks to greater scrutiny.  This is but one manifestation of stricter antitrust enforcement by the Obama Administration.  In this environment, private equity firms should take several steps to minimize their exposure:

• Identify whether any less-than-majority-owned portfolio companies have competing sales with any other portfolio company before placing representatives on more than one board.  As noted above, a private equity firm can violate section 8 if it has representatives serving on the boards of two competing corporations, notwithstanding that the representatives are different people.  While it is a factual question whether a person is serving on a board in his individual capacity or as a representative of the private equity firm, the closer the association between the private equity firm and the director, the more likely that the individual will be found to be a representative.  For example, courts are more likely to find that an employee of a private equity firm is a representative of the firm than they are to find that a co-investor is a representative.

• Identify whether any less-than-majority-owned portfolio companies may compete in the future with any other portfolio company as a result of one of them  introducing new products, expanding the geographic scope of its operations, or making an acquisition.  It is important to note that when the FTC publicly announced its investigation of the Google-Apple interlock in May 2009, it was likely the parties were then exempt from section 8 because it appears that none of Google’s sales that competed with Apple constituted more than 2% of Google’s sales.  It was clear that the parties could become substantial competitors in the future ? as they are now, with Google’s introduction of Nexus One, a direct competitor to Apple’s iPhone ? and thus it appears that the FTC was prepared to challenge the interlock under section 5 of the FTC Act.  Accordingly, if one portfolio company has plans that would place it in competition with another portfolio company, especially if those plans have been publicly announced, it would be prudent to avoid placing directors on both boards.

• Monitor these issues on an ongoing basis.  For example, a director of a portfolio company should report to the board if he is planning to sit on any additional boards so that the board can determine whether the new directorship would raise section 8 issues.  Similarly, if a portfolio company makes an acquisition or expands its product offerings, a section 8 analysis should be performed.

• Have a written antitrust compliance policy that alerts all employees to the dangers of antitrust violations and warns employees to avoid communications that could give rise to antitrust issues, and take special care that representatives that sit on portfolio company boards understand the limits on sharing competitively sensitive information.

Robert  Bell is a partner in Kaye Scholer’s Washington, DC office, where he practices antitrust law, and is co-chair of the firm’s Antitrust Practice Group.