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Companies considering how to structure a business combination often find themselves limited to a merger, as opposed to a tender offer, merely because of how the federal courts are applying the Securities and Exchange Commission’s “best price” rule to tender offers. The best-price rule, Rule 14d-10(a)(ii) under the Securities Exchange Act of 1934, requires the bidder in a tender offer to pay the same price to every shareholder. The problem is that certain courts take the view that the best-price rule can apply to changes made to the target company’s executive compensation and severance arrangements in contemplation of the sale of the company. It is very common for companies to re-evaluate or update their severance arrangements with executives once they decide to consider a business combination, making this interpretation a real deterrent to the use of tender offers. The broader application of the best-price rule arose in shareholder suits claiming that, where the executives in question are also shareholders, the revised compensation or severance arrangements constituted additional consideration to be paid for the executives’ shares tendered in the offer. These suits allege that the bidder violates the best-price rule where executives sign agreements or receive compensation shortly before the actual commencement of the tender offer or shortly after its conclusion. The types of transactions contested include severance payments, cash retention bonuses, stock options, and other equity compensation. CONFUSION IN THE COURTS Federal courts have applied two different tests in analyzing the best-price rule � the “bright line” test and the “integral part” test. The bright-line test, originally developed by the U.S. Court of Appeals for the 7th Circuit and subsequently adopted by the 3rd Circuit, takes a narrow approach to the best-price rule. It states that no compensation or agreement can be construed to violate the best-price rule if the compensation was paid or the agreement was consummated before the tender offer was actually commenced or after the tender offer concluded. Therefore, only compensation or severance paid during the tender-offer period violates the best-price rule. (The 3rd Circuit has noted one possible exception to the bright-line test, where a bidder deliberately inflates the compensation given to management to provide a premium not given to other shareholders, which would defraud shareholders.) The bright-line test gives more certainty to companies and transactions with respect to a tender offer. The integral-part test, which is a more expansive test, was first adopted in the 9th Circuit’s 1995 ruling in Epstein v. MCA. Instead of focusing on when the tender offer was actually commenced and concluded, the 9th Circuit focused on the relationship of a given transaction or agreement to the tender offer. The 9th Circuit determined that a transaction or agreement that is an integral part of or closely related to the tender offer is subject to the best-price rule. The court rejected the bright-line test because of its concern that it could permit bidders in a tender offer to structure the transaction so that management and other insiders could receive extra compensation before or after the tender offer. Under the integral-part test, all agreements related to the overall business combination, not just those consummated within the tender-offer period, will be examined under the best-price rule. The courts will seek to determine whether the agreements were entered into in furtherance of the tender offer. Courts applying the integral-part test have held that the following types of arrangements, if done in relation to a tender offer, would constitute additional consideration in violation of the best-price rule: change-of-control arrangements just before the tender offer, signing bonuses for management if they accept employment with the bidder, retention bonuses, stock options, transition services agreements, and noncompete agreements. The integral-part test has created a lot of risk and uncertainty in the use of tender offers because it casts such a broad net and captures otherwise legitimate compensation and severance arrangements. THE SEC’S VIEW When Epstein was first decided by the 9th Circuit, the case drew little attention. In fact, Epstein was reversed by the Supreme Court on other grounds in 1996. A few practitioners questioned whether the lower court’s analysis of the best-price rule was correct. In 1996, the 7th Circuit developed the bright-line test in Lerro v. Quaker Oats Co. Nothing more developed until the year 2000. Then, the plaintiffs bar realized that some courts applying the integral-part test would allow the plaintiff to survive a motion to dismiss in order to allow the discovery necessary to prove a violation of the best-price rule. The staff in the SEC’s Division of Corporation Finance, which administers and interprets the tender-offer rules, has always taken the position that the best-price rule should not apply to bona fide compensation and severance arrangements. When cases started to develop in 2000 and some early decisions adopted the integral-part test, the SEC staff took a wait-and-see approach. The staff believed that the courts would eventually correct themselves by not applying the best-price rule to bona fide compensation and severance arrangements. Meanwhile, the staff made its position very clear in public speeches and discussions. But the staff’s interpretive view has not eliminated the problem because, like the integral-part test, it is based on a facts-and-circumstances analysis, and thus a court following the agency’s test may be willing to allow the case to proceed to discovery. The staff has said recently that it expects to issue by the end of this year a proposed change to or interpretation of the