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The Securities and Exchange Commission’s “best-price rule” (Rule 14d-10 under the Exchange Act of 1934) continues to trouble parties that wish to conduct tender offers. Under the rule, a bidder must pay to each tendering shareholder the highest consideration paid to any other tendering shareholder. The intent of the rule is to ensure equality among tendering shareholders. In some cases, however, courts have characterized amounts paid to some shareholders, ostensibly for other reasons, as consideration for tendered shares. Some of the more problematic payments are amounts paid to management employees as severance, retention bonuses or other compensation, or in exchange for an agreement not to compete. Moreover, different courts have used different tests in applying the rule. Recent cases suggest that this confusion continues, although some patterns are emerging that may be useful for companies that have strong reasons for using a tender-offer structure. The potential damages from violation of the best-price rule can be significant. In theory, every shareholder would be entitled to the per-share premium found to have been received by any other shareholder. The leverage can be particularly daunting when a target executive or other shareholder who allegedly receives a premium holds relatively few shares. Moreover, application of the rule generally requires a review of facts and circumstances. Accordingly, courts often are reluctant to grant a motion to dismiss or for summary judgment, and the outcome of a case may not be known until years after a transaction has closed, making it difficult to plan and resulting in large legal costs and management disruption even if the case ultimately is unsuccessful. As a result, parties often forgo the advantages of a tender offer and utilize a merger or other acquisition technique instead. A key benefit of a tender offer over a merger is speed to closing. The difference results primarily from the SEC review process, which in a tender offer is done during the pendency of the offer but in a merger must be completed before the proxy can be circulated. Antitrust regulators also aim to complete their “first review” of a cash tender offer in 15 days rather than 30 days in the case of a merger. Of course, countervailing factors such as a lengthy antitrust review process or an SEC “no review” of the merger proxy can reduce or even eliminate the speed advantage of a tender offer. A tender offer structure also can allow an acquiror that is affiliated with the target to take advantage of the Pure Resources line of cases (see In re Pure Resources Shareholders Litig., 808 A.2d 421 (Del. Ch. 2002)) and potentially avoid application of an entire fairness test. The two primary tests for applying the best-price rule are the “integral part” test and the “bright line” test. The integral part test emerged primarily from the ruling of the 9th U.S. Circuit Court of Appeals in Epstein v. MCA Inc., 50 F.3d 644 (9th Cir. 1995), vacated on other grounds, 516 U.S. 367 (1996). Under this test, the court determines whether the compensation arrangements are so material to a tender offer that they should be characterized as part of the tender offer. The bright-line test Under the bright-line test adopted by the 7th Circuit in Lerro v. Quaker Oats, 84 F.3d 239 (7th Cir. 1996), the best-price rule generally does not apply to transactions that occur before or after a tender offer. At least in theory, the application of this test seems to have rendered it simpler for parties to structure compensatory transactions to comply with the best-price rule. Recent cases reflect the continued division between the courts on the standards applicable to compensatory arrangements. In In re Luxottica Group SpA Sec. Litig., 293 F. Supp. 2d 224 (E.D.N.Y. 2003), Luxottica had discussed an acquisition of Sunglass Hut for several months without reaching agreement. Luxottica then indicated it would increase its offer price if James Hauslein, Sunglass’ chief executive officer and the holder of 4% of Sunglass’ outstanding stock, would enter into a noncompete and consulting agreement that gave him approximately eight times his salary for five years. Hauslein agreed and, with his support, Sunglass agreed to the acquisition. The consulting agreement and the merger agreement were signed on the same day, and Luxottica formally commenced the tender offer a few days later. Payments under the consulting agreement were made after completion of the merger. Because the case was brought as a motion to dismiss, the court accepted all alleged facts as true. The court, relying on the functional test adopted in Field v. Trump, 850 F.2d 938 (2d Cir. 1988) (a test adopted in the 2d Circuit that is similar to the integral-part test), considered “all the circumstances attendant to the challenged tender offer, including whether the consulting agreement was necessary to its consummation.” The court noted that the “protracted” negotiations over the merger had been completed “only after the target’s lead negotiator [was] offered $15 million,” which reflected a continuing intent of the acquiror throughout that process to complete the acquisition. The court concluded that the acquiror’s motivation for entering into the consulting agreement raised “factual issues which cannot be resolved on a motion to dismiss.” One court changes tests In Katt v. Titan Acquisitions Inc., 244 F. Supp. 2d 841 (M.D. Tenn. 2003), the U.S. District Court for the Middle District of Tennessee essentially reversed itself, and applied a bright-line test to grant the defendants’ motion for summary judgment. The case related to the acquisition of International Comfort Products (ICP) by United Technologies Corp. (UTC). During negotiations with potential acquirors, ICP had entered into golden-parachute agreements with several ICP executives. UTC did not learn about the golden parachutes until several months later, just before it signed an acquisition agreement with ICP and commenced the tender offer. UTC also entered into transition services agreements with several ICP managers, agreeing to pay retention bonuses of $50,000 to $500,000 if the executives stayed 90 days after the acquisition. In Katt v. Titan Acquisitions Inc., 133 F. Supp. 2d 632 (M.D. Tenn. 2000), its prior decision on this case, the court had applied the integral-part test and denied the defendants’ motion to dismiss. In its second decision, however, the court determined that the integral-part test was overly broad and adopted the bright-line test. Under the bright-line test, the court noted