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For years, the SEC’s “best price” rule has raised difficulties for companies planning tender offers, and the task has recently become even more challenging. In a recent decision, a key federal court has applied the rule against the payment of a non-competition fee to an executive officer of the target company in a tender offer. This decision by the 2nd U.S. Circuit Court of Appeals, Gerber v. Computer Associates, [FOOTNOTE 1]represents a broad application of the best price rule. The case may be used as precedent to block a wide variety of payments and transactions that often occur in connection with tender offers. Meanwhile, other recent cases, particularly Katt v. Titan Acquisitions,a Tennessee case, set forth a less restrictive view of these arrangements. As a result of these conflicts, companies planning tender offers will need to continue to carefully consider the best price rule. [FOOTNOTE 2] BACKGROUND Rule 14d-10 under the Securities Exchange Act of 1934 requires a bidder in a tender offer to permit all holders of the target class of securities to participate in the transaction (the all holders rule), and to pay to each tendering holder the highest price paid to any other holder during the offer (the best price rule). The best price rule is designed to ensure that all the target’s shareholders will be treated equally in a tender offer — no shareholder should receive more for its shares than any other. The rule appears simple enough. However, in an acquisition of a public company, some types of transactions often occur before, after, or simultaneously with, the purchase of the target’s shares. Some of the target’s officers and directors, who are frequently also shareholders of the target, are often involved in these transactions, receiving a payment or benefit of one kind or another. After all, the terms of their post-merger compensation (or the terms of their departure) are very important to the buyer. There are a variety of transactions that could be implicated under this rule: • Severance payments to management shareholders; • Retention bonuses to management shareholders who remain with the company post-merger; and • Non-compete fees for management shareholders. If, in connection with a tender offer, the buyer or the target makes payments, or provides some other benefit to a target’s management shareholder, other than the tender offer price, is the best price rule violated? The text of the best price rule does not provide much guidance on how to treat these transactions. The job has been left to the courts to figure out. The federal courts have generally applied two tests to interpret the rule: the “integral part” test and the “bright line” test. The integral part test was used in a 9th Circuit decision in Epstein v. MCA. [FOOTNOTE 3]Under this test, the key is the relationship that the management transaction has to the tender offer. For example, was the transaction expressly conditioned upon completing the tender offer? The bright line test, adopted by the 7th Circuit in Lerro v. Quaker Oats, [FOOTNOTE 4]makes transaction planning easier. Under this test, the best price rule is only applied to management transactions that occur during the tender offer. Once the tender offer is completed, and the target’s shares are tendered by their holders, a management transaction would not be prohibited. ‘COMPUTER ASSOCIATES’ The Computer Associatescase involved the company’s tender offer for On-Line Software International. The plaintiff, Joel Gerber, an On-Line shareholder, filed a class action on behalf of On-Line shareholders who tendered in the tender offer. The plaintiff argued that, in acquiring On-Line, Computer Associates paid more per share to Jack Berdy, On-Line’s chairman and CEO, than it paid to other On-Line shareholders, violating the best price rule. Before the tender offer, Berdy owned 1.5 million shares of On-Line stock, approximately 25 percent of the company. Computer Associates and On-Line agreed that Computer Associates would offer to purchase On-Line’s shares for $15.75 per share, and that as part of the deal, Computer Associates would pay Berdy $5 million for a five-year non-compete agreement. The central issue was whether the $5 million payment was an unlawful additional payment for his On-Line shares, violating the best price rule. In a lower court, based upon testimony of the parties and expert testimony, a jury determined that $2.3 million of the $5 million was compensation for his shares, and the remainder was a separate payment for the non-compete agreement. Computer Associates appealed to the 2nd Circuit. Based on the rules that applied at the time of the tender offer, the appeals court concluded that the non-compete agreement was executed after the commencement of the tender offer. The court also examined whether Berdy’s payment should be considered to have been made “during” the tender offer, even though his actual payment occurred after On-Line’s shareholders had tendered. The court concluded that the phrase “during the tender offer,” as used in the best price rule, was broad enough to include the payment to Berdy. The court especially focused on the fact that he was paid before the other On-Line shareholders. The decision leaves open the possibility that this kind of payment could be challenged 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 Berdy’s payment, the court pointed out that drawing arbitrary timing lines to the phrase “during a tender offer,” as the bright line test does, would enable parties to evade the best price rule. The timing of payments might change, but the economic impact would be identical, and the rule would be rendered ineffective. However, the facts of the Computer Associates tender offer were different, so the court did not need to rule on this issue specifically. The 2nd Circuit did not state that all non-competition payments of the kind made to Berdy would violate the best price rule. But in this case, where the non-competition payment was negotiated at the same time as the tender offer price, the court held that the jury could determine whether all or part of Berdy’s payment was intended as an additional payment for his shares. A TENNESSEE CASE Other courts have recently adopted a less restrictive approach. One significant example is a January 2003 case, Katt v. Titan Acquisitions. [FOOTNOTE 5] In Katt, a federal district court in Tennessee determined that certain compensation arrangements and retention packages established for a target company’s executive shareholders could not be deemed to have violated the best price rule, including: • Change-of-control agreements that the target signed with members of management a few months before the