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In a recent decision that may substantially impact the structure of merger and acquisition transactions in the U.S., a key federal court has applied the SEC's "best price" rule, Rule 14d-10, to the payment of a non-competition fee made to an executive officer of a target company. This decision by the U.S. Court of Appeals for the Second Circuit, Gerber v. Computer Associates International (the "Computer Associates decision"),[fn1] represents a broad application of the best price rule, and may be used as precedent to block a wide variety of payments and transactions that often occur in connection with a tender offer.

When considered in light of other recent judicial activity in this area, particularly the California and Tennessee cases described below, the Computer Associates decision should serve as an important reminder to participants in tender offers to carefully consider the possible impact of the best price rule. In the section below, "Designing Compensation Arrangements," we provide several considerations that can be applied to help avoid implicating the best price rule when developing executive compensation and related arrangements for the management team of a company that is a potential target of a tender offer.

The Best Price Rule - A Brief Overview

Rule 14d-10(a) under the Securities Exchange Act of 1934 (the "Exchange Act") requires a bidder in a tender offer to permit all holders of the relevant class of securities to participate in the transaction (the "all holders rule"), and to pay to each tendering securityholder ". . . the highest consideration paid to any other security holder during such tender offer" (the "best price rule"). The rule is designed to ensure that all of the target's shareholders are treated equally in the context of a tender offer - no shareholder should receive consideration for its shares that is not received by the other shareholders.

The rule appears simple enough in principle. However, in connection with any significant corporate acquisition, a variety of transactions often occur before, after, or simultaneously with, the purchase of the target's shares. The target's management, who are also often also shareholders of the target, are often party to these transactions. After all, the terms of their post-merger compensation, or their post-merger departure, is of great concern to any acquiror.

In these situations, the best price rule has been subject to differing interpretations during the past several years. If, in connection with a tender offer, the bidder, the target, or one of their affiliates makes payments or provides some other benefit to a management shareholder of the target, other than the consideration paid in the tender offer, has Rule 14d-10 been violated? There are a variety of types of transactions that could be implicated under this rule:

• severance payments to management shareholders, whether put in place by the target or the acquiror;
• cash retention bonuses or equity compensation to management shareholders who remain with the combined company following the merger; and
• fees paid to management shareholders in exchange for a covenant not to compete.

The best price rule, in and of itself, does not provide much guidance on how to treat transactions of this kind. Accordingly, the task has been left to the federal courts to apply the rule to transactions challenged by purportedly aggrieved shareholders of the target.

"Bright Line" Test vs. "Integral Part" Test

Based upon cases decided in the U.S. Courts of Appeals in the Seventh Circuit and the Ninth Circuit, federal courts have generally applied two primary theories in interpreting the "best price" rule: the "integral part" test and the "bright line" test.

The Integral Part Test. The "integral part" test emerged primarily from the ninth circuit's ruling in Epstein v. MCA.[fn2] Under this test, the court's analysis focuses upon the relationship of the transaction in question to the tender offer. For example, such analysis could depend upon whether the transaction is expressly conditioned upon the completion of the tender offer, therefore lacking commercial significance of its own. The integral part test requires careful planning of transactions to ensure that they do not implicate the best price rule.

The Bright Line Test. In contrast, the "bright line" test adopted by the Seventh Circuit in Lerro v. Quaker Oats Co.,[fn3] renders transaction planning less complicated. Under the "bright line test," the best price rule would only be applied to transactions that occur during the pendency of the tender offer. Once the tender offer is completed, a transaction would fall outside the scope of the best price rule. At least in theory, the application of this test would render it simpler for parties to plan transactions that comply with the best price rule.

Practitioners have been watching judicial action, and the SEC's rule-making and public statements in this area, seeking clarification as to how to apply the best price rule. While the "bright line" test may make it easier to structure transactions in a manner that would not violate Rule 14d-10, some commentators and courts have argued that its strict implementation would enable parties to violate the spirit of the rule, simply by paying consideration to insider shareholders after the completion of the tender offer. Although the decisions of each federal circuit court are not necessarily binding authority on the district and appellate courts in other circuits, each new decision in this area has important implications for planning new transactions, and may provide guidance as to the direction of the views of the federal courts. Accordingly, the Computer Associates decision is likely to receive serious attention.

