SEC Amends Best-Price Rule to Exempt Compensatory Arrangements

December 19, 2007 — 1,267 views  
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On November 1, 2006, the SEC issued Release No. 34-54684 in which the staff amended the tender offer best-price rule to exempt "employment compensation, severance, or other employment benefit arrangements" from the scope of the rule.  The new amendments are intended to permit bidders to negotiate and enter into service-based, compensatory arrangements with security holders of a subject company without running afoul of the best-price rule.  The new amendments also provide a non-exclusive safe harbor for such arrangements if approved by an independent committee of the board of directors of either the subject company or the bidder, if the bidder is party to the arrangement.

Reasons for the Amendment

Cash tender offers have advantages over other cash transaction structures, most notably timing (that is, the shorter time to closing typically required for a tender offer) and the ability to acquire control without purchasing all outstanding securities.  Due to concerns of unfair treatment of security holders; however, the SEC adopted the best-price rule in 1986 to prevent discriminatory tender offers in which bidders made offers to security holders at varying prices.  The SEC sought to assure the equal treatment of all security holders by codifying its position that all security holders must be paid the highest consideration paid to any holder in a tender offer.  Prior to the recent amendments, the best-price rule under Exchange Act Rules 13e-4 and 14d-10 required that "the consideration paid to any security holder pursuant to a tender offer is the highest consideration paid to any other security holder during such tender offer." The issue raised by plaintiff lawyers in recent years is whether arrangements entered into in connection with a transaction resulted in consideration paid to a holder "during such tender offer."

Since the rule's adoption, courts have been asked to consider whether payments to security holders under compensatory arrangements constitute additional consideration under the best price rule.  Courts have applied divergent standards to the analysis of these payments; thereby creating uncertainty in the law for bidders and forum-shopping opportunities for plaintiffs.  Further, the severe remedy for a violation of the best-price rule is to require the bidder to pay all security holders an equivalent amount in respect of all shares tendered.  The relatively small amount paid to an executive under an employment agreement can produce enormous damages when an equivalent amount is required to be paid to all other security holders in proportion to the securities held by them.

These uncertainties and the potential risk of astronomical liability associated with tender offers  led M&A practitioners to avoid structuring transactions as tender offers if an alternative structure, such as a merger, was available.  The SEC, by these amendments, has sought to make clear that the best-price rule does not apply to compensatory arrangements and that the analysis, for best-price rule purposes, should turn on whether the consideration was paid for securities tendered into a tender offer, regardless of the timing of the arrangement.  By doing so, the SEC hopes to eliminate the regulatory obstacles and reduce the disincentives to structuring acquisitions as tender offers.  The SEC made it clear in the adopting release that the best-price rule was "never intended to apply to consideration paid pursuant to arrangements, including employment compensation, severance or other employee benefit arrangements, entered into with security holders of the subject company, so long as the consideration paid pursuant to such arrangements was not to acquire their securities."

The SEC took three regulatory steps to accomplish the goal of clarifying the application of the best-price rule.  The SEC amended the best-price rule itself in each of Exchange Act Rules 13e-4 and 14d-10, adopted an exemption for compensation arrangements, and adopted a non-exclusive safe harbor for bidders and subject companies to follow.  The SEC amended Exchange Act Rules 13e-4 and 14d-10 to read: "The consideration paid to any security holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer." Thus, the SEC sought to eliminate the ambiguity in the rules themselves by eliminating the phrases "pursuant to the tender offer" and "during such tender offer," substituting in their places the phrase "for securities tendered in the tender offer."

Scope of New Exemption for Compensatory Arrangements

The newly adopted amendments exempt from the best-price rule the negotiation, execution, or amendment of an employment compensation, severance, or other employment benefit arrangement so long as two criteria are met.  Amounts payable under the arrangement must be paid or granted for past services performed, future services to be performed, or future services to be refrained from performing by the security holder, or matters incidental thereto.  Further, amounts payable may not be calculated based on the number of securities tendered or to be tendered by the security holder.

As originally proposed by the SEC in 2005, the exemption would have only applied to third party tender offers.  Further, the exemption would have only extended to arrangements with employees and directors of the subject company.  However, the final release amends the best-price rule to include the exemption and safe harbor for both third party tender offers and tender offers by an issuer or its affiliate.  Also, the exemption applies to compensatory arrangements with any security holder of the subject company, not just employees and directors of the subject company.

The amendments are not intended to restrict the forms of compensation paid under a qualifying arrangement. The arrangement may provide for alternative forms of compensation, including equity-based awards such as options or other equity, cash payments for options or other equity, or changes in vesting terms, so long as the compensation is service-related and not calculated based on the number of securities tendered or to be tendered by the security holder.

Conditioning an arrangement on a security holder's tendering securities in a tender offer would likely violate the exemption.  However, the exemption should not be violated if the arrangement is conditioned on the consummation of a tender offer, without any requirements as to the security holder's tendering shares.  Another issue which will be developed over time is the definition of "matters incidental to" the compensatory arrangement.  These matters might include the transfer of company property such as automobiles, telephones, computers, or other tangible property or other matters incidental to a separation from service with the company.