that the golden parachutes had been entered into prior to commencement of the tender offer, and that the payments had been made after the closing of the tender offer and the merger, so that both were outside the tender-offer period. The court noted that it would have granted the motion under the integral-part test as well, since that test required the plaintiffs to show that the agreements were intended to induce the executives to tender their shares. The court noted that the executives’ shares constituted only 1% of ICP’s shares, while UTC had obtained lockups of more than 40% of ICP’s shares. The court also found that, even though some of the transition services agreements had been entered into during the tender-offer period, the plaintiffs had not raised a genuine question as to whether the purpose of the payments under those agreements was to induce the executives to tender. Rather, the court noted that the agreements were intended to help retain ICP’s customers, ensure a smooth transition and continuity of ICP’s business, obtain antitrust approval and generally obtain the executives’ cooperation in closing the tender offer, including the solicitation of ICP’s shareholders. Thus, the facts as alleged did not support a violation of the best-price rule under either test. In re Digital Island Securities Litig., 357 F.3d 322 (3d Cir. 2004) related to the acquisition of Digital Island Inc. by Cable & Wireless PLC. On the date the two companies signed the merger agreement, and prior to commencement of the tender offer, Cable & Wireless entered into an employment agreement with Digital’s CEO, which the plaintiffs described as “lucrative.” The court applied the bright-line test, but added an important exception. Citing Epstein for the proposition that a tender offer cannot be permitted to evade the requirements of the best-price rule by delaying the actual payment, or by agreeing on the extra payment beforehand, the court reasoned that the bright-line rule should prohibit schemes “fraudulently devised . . . to circumvent the rule.” In fact, the court noted that the employment agreement was a “perfect example” of an agreement that could be conditioned on the success of a tender offer, unless the acquiror “deliberately inflate[d] [the] compensation to provide a premium” for the employee’s shares. The court thus analyzed the plaintiffs’ allegation under a fraud standard of pleading. The court stated that the plaintiff had not alleged that the compensation was “excessive,” or “out of line with amounts that similarly situated executives were paid” or any other facts that would make the employment agreement “suspect.” Accordingly, the court upheld the lower court’s dismissal. Transactional considerations Although the confusion over the application of the best-price rule makes it difficult to predict the outcome of a particular situation with a high level of certainty, parties that may want to use a tender-offer structure should consider the following steps in connection with management contracts that may be entered into or modified in contemplation of a transaction. Assess the likely jurisdiction where litigation may arise. Typically the venue will be the acquiror’s or target’s headquarters or principal place of business, although other factors, such as the location of shareholders, may result in a different venue. The greater the likelihood that the plaintiffs will not be able to choose an integral-part jurisdiction, the more flexibility will be available to the parties in structuring their compensatory arrangements. For a target, adopt compensatory arrangements in advance. Courts generally have held that payments based on a target’s contracts entered into prior to negotiations with a specific bidder and without the participation of that bidder do not violate the best-price rule, as noted by the Katt court with respect to existing golden-parachute arrangements. A company that believes it may become the target of an acquisition should consider whether severance or similar agreements should be adopted in advance of discussions with potential acquirors. Limit modifications to existing arrangements. Some courts have allowed modification of existing arrangements in connection with a tender offer. In Harris v. Intel Corp., 2002 U.S. Dist. Lexis 13796 (N.D. Calif. 2002), using the integral-part standard, the court allowed limited modification to existing severance arrangements when it found a legitimate business purpose other than to induce the tender of shares in the tender offer. Factors that the court considered were that the compensation primarily was restructured, rather than increased, and that the compensation arrangements purportedly were designed to keep senior management in place following an acquisition to facilitate the sale of the company as a going concern. When providing additional compensation, be reasonable. Courts generally will deem best-price rule disputes over compensatory arrangements as dependent on factual matters that a jury must decide. However, courts may be willing to find that as a matter of law the best-price rule has not been violated by arrangements that are reasonable in scope and entered into for legitimate business reasons, as in the Katt and Digital Island cases. Other steps that may help reduce litigation risk include structuring compensatory arrangements so that they are not correlated with shareholdings, become effective as far into the future as possible and, in any event after completion of the post-tender offer back-end merger and payment for all the shares, are entered into by the target, rather than by the acquiror and are a payment for future services. None of these techniques, individually or in combination, will eliminate the risk of litigation or a finding of violation of the best-price rule. Pending further clarification, if a transaction is likely to involve new or modified compensatory arrangements for a target’s management, particularly if a significant or unique arrangement, the parties may want to consider a merger structure to avoid the potential risks that may arise out of these arrangements. Michael O’Bryan ([email protected]) is a partner and co-chairman of the M&A group, and Lior Zorea ([email protected]) is a senior associate in the corporate group, at San Francisco’s Morrison & Foerster. O’Bryan’s practice focuses on U.S. and international M&As, including the representation of companies and special committees in “going private” and other related-party transactions. Zorea’s practice focuses on corporate, securities and M&A transactions.

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