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In the 1980s and early 1990s, most cash acquisitions of U.S. public companies were structured as two-step transactions: a cash tender offer followed by a merger. This was primarily because, all else being equal, the first-step tender offer frequently could be completed (and control of the target company obtained) much more quickly than with a one-step merger. In addition, if the tender offer resulted in ownership of more than a statutorily prescribed minimum percentage of the outstanding shares of the target company (90% under Delaware law), the second-step merger could be completed immediately following the completion of the tender offer. Since the mid-1990s, however, acquirers in negotiated acquisitions of U.S. public companies have all but abandoned this two-step process in favor of the one-step merger. This shift is largely attributable to judicial interpretations of the so-called best-price rule that present significant risks to acquirers that use tender offers. In general, these risks relate to the possible judicial characterization of payments made to certain shareholders in the context of employment or commercial relationships as tender-offer consideration that must be paid to all tendering shareholders. On October 18, the U.S. Securities and Exchange Commission (SEC) adopted simple, yet significant, changes to the best-price rule to clarify that it applies only to consideration paid for securities tendered in the tender offer, and not to consideration paid in connection with employment and certain other relationships. Although the final text of the amendment was not available at the time this article was written (it will be available soon on the SEC’s Web site), if the agency acted as expected, tender offers likely will regain their prominence as the transaction structure of choice for many U.S. public-company acquisitions. The best-price rule is codified as Securities Exchange Act Rule 14d-10(a)(2) for third-party tender offers, and as Securities Exchange Act Rule 13e-4 for issuer tender offers. In either case, the original best-price rule provided: “No bidder shall make a tender offer unless . . . the consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer.” The rule was designed to ensure fair and equal treatment of all shareholders of a target company. Since its adoption, however, some courts have held that the rule was violated when bidders or targets entered into new agreements, or amended existing agreements, with selected target shareholders relating to employment, severance, non-competition or commercial transactions. Two tests Most courts interpreting the original best-price rule have applied one of two tests: the “integral-part test” or the “bright-line test.” Under the integral-part test, the best-price rule applies to all of the integral elements of a tender offer, including employment, severance, noncompetition, employee benefits and other arrangements that are deemed to be part of the tender offer, regardless of whether the arrangements were entered into during the tender-offer period. See Epstein v. MCA Inc., 50 F.3d 644 (9th Cir. 1995) (rev’d on other grounds, Matsushita Electrical Industrial Co. v. Epstein, 516 U.S. 367 (1996)). In Epstein, the 9th U.S. Circuit Court of Appeals analyzed an arrangement that the acquirer entered into with the target company’s majority shareholder that allowed him to roll over his shares of the target company into securities of a subsidiary of the surviving company. The court found that “[b]ecause the terms of the [rollover] were in several material respects conditioned on the terms of the . . . tender offer, we can only conclude that the [rollover] was an integral part of the offer and subject to [the best-price rule].” Id. at 656; see also Maxick v. Cadence Design Systems Inc., No. C-00-0658-PJH, 2000 WL 33174386 (N.D. Calif. Sept. 21, 2000) (finding that retention bonuses paid to target-company insiders were an integral part of tender offer); Millionerrors Investment Club v. General Electric Co. PLC, No. Civ. A. 99-781, 2000 WL 1288333 (W.D. Pa. March 21, 2000) (finding that payment to target-company insiders for unvested stock options stated a claim for violation of best-price rule); and Perera v. Chiron Corp., No. C-95-20725 SW, 1996 WL 251936 (N.D. Calif. May 8, 1996) (finding that alleged options enhancements to target-company insiders constituted a premium for their shares and stated a claim for unequal consideration under the best-price rule). Under the bright-line test, on the other hand, the best-price rule applies only to arrangements entered into and performed between the time the tender offer formally commences and the time it expires. See, e.g., Kramer v. Time Warner Inc., 937 F.2d 767 (2d Cir. 1991) (holding that payments for unvested options of target-company insiders in a second-step merger did not violate the best-price rule because the first-step tender offer had ended), and Lerro v. Quaker Oats, 84 F.3d 239 (7th Cir. 1996) (holding that distribution agreements with the controlling shareholder of the target company did not state a claim under the best-price rule because the agreements were entered into one day before the tender offer commenced). Under this test, courts have ruled that arrangements with individual shareholders do not violate the best-price rule as long as they were entered into and performed outside the tender-offer period, even if those arrangements were arguably integral to the transaction. In formulating the bright-line test, the 7th Circuit strictly interpreted the best-price rule, focusing on the phrase “during such tender offer.” The court noted that “before the offer is not ‘during’ the offer” and that “the difference between ‘during’ and ‘before’ (or ‘after’) is not just linguistic.” Lerro, 84 F.3d at 242. These inconsistent approaches by the courts led to substantial uncertainty in a context in which certainty is vitally important. If, for example, an acquirer were required under the best-price rule to pay to every tendering shareholder of the target company an additional amount equal to the greatest per-share equivalent of the consideration paid to any executive of the target company in connection with his or her new employment, retention, severance or other arrangements, the effect on the total acquisition price could be staggering. Accordingly, acquirers generally abandoned the two-step acquisition structure in favor of one-step mergers to which the best-price rule does not apply. Regulators