The exemption does not extend to other arrangements, such as commercial arrangements.  However, the newly adopted instructions provide that an inference should not be drawn that such arrangements constitute consideration for securities and thereby violate the best-price rule.  Those arrangements would need to be evaluated independently to determine whether they provide for consideration for securities tendered or to be tendered in an offering.

The SEC also considered whether to implement a de minimis exception to the best-price rule, which would allow for minor variances in prices for securities.  A similar concept exists in the notice provisions of Exchange Act Rules 13e-4(f)(1) and 14e-1(b), which provide that a bidder is required to give prior notice of the acceptance of payment of an additional amount of securities unless the additional amount does not exceed two percent (2%) of the class of securities subject to the tender offer.  The SEC refused to create a similar de minimis exception to the best-price rule over fears that such an exception could undermine the rule's protections.

Safe Harbor with Independent Director Approval

To enhance the certainty in planning and structuring acquisitions by tender offer, the SEC provided a non-exclusive safe harbor for arrangements approved as an employment compensation, severance, or other employment benefit arrangement by independent directors of the subject company or the bidder, if the bidder is a party to the arrangement.  The approval must be given before the tender offer consideration is paid, so arrangements may be approved in advance or ratified after the fact so long as the tender offer consideration has not been paid.

If the bidder is party to a compensation arrangement, the safe harbor in a third party tender offer does not require the approval of independent directors of both the bidder's board of directors and the subject company's board of directors.  Rather, the arrangement may be approved solely by a compensation committee or special committee of the bidder.  Alternatively, the arrangement may be approved by the compensation committee or special committee of the subject company, regardless of whether the subject company is a party to the arrangement.

The safe harbor in an issuer tender offer requires the approval of independent directors of the issuer's board of directors regardless of whether the issuer is a party to the compensation arrangement.  Alternatively, if an affiliate is party to the arrangement, the arrangement may be approved by the compensation or special committee of the affiliate.

In the absence of a compensation committee or if certain of the compensation committee members are not independent, a special committee consisting of independent directors may be formed to consider and approve the arrangement.  Therefore, a subcommittee of the compensation committee or a special committee of the board of directors generally may be established so long as all members of the established committee are independent.

If the bidder or subject company, as applicable, is a foreign private issuer, any or all of the directors or any committee authorized to approve arrangements under the laws or regulations of the home country approves the arrangement.

What Must the Directors Approve

For the safe harbor to apply, the only requirement is that the approving committee of the subject company or bidder, as applicable, approves the arrangement as an employment compensation, severance, or other employment benefit arrangement.  The committee does not have to approve the arrangement as meeting the other requirements of the exemption.  For example, the committee does not have to determine whether the arrangement relates to past services performed or future services to be performed or refrained from performing.  The committee also does not have to determine whether the arrangement is based on the number of securities the employee owns or tenders. As discussed further below, the approval by the committee will be subject to challenge under state law as a potential violation of the directors' fiduciary duty, rather than as a violation of the best-price rule.

In the release, the SEC noted that for purposes of the safe harbor, directors must have knowledge of and approve the specific arrangements with security holders.  It is not sufficient for the safe harbor that directors approve general plans or programs. The safe harbor is available, however, for preexisting arrangements approved by the committee after the effective time of the amendment.

Standards for Independence of Directors

A determination by the board of directors that the directors who approve an arrangement are independent in accordance with the provisions below will satisfy the independence requirements of the safe harbor:
*       If the bidder or subject company, as applicable, is a listed issuer and the securities are listed on an exchange or quotation system that has independence requirements for compensation committee members that have been approved by the SEC, the bidder or subject company should apply its respective definition of independence used for determining independence of compensation committee members or in compliance with applicable listing standards.
*       If the bidder or subject company, as applicable, is not a listed issuer, the bidder or subject company should apply the independence requirements of an exchange or quotation system that has independence requirements for compensation committee members that have been approved by the SEC.
*       If the bidder or subject company, as applicable, is a closed-end investment company, a director will be considered independent if the director is not, other than in his or her capacity as a director, an "interested person" of the investment company.
*       If the bidder or subject company, as applicable, is a foreign private issuer, the bidder or subject company should apply the independence requirements of the first two bullets above or the independence requirements of the laws of the home country.

Impact of Fiduciary Duty Claims on Safe Harbor
The SEC also considered whether the new amendments would create the opportunity for new claims by plaintiffs that directors violated their state law fiduciary obligations in approving an arrangement.  In doing so, the SEC determined that a violation of state law fiduciary duty claims should not impact the safe harbor's availability so long as the requirements of the safe harbor are met.  State law remedies may remain available for breaches of fiduciary duties, but the remedies based on the best-price rule would not be available.
Effective Date of the Amendments

The amendments will become effective December 8, 2006.

DLA Piper Rudnick Gray Cary US LLP