Amendment Reduces Litigation Risk of Using Tender Offers to Accomplish Acquisitions

On October 18, 2006, the SEC amended the tender offer “best price” rule to reduce the litigation risk that has dissuaded many acquirors from using tender offers in structuring acquisitions.  Among other things, the amendments:

• clarify that the rule applies only to consideration paid for securities tendered in the tender offer;
• exempt employment compensation, severance and employee benefit arrangements that meet specified criteria; and
• create a safe harbor for such arrangements that are approved by independent directors pursuant to procedures outlined in the amendments.

We anticipate that with the amendments companies will use tender offers more frequently, in order to enjoy the efficiencies of a tender offer as an acquisition structure.  We also expect that companies will seek to follow the safe harbor requirements in connection with employment and other compensatory arrangements for target security holders.  Other arrangements with target security holders, however, such as commercial arrangements, may remain subject to scrutiny.

The amended rule will be effective 30 days following the publication in the federal register, which is expected shortly. 

Background

The best price rule is the common name for the provision of Rule 14d-10 under the Securities Exchange Act of 1934 that, as in effect prior to the amendments, requires a bidder in a tender offer to pay to “any security holder pursuant to the tender offer … the highest consideration paid to any other security holder during such tender offer.”  The SEC adopted the rule in 1986 to prevent coercive tender offers by ensuring equal treatment of all target shareholders. 

In some circumstances, however, courts applied the best price rule to transactions that typically accompany corporate acquisitions, such as severance, retention, noncompetition payments and other compensation arrangements for target company executives.  Target shareholders claimed that such arrangements actually were intended to compensate the recipients for tendering their shares, and that the buyer must pay the same compensation to all other shareholders.  Potential damages were enormous, since in theory every shareholder was entitled to the per-share premium deemed to have been received by the target company executive or other beneficiary of the arrangement.[1]

Courts differed in their interpretation of the best price rule, with some following a “bright line” test, applying the best price rule only to transactions that occurred during the pendency of the tender offer,[2]  and others following an “integral part” test, under which a payment might violate the best price rule if it was sufficiently related to the tender offer, regardless of when it occurred.[3]  Moreover, resolution of claims generally requires a review of facts and circumstances surrounding the challenged compensation arrangements, so courts have been reluctant to grant a motion to dismiss or for summary judgment.  In a previous update, we provided some illustrations of the application of the rule (see The SEC's "Best Price" Rule: Recent Case Law Complicates Planning for Tender Offers, November 2002).

Many acquirors reacted to this confusion by avoiding tender offers in favor of other acquisition structures, such as statutory mergers.  The SEC’s intent in amending the rules is to eliminate the regulatory disincentive to the use of tender offers and put tender offers on an equal footing with other acquisition structures, principally mergers.

SEC Best Price Rule Amendments

General Rule
The best price rule as amended will require that:

[t]he consideration paid to any security holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer.

The rule thus will focus on “securities tendered in” a tender offer rather than payments “pursuant to” or “during” a tender offer.  The SEC declined, however, to limit the application of the best price rule to a specific time period, as had been requested by some practitioners.  

Exemption for Compensatory Arrangements 
The SEC added an exemption for employment compensation, severance and other employee benefit arrangements for target security holders, where the amount payable:

(i) is being paid or granted for past services performed or future services to be performed or refrained from performing, and

(ii) is not calculated based on the number of securities tendered. 

The SEC acknowledged that companies often make critical personnel decisions in connection with acquisition transactions, and that these arrangements were not intended to be captured by the best price rule.  The SEC declined to extend the exemption to commercial arrangements, although it noted that the absence of a specific exemption was not intended to indicate that such arrangements should be seen as consideration for securities tendered in the tender offer.  

Safe Harbor for Compensatory Arrangements
To facilitate reliance on the exemption, the SEC created a safe harbor for the exempted compensatory arrangements if they are approved by independent directors pursuant to specified procedures.  Generally, the arrangements must be approved as compensatory arrangements by the compensation committee or another committee of the board, comprised solely of independent directors, of either:

• the target, for all such arrangements, whether the target is a party thereto or not, or 
• the acquiror, for any such arrangement to which the acquiror is a party. 

If the target or acquiror, as applicable, does not have a compensation committee or similar committee, the approval may be provided by a special committee formed to consider the arrangements.  For purposes of the safe harbor, a board’s determination that the members approving the arrangements are independent is conclusive.

In requiring a director vote, the SEC believes the target’s security holders will be protected by the directors’ state law fiduciary duties.  Conversely, directors making the safe harbor determination with respect to the arrangements, and thus removing them from the restrictions of the best price rule, may find their determination challenged by plaintiff shareholders under those duties. The SEC also anticipates that directors will need to have knowledge of the specific arrangements and the related tender offer when giving their approval for purposes of the safe harbor. 

For foreign private issuers, arrangements can be approved by any directors or any committee of the board of directors that is authorized to approve the arrangement under the laws of their home country, where such members are independent in accordance with the laws of their home country.

Efficiencies of a Tender Offer

A key benefit of a tender offer over a merger is speed to closing.  In a merger, the shareholder disclosure documents cannot be distributed until the SEC has completed its review of (or has determined not to review) preliminary versions of the documents.  In a tender offer, however, the SEC reviews the documents during the pendency of the offer, typically allowing tender offers to close several weeks earlier than a comparable merger transaction.  A cash tender offer also may result in quicker initial antitrust review, since the waiting period under the Hart-Scott-Rodino Act for a cash tender offer is 15 days while for a merger it is 30 days. 

The efficiency of a tender offer, however, is not always available.  Closing may be delayed by other aspects of the transaction, such as the need for a shareholder vote on the part of the bidder (for example, where the bidder is paying with stock and is required by exchange rules to obtain shareholder consent) or regulatory approvals.  The overall acquisition also will not be completed until after the “second step” merger is completed, which could require its own merger process if the tender does not result in the bidder owning more than 90% of each class of the target’s outstanding shares. 

Conclusion

The amendments respond to expansive and conflicting court interpretations of the best price rule that effectively limited acquirors’ willingness to use tender offers.  The SEC’s goal is to further level the playing field between tender offers, mergers, and other forms of business combinations, so that market considerations can determine which structure creates more value for shareholders.  Targets and acquirors both can benefit from the changes, although some issues still remain.

Footnotes:

1:  The cost can be particularly daunting when a target executive or other shareholder who allegedly receives extra compensation holds relatively few shares, as the bidder would then have to pay a proportionate premium to all other tendering shareholders.  For example, in In re Luxottica Group SpA Sec. Litig., 293 F. Supp. 2d 224 (E.D.N.Y. 2003), the court found that there were questions of fact as to the motive for making a noncompete and consulting payment to the target’s CEO, who held approximately 4% of the target’s shares.  If the best price rule were applied to those payments, the acquiror would have to pay proportional amounts to the holders of the other 96% of the shares.
 
2:  See, for example, Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996).

3:  See, for example, Epstein v. MCA, Inc., 50 F.3d 644 (9th Cir. 1995), rev'd on other grounds, 516 U.S. 367 (1996). A variation on the integral part test is the “functional test.”  See Field v. Trump, 850 F.2d 938 (2d Cir. 1988).