take note The SEC noted this phenomenon when it first proposed amending the best-price rule. “Because the retention of key employees or directors, or the execution of definitive severance arrangements, can be such an important aspect of a merger or acquisition, the bidder and subject company are not likely to forgo entering into or modifying employment compensation, severance or other employee benefit arrangements in favor of retaining the tender offer structure.” Amendments to the Tender Offer Best-Price Rule, Release No. 34-52968 at 76118 (Dec. 22, 2005). The draft amendment to the best-price rule did not embrace either the integral-part test or the bright-line test, but rather refocused the rule on its original premise: that bidders must pay consideration of equal value to all security holders for the securities they tender. Specifically, the amendment recast its best-price rule as follows: “No bidder shall make a tender offer unless . . . the consideration paid to any security holder for securities tendered in [as opposed to the old language, 'pursuant to'] the tender offer is the highest consideration paid to any other security holder for securities tendered in the [as opposed to 'during such'] tender offer.” In addition, it is expected that the amendment will add a new clause to the best-price rule to exempt the following items from its application (at least with respect to third-party tender offers): “The negotiation, execution or amendment of an employment compensation, severance or other employee benefit arrangement, or payments made or to be made or benefits granted or to be granted according to such arrangements, with respect to employees and directors of the [target] company, where the amount payable under the arrangement: (i) relates solely to past services performed or future services to be performed or refrained from [being performed], by the employee or director (and matters incidental thereto), and (ii) is not based on the number of securities the employee or director owns or tenders.” Although the final amendment remains to be seen, the SEC did not contemplate adding a similar exemption for issuer tender offers, under the rationale that issuers offering to purchase their own securities generally do not have the same need to negotiate, execute or amend compensatory arrangements when they structure and execute tender offers. It is also expected that the SEC will establish a nonexclusive safe harbor to allow both acquirers and target companies to take advantage of the exemption described above. Under the safe harbor, an arrangement would be deemed exempt from the best-price rule if it is approved as meeting the requirements of the proposed exemption by the compensation committee of the board of directors of the acquirer or the target company (the appropriate committee depending on whether the acquirer or the target company is the party to the arrangement). If the applicable board does not have a compensation committee, the safe harbor would be satisfied if the arrangement were approved by a committee of the board of directors that performs functions similar to those of a compensation committee. In either case, the committee must consist solely of independent directors. The exemption and related safe harbor are meant to strike a balance between the need for certainty and the protection of security holders from actual and perceived abuses in connection with tender offers. Although the exemption and safe harbor as proposed grant broad flexibility to board committees in approving employment-related arrangements, the SEC believes that security holders of the target company would be adequately protected by the fiduciary responsibilities of the independent directors who approve the arrangements. The SEC is listening The final amendment to the best-price rule may be broader in scope than the SEC’s original proposal. Most comments to the proposed amendment focused on expanding the exemption and related safe harbor. Many commentators, including the American Bar Association Section of Business Law, believe that the exemption should be applicable to issuer tender offers and to commercial arrangements such as licenses, leases and supply and distribution contracts. In addition, many commentators believe that the safe harbor should not be limited to arrangements approved by a compensation or similar committee of the applicable board, but rather, available so long as any committee of independent directors-even an ad hoc committee formed for the particular purpose-approves the arrangement. Anecdotal evidence suggests that the SEC gave serious consideration to the comments and, at this point, it appears that the final amendment will include at least some of the suggestions. In a recent speech to the Association of the Bar of the City of New York’s Committee on Mergers, Acquisitions and Corporate Control Contests, Brian Breheny, the chief of the SEC Division of Corporation Finance’s mergers and acquisitions office, indicated that the SEC likely would expand the proposed exemption and safe harbor to apply to issuer tender offers as well as third-party tender offers. He also indicated, however, that some of the other comments, such as expanding the exemption for commercial arrangements in addition to employment-related arrangements, were given serious consideration by the SEC before the amendment was proposed and, accordingly, are less likely to appear in the final amendment. See www.deallawyers.com/blog/archives/ 2006_06.html. In any event, the adoption of the proposed amendments should go a long way toward reviving the use of tender offers for the acquisition of U.S. public companies. By amending the best-price rule to limit its application to the amount of consideration offered for securities tendered in a tender offer and not to employment compensation, severance or other employee-benefit arrangements (and, possibly, other extraneous arrangements), the SEC expects to eliminate a litigation risk that resulted in a dramatic decline in tender offers since the mid-1990s. Due principally to the timing advantages associated with tender offers, the amendment to the best-price rule should result in the two-step acquisition again becoming the preferred transaction structure for negotiated U.S. public company acquisitions. Mark E. Betzen is a mergers and acquisitions partner in the Dallas office of Jones Day. Jeffrey D. Litle is a mergers and acquisitions associate in the firm’s Columbus, Ohio, office.

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