best-price rule, although the staff realizes that an interpretation alone may not address the problem. The staff has also said that it does not intend to adopt the bright-line test, claiming that the test is too narrow and that regulatory policy requires that the rule prohibit any instance where the bidder is using some means to pay additional consideration to certain shareholders. Many practitioners are concerned that the staff’s proposed rule change will be nothing more than an inclusion of the factors that tend to show when a compensation or severance arrangement is bona fide and therefore outside the best-price rule. This approach will not sufficiently eliminate uncertainty since it will still require a court to make a factual inquiry into the issue. NOT WHAT CONGRESS MEANT The courts applying the integral-part test to compensation and severance arrangements clearly have it wrong. The language of the best-price rule states that consideration paid to any shareholder “pursuant to the tender offer” must be the highest consideration paid to any other shareholder “during such tender offer.” This language seems to make clear that the payments at issue are those payments made during the period of the offer. The bright-line test is more consistent with the intent of the best-price rule. The rule was not intended to capture arrangements that, although made around the time of a tender offer or even in contemplation of the offer, are not directly part of the consideration paid in the offer. The best-price rule was adopted by the SEC in 1986 in conjunction with the “all holders” rule that requires tender offers to be open to all holders of the subject class of securities. Both rules were adopted to prevent discriminatory tender offers. Specifically, the rule was adopted in response to the discriminatory tender offer made by the Unocal Corp. in 1985 as a defense against a takeover by T. Boone Pickens. In response to Pickens’ tender offer for Unocal, the company itself commenced a tender offer open to all its shareholders other than Pickens and his transferees. The SEC believed that discriminatory offers were inappropriate. Even before the adoption of the all-holders and best-price rules, the SEC had interpreted the tender-offer regulations as requiring equal treatment of shareholders. The legislative intent of the best-price provisions in the 1934 Exchange Act was to ensure fair treatment of shareholders who participated in the offer by tendering their shares. In other words, a shareholder had to tender to enjoy the protections of the best-price provisions. The legislative history also indicates that Congress was concerned with secret payments to other shareholders during the course of the tender offer. Congress concluded that this concern was best addressed by the best-price provisions in the statute and by disclosure. The initial statutory protections were meant primarily to address hostile tender offers, not negotiated transactions. Likewise, the tender-offer regulatory scheme was created primarily to address hostile offers. Put in the proper context, the best-price protections were designed primarily to govern the mechanics of the offer, not the overall business combination. This is a much more narrow approach than today’s application of the best-price rule. A PROPOSED APPROACH Going forward, the SEC should adopt an approach more closely aligned with the bright-line test and that also focuses on disclosure. The best-price rule should apply upon the first public announcement of the tender offer and continue through the expiration of the offer. This would prohibit a bidder from publicizing its upcoming offer in order to elicit side agreements with shareholders before commencement of the offer proper. Additionally, the SEC should adopt a specific requirement for bidders and targets to disclose in a prominent location in the offer documents all agreements or arrangements entered into with any shareholder within a specific time period (e.g., six months) before the announcement of the tender offer. The disclosure should include any agreement with a shareholder of the target company, whether it is a compensation or severance arrangement or a business-related agreement, and the purpose of such agreement. Disclosure will address the SEC’s concern regarding side deals with certain shareholders before the announcement of the tender offer. This approach does not address the problem that always exists when a bright line is established for application of a rule � someone can act just before or after the bright-line restriction. Yet the better approach to address that problem would be to analyze whether an agreement with a shareholder entered into on the eve of the public announcement of the tender offer does, in fact, constitute commencement of the offer itself or, at a minimum, whether it was the first public announcement of the offer that triggers the rule. This approach to the best-price rule would provide the substantive protections of the rule while also allowing shareholders, through disclosure, to decide for themselves whether to tender their shares in light of any additional arrangements with other shareholders. It would also put tender offers on more equal footing with mergers, which are not subject to a best-price requirement. If there were more certainty in the application of the best-price rule, the tender offer would again become a real alternative for companies structuring a business combination. Dennis O. Garris is a partner in the D.C. office of Alston & Bird. He served for more than 10 years in the SEC’s Division of Corporation Finance and was chief of the Office of Mergers and Acquisitions from 1997 to 2003. David A. Brown is an associate in the firm’s D.C. office. They can be reached at [email protected] and [email protected], respectively.

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