The Computer Associates Decision

The Computer Associates decision relates to the acquisition by Computer Associates International ("CA") of On-Line Software International ("On-Line"), by means of a tender offer and back-end merger. The plaintiff, Joel Gerber, who was a shareholder of On-Line, filed a class action on behalf of On-Line shareholders who tendered their stock in the tender offer. The plaintiff alleged that, in acquiring On-Line, CA paid more money per share to Jack Berdy, On-Line's chairman and chief executive officer, than it paid to other On-Line shareholders, thereby violating the best price rule.

At the time of the tender offer, Mr. Berdy owned 1.5 million shares of On-Line stock, representing approximately 25% of the company's outstanding shares. After negotiations between the parties, CA and On-Line agreed that CA would offer to purchase On-Line's shares for $15.75 per share, and that CA would pay Berdy $5.0 million for a five-year non-compete agreement. CA's payment of this fee occurred after On-Line's shareholders tendered their shares, but before any On-Line shareholder was actually paid the tender offer consideration. The central issue in this litigation was whether this $5.0 million payment was unlawful additional compensation for his On-Line shares, in violation of the best price rule. At the trial level, the jury determined that $2.3 million of the $5.0 million that CA had paid to Berdy was compensation for Mr. Berdy's On-Line shares, while the remainder was separate consideration for the non-compete agreement. The court entered judgment in favor of the plaintiff class, and the Second Circuit considered CA's appeal.

Based upon its analysis of SEC Rule 14d-2 (relating to the time at which a tender offer commences, and which was amended during the period after the transaction in question was completed), the court concluded that the agreement providing for Mr. Berdy's non-compete payment was executed after the commencement of the tender offer. In addition, the court examined whether Mr. Berdy's payment could be deemed to have been made "during" the tender offer, even though his actual payment occurred after On-Line's shareholders had tendered their shares. The Second Circuit concluded that the phrase "during the tender offer," as used in the best price rule, was flexible enough to include CA's payment to Berdy. The court especially focused on the fact that Mr. Berdy was paid before all of the other On-Line shareholders.

The decision also leaves open the possibility that a payment of this kind could be subject to challenge under the best price rule even if it was paid after the target's shareholders received the payment for their shares, and the transaction closed. In the case of the payment to Mr. Berdy, the court noted that, to equate the termination of a tender offer with the offer's self-imposed expiration date, as the defendant effectively asked the court to do (the "bright-line test"), would make it easy to contract around the best price rule. Imposing a rigid timing requirement on the duration of a tender offer would drain the best price rule of its force. Accordingly, although the court did not need to consider the issue, in this case, it would appear that a payment occurring after the closing date of the acquisition could also be subject to challenge based upon the Second Circuit's reasoning.

The Second Circuit did not state that all non-competition payments of the kind made to Mr. Berdy would violate the best price rule. However, in the case at hand, where the non-competition payment was negotiated in connection with the tender offer, the court held that it was proper for the district court to instruct the jury to determine whether all or any portion of Mr. Berdy's $5.0 million payment was intended to constitute compensation for his shares. Expert testimony was presented at the trial in order to help the jury consider whether any portion of the payment could be considered to be such compensation.

"Titanic" Consequences in Tennessee

The Computer Associates decision follows another recent federal case that poses difficulties of this kind for companies planning tender offers. In 2000, a federal district court in the state of Tennessee determined that certain employment compensation arrangements and retention packages established for a target company's executive shareholders violated the best price rule. In Katt v. Titan Acquisitions (the "Titan decision"),[fn4] the federal district court for the Middle District of Tennessee determined that a variety of executive compensation arrangements would violate the best price rule, including:

• change-of-control agreements that the target entered into with certain members of its management team several months prior to the initial announcement of the tender offer, and which were assumed by the acquiror;
• signing bonuses offered by the acquiror to certain target officers if they accepted employment with the acquiror following the acquisition;
• a retention bonus adopted by the target for certain officers following the acquisition; and
• an incremental bonus plan for certain officers relating to the services that they provided in connection with the change of ownership.