announcement of the tender offer; • Signing bonuses offered by the buyer to target officers if they accepted employment with the buyer after the acquisition; • A retention bonus adopted by the target for certain officers after the acquisition; and • A bonus plan for certain officers relating to the services they provided in connection with the ownership change. Reversing the decision of a different Tennessee judge in the same case, the court strongly adopted the bright line test, and rejected the integral part test. Moreover, the court went on to state that, even under the integral part test, a plaintiff must prove that the acquiror intended to pay the management shareholders in order to induce them to tender their shares. A violation of the best price rule would not occur only because the payment of the compensation was conditional upon the completion of the tender offer. The court provided additional comfort to future acquirors by stating that an acquiror does not violate the best price rule by honoring the existing compensation arrangements of the target. If other courts follow this lead, the case could represent a significant reduction of the impact of the best price rule. STRUCTURING THE TRANSACTION In tender offers for public companies, the parties must carefully consider whether any arrangements with target management will be problematic under the best price rule. Plaintiffs in any future class action challenging the tender offer will try to select a court that adopts the hardest line as to the best price rule, and could reject the reasoning of cases such as the Kattdecision. Even if one or more courts reject the reasoning in the Computer Associatesdecision or the Epsteindecision, as did the Kattcourt, plaintiffs may still be able to rely upon these “stricter” cases in the jurisdiction in which they bring an action. When the parties are in doubt whether a payment or other arrangement involving a management shareholder of the target is acceptable under the best price rule, the risk may not be acceptable. The transaction structure may need to be recast from a tender offer to a merger of the target with the buyer or a subsidiary of the buyer. This may sound like an easy fix, but a merger is not necessarily a desirable solution. Under state corporate law and applicable stock exchange rules, the amount of time needed to complete a merger is usually longer than that needed to close a tender offer. In a merger, a draft proxy statement is filed with the SEC before the final proxy statement is mailed to the target’s shareholders. The SEC reviews most proxy statements, and some of these reviews take quite some time. During this period, the risk increases that a competing buyer, or other parties opposed to the transaction, could launch a competing offer or otherwise disrupt the acquisition. In addition, in a merger structure, the target’s shareholders may be more likely to exercise state law appraisal rights than they would be in the case of a tender offer. In short, although a deal may be completed with a different structure, some advantages may be lost. Buyers must be sensitive to these matters during their “due diligence” review of the target. What sort of arrangements does the target have with its management team that raise issues under the best price rule? What new arrangements of this kind are under consideration? Carefully-crafted arrangements that would be completely legal if adopted in the ordinary course of business may have unexpected and negative consequences if adopted during merger discussions. CONCLUSION At some point, the SEC may provide guidance in applying the best price rule to these arrangements. For example, it may create “safe harbors” for certain types of management transactions relating to a tender offer. But for now, in light of the differing views of the federal courts, there is substantial uncertainty. Until these questions are answered, companies should carefully examine these arrangements, and they may need to replace their tender offers with alternative transaction structures. What practical lessons can be learned from the case law? Parties:A buyer should avoid being a party to any agreements providing additional or new compensation to the target’s management after the tender offer. Timing of new arrangements:Any compensation for members of the target’s management team should be effective immediately upon execution of the agreements, and should not depend upon completion of the tender offer. The ideal time to adopt change-of-control compensation packages is before any acquisition negotiations begin. Delayed effectiveness:If it is not possible to make the new compensation arrangements immediately effective, the effectiveness should be postponed until the completion of the back-end merger that follows the tender offer, and should not take place until at least the time that the target’s other shareholders have received payment for their shares. Incentives should reflect future performance:Compensation arrangements are most likely to pass muster if they are structured as payment for future services, and not as additional tender offer payments. Benefits may be tied to future vesting, based upon the individual’s continued employment. Compensation should not reflect share ownership:If more than one member of the target’s management team is involved, compensation plans should not depend on the number of shares held by each. Justify compensation:A company may need to demonstrate that the compensation arrangements created at the time of a tender offer were not extra tender offer payments. Ideally, companies should obtain independent third-party advice from compensation experts that validate these payments, or they should document why they were appropriate. None of these steps will guarantee that a compensation arrangement will satisfy the best price rule. However, depending on the situation, these tips may help the parties remain within the rule. Priscilla C. Hughes is a partner at Morrison & Foerster ( www.mofo.com) in Manhattan. Lloyd Harmetz is an associate at the firm. If you are interested in submitting an article to law.com, please click herefor our submission guidelines. ::::FOOTNOTES:::: FN 1 Gerber v. Computer Assocs. Int’l Inc., 303 F.3d 126 (2d Cir. 2002). FN 2The end of this article contains pointers to help avoid implicating the best price rule when designing executive compensation and related arrangements for the target’s management team. FN 3 Epstein v. MCA Inc., 50 F.3d 644 (9th Cir. 1995), rev’d on other grounds, 516 U.S. 367 (1996). FN 4 Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996). FN 5 Katt v. Titan Acquisitions Ltd., No. Civ. 99-0655 (M.D. Tenn. Jan. 10, 2003).

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