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John C. Malone, chairman and CEO of Discovery Holding Company, has agreed to pay $1.4 million to settle Federal Trade Commission charges that he violated the Hart-Scott-Rodino Act in connection with a series of acquisitions of Discovery stock between August 2005 and June 2008.

Malone agreed to the settlement despite having complied with the HSR Act in connection with his 2005 acquisition of stock of Discovery’s former parent, Liberty Media Corporation, having made a corrective filing with respect to all but one of his Discovery stock acquisitions from 2005 to 2008, and having used an escrow arrangement in an effort to prevent a violation in connection with the remaining Discovery stock acquisition in June 2008.

The case serves as a reminder that the HSR Act applies to acquisitions made by corporate insiders and not just to acquisitions made by independent buyers. In addition, the case makes clear the FTC’s position that HSR Act compliance in connection with the acquisition of the stock of a parent company does not exempt later acquisitions of the stock of subsidiaries that are spun off after the filing. Finally, this case is also a warning that acquiring persons should be cautious in using escrow agreements to transfer securities during the HSR Act waiting period.

Acquisition of Discovery Shares Between August 2005 and April 2008

The HSR Act requires parties to a stock acquisition meeting certain thresholds to give advance notice to the FTC and the Antitrust Division of the Department of Justice and to observe a statutory waiting period before consummating the acquisition.

According to the complaint filed on June 23, 2009 in the United States District Court for the District of Columbia by the DOJ at the FTC’s request, in May 2005 Malone made an HSR filing to acquire shares of Liberty Media and observed the requisite waiting period before completing the transaction. Liberty Media was Discovery’s parent company at the time. Under the HSR Act, additional acquisitions of Liberty Media stock by Malone would have been exempt from reporting requirements for a period of five years from the expiration of the waiting period relating to the May 2005 filing, as long as Malone did not exceed the next relevant notification threshold.

A few months later, Discovery was spun off from Liberty Media and became independently owned. Between August 9, 2005, and April 2008, Malone made a number of acquisitions of Discovery stock, apparently believing that these acquisitions would be covered by the five-year grace period relating to his May 2005 filing for the Liberty Media acquisition. According to the complaint, however, Malone was wrong, and his acquisitions of stock of Discovery were not exempt from the HSR Act by virtue of his filing relating to Discovery’s former parent. Thus, according to the FTC, because Malone’s August 9, 2005 acquisition of Discovery stock was otherwise reportable, Malone was required to comply with the HSR Act prior to completing that acquisition. By failing to comply, Malone allegedly also violated the HSR Act with each subsequent acquisition of Discovery stock.

Malone made a corrective filing for his acquisitions of Discovery stock on June 12, 2008, the waiting period for which expired on July 14, 2008. Accordingly, the FTC claimed that Malone was in continuous violation of the HSR Act from August 9, 2005 through July 14, 2008.

Escrow Agreement to Acquire Discovery Shares in June 2008

On June 14, 2008, before the expiration of the waiting period on his corrective filing, Malone exercised an option to acquire additional Discovery stock. Because HSR Act compliance must be achieved before beneficial ownership of the securities in question passes to the buyer, Malone sought to prevent another HSR Act violation by exercising the option through an escrow agreement. Pursuant to that agreement, Malone paid for the securities on June 14 and had them delivered to the escrow agent, with instructions to deliver them to Malone upon the expiration of the HSR waiting period. Had the waiting period not expired within 120 days, the escrow agent was required to sell the securities and remit the proceeds to Malone. Neither Malone nor the escrow agent was permitted to vote the securities during the escrow period.

According to the FTC, this escrow arrangement was insufficient to prevent passage of beneficial ownership to Malone because, as of June 14, 2008, the risk of loss in the securities’ value was Malone’s – not Discovery’s – and Discovery no longer had the right to receive the securities back, or to vote or dispose of them in any way. According to the complaint, Malone violated the HSR Act by exercising the option prior to the expiration of the waiting period. Accordingly, the FTC claimed that, like his earlier acquisitions of Discovery stock, Malone’s June 14, 2008 acquisition also violated the HSR Act.

Civil Penalties

For the time period in question, a court could impose a civil penalty of up to $11,000 for each day in which a person is in violation of the HSR Act (today, the daily penalty could be as high as $16,000). According to the complaint, Malone was in violation of the HSR Act each day from August 9, 2005 to July 14, 2008 – a little less than three full years. In settling the case, Malone agreed to pay $1.4 million, which constitutes approximately 11 percent of the maximum allowable penalties.

HSR Lessons

As indicated above, this case is a reminder that the HSR Act can apply not only to acquisitions made by independent buyers, but also to acquisitions made by corporate insiders.

In addition, acquiring persons should bear in mind that, while subsequent acquisitions of the same issuer’s stock within the five-year grace period are exempt from the HSR Act so long as the next applicable threshold is not exceeded, the exemption does not apply to acquisitions of securities of subsidiaries that are spun off after the original filing is made.

Finally, the case is also a warning for buyers to be cautious in using escrow agreements to acquire securities prior to the expiration of the waiting period. To prevent an HSR violation, an escrow agreement must be iron-clad, in that it must prevent the premature transfer of “beneficial ownership” within the meaning of the HSR Act.