The court concluded that these arrangements were integral parts of the tender offer, and constituted additional consideration paid to these management shareholders to induce them to tender their shares.

The Titan decision has not yet been followed by other federal courts, and it is relatively early to say how the federal courts will respond to the Computer Associates decision. However, these cases call in to question a variety of compensation arrangements for the executive officers of a target, arrangements that are not at all uncommon in connection with merger transactions.

"Intel-ligent" Consequences in California

By way of contrast to the Titan decision, a recent district court opinion issued by the Northern District of California provides additional guidance as to the types of transactions that may be acceptable under the best price rule. Harris v. Intel (the "Intel decision"),[fn5] relating to Intel's 1999 tender offer for DSP Communications, upheld bonus payments paid to management shareholders of the target that were made under a bonus plan adopted prior to the commencement of negotiations with the offeror. In this case, no evidence was provided indicating that these payments were intended to induce these management shareholders to tender their shares. The Intel decision also permitted limited modifications to these arrangements made during the actual negotiation of the tender offer, where there was a legitimate business purpose for the modifications other than to induce the relevant executives to tender their shares.

Some of the factors that led the court to uphold these arrangements are useful to note. The compensation paid to the members of the management team did not increase as a result of the acquisition; rather, the payment terms created before DSP commenced negotiations with Intel were left essentially in place, even after Intel found out about them. These compensation terms did not depend upon the identity of the acquiror, or the specific form of transaction. The compensation plans at issue were purportedly designed to keep senior management in place following an acquisition, in order to facilitate the sale of the company as a going concern, thereby maximizing its value; the plaintiffs did not produce any evidence indicating that the bonuses at issue were unusually generous.

Designing Compensation Arrangements

What practical lessons can be learned from these recent cases?

Proper Parties. A potential acquiror should not be a party to any agreements providing additional or new compensation to the target's management following the completion of a tender offer. If an acquiror is party to these arrangements, the benefits received by management are far more likely to be deemed to be part of the tender offer consideration.

Effectiveness and Timing of New Arrangements. Any compensation to be received by the members of the management team should, if possible, be effective immediately upon execution of the agreements. In fact, with respect to the best price rule, the ideal time to adopt change-of-control compensation packages is prior to the time that acquisition negotiations begin. This compensation should not be based upon the completion of the tender offer, or else it will be more likely to be viewed as an "integral part" of the offer.

Delayed Effectiveness. If it is not possible to make the new compensation arrangements immediately effective, the effectiveness should be postponed as far into the future as possible. For example, if the transaction is structured as a tender-offer followed by a back-end merger, the effectiveness should be postponed to the completion of the back-end merger, and should in all events not take place until at least the time that the target's other shareholders have received the consideration for their shares.

Structure Incentives to Reflect Future Performance. Compensation arrangements are less likely to be deemed to violate the best price rule if they are clearly structured as payment for future services, as opposed to additional tender offer consideration. Accordingly, it is helpful to set forth terms that are designed to incentivize the individual's future employment. To the extent possible, it may be useful to tie the benefits to future vesting, based upon the individual's continued employment following the completion of the acquisition.

Avoid Correlation of Compensation to Shareholdings. If multiple members of the target's management team are involved, compensation plans that are dependent upon the number of shares held by the relevant individuals should be avoided. For example, if two officers have comparable positions in terms of authority within the target, they should not receive different levels of compensation if their shareholdings are markedly different.

Obtain Validation. In light of the current uncertainty, it may become necessary for a company to demonstrate that compensation arrangements entered into around the time of a tender offer did not constitute extra tender offer compensation. Ideally, companies will want to obtain independent third party advice from executive compensation or other experts as to whether the size of the payments under a proposed arrangement were appropriate in light of the circumstances. If it is not possible to obtain such advice, a company should try to carefully document its determination as to why a particular compensation arrangement was appropriate, regardless of the number of target shares held by the individuals who are to receive the compensation. To the extent possible, prevailing compensation standards in a particular industry should be considered.

None of these steps, or any combination of them, will guarantee that a compensation arrangement will satisfy the best price rule. However, these and other considerations that may be relevant to a given situation, depending upon its own particular facts, will help the parties to a tender offer remain within the parameters of the rule.

Structuring the Transaction

In connection with acquisitions of public companies that are structured as tender offers, the parties are strongly encouraged to work with their counsel to determine whether any arrangements with the executive officers or directors who are shareholders of the target are likely to have implications under the rule. Because a public tender offer typically involves shareholders located in many U.S. jurisdictions, plaintiffs in any post-merger purported class action may have the ability to select a court that adopts the hardest line with respect to the best price rule. Accordingly, even if one or more courts reject the reasoning in the Computer Associates decision or the Titan decision, plaintiffs may still rely upon the more exacting standards adopted by other courts.

In situations in which the parties are in doubt or uncertain as to whether a payment or other arrangement involving a management shareholder of the target company would be acceptable under the best price rule, the risk of proceeding with a tender offer may not be acceptable to the parties. In such situations, the structure of the transaction may need to be recast as a merger of the target with the acquiror or with a newly-formed subsidiary of the acquiror.

However, restructuring a tender offer transaction into a merger is not necessarily a desirable solution. First, under applicable corporate law and stock exchange rules, the period of time between the public announcement of the transaction and any shareholder meeting approving the transaction will tend to be longer than the period of time between the public announcement of a tender offer and the closing of a tender offer. In the case of a public merger, a preliminary proxy statement is filed with and may be reviewed by the SEC before the final proxy statement is distributed to the target's shareholders. These factors lengthen the time frame needed to complete a transaction, increasing the possibility that a competing acquiror, or other parties opposed to the transaction, could launch a competing offer or otherwise disrupt the acquisition. In addition, in the case of a merger structure, the target's shareholders may be more likely to exercise any appraisal rights that are available under applicable corporate law than they are in the case of a tender offer and back-end merger. In short, although an acquisition may be completed notwithstanding the issues arising under the best price rule, there may be considerable disadvantages in doing so.

Acquirors must also be sensitive to these issues during their "due diligence" examination of the target. What sort of arrangements does the target have in place with members of its management team that raise issues under the best price rule? What sort of additional arrangements of this kind are under consideration? Carefully-crafted arrangements that would be completely lawful and appropriate in the absence of a tender offer transaction may have unexpected and undesirable consequences if adopted during the course of merger discussions with a potential acquiror.

Conclusion

SEC staff members have indicated that the SEC is considering regulatory guidance concerning the application of the best price rule to various arrangements with management shareholders. Possible regulatory action could include the creation of safe harbors for certain types of transactions effected in connection with a tender offer, or rules that help identify management compensation arrangements that are consistent with the best price rule. Until then, M&A practitioners will need to carefully examine these types of arrangements, and possibly consider alternative transaction structures.

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Footnotes

1: Gerber vs. Computer Assocs. Int'l, Inc., 303 F.3d 126 (2d Cir. 2002).

2: Epstein v. MCA, Inc., 50 F.3d 644 (9th Cir. 1995), rev'd on other grounds, 516 U.S. 367 (1996). The best price rule is sometimes referred to as the "functional test." See Field v. Trump, 850 F.2d 938 (2d Cir. 1988).

3: Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996).

4: Katt v. Titan Acquisitions, Ltd., 153 F. Supp. 2d 632 (Mid. Tenn. 2000).

5: Harris v. Intel Corp., 2002 WL 1759817 (N.D. Cal. 2002)