SEC tender offer rules revamped

The Securities and Exchange Commission last month revised its tender offer rules by eliminating a significant impediment to mounting friendly tender offers for public companies.
The revisions eliminate the risk that compensation arrangements entered into with target company executives, who are also tendering shareholders, constitute additional payment for the stock being tendered.
The SEC’s “best-price rule” requires that the highest price paid any shareholder must be paid to all shareholders. As a result, a determination that compensation payments were included in stock price means all shareholders must be paid for their stock at a per share price that is the aggregate of the tender price, plus the per share value of the executive compensation payment.
The SEC’s rules revisions were “intended to make it clear that the best-price rule was not intended to capture employment compensation, severance or other employee benefit arrangements.” (SEC Release 34-54684 is available at www.sec.gov.)

Best-price rule history
The purpose of the best-price rule was to make sure all shareholders were treated fairly and evenly, and that early tenderors (including insiders) could not secure a higher price for themselves than the price afforded to later–tendering, non-insider shareholders. In addition, it took the pressure off having to tender shares early in the process, preventing something of a tender stampede to get the better earlier price.
To illustrate the problem of including executive compensation into a tender stock price, assume a tender price for a share of stock is $1 for all 1 million outstanding shares. Also assume that a senior vice president is paid a $100,000 fee to resign and to sign a non-competition agreement with the acquirer. The vice president owns 1,000 shares of stock, which means the vice president is receiving not only the $1 per share of stated tender price, but also an additional $100 per share (the $100,000 non-competition payment divided by the 1,000 shares held by that executive).
The result: The vice president would be deemed to have received $101 per share, and, as a consequence, every other shareholder must receive the same $101 per share. The unintended incremental cost to the tenderer would be about a $100 million extra dollars.
This consequence came about through the ingenuity of the plaintiffs’ bar and through class-action litigation. Lawyers for non-executive shareholders filed suits seeking the same “share premium” that was being paid to tendering executives.
Various federal courts on occasion had given relief to these plaintiffs, sometimes holding that any executive compensation arrangement made during the course of such tender offer was consideration for the stock, and sometimes holding that such arrangements must be treated as payment for stock if they are “integral” to the tender offer transaction (conditioned upon the completion of the deal).
The risk was compounded by the differing legal approaches of the federal appeals courts. Plaintiffs could “forum shop” for the judicial approach favoring their particular fact pattern.
The result of these court-imposed risks was to be expected: Executives receiving enhanced compensation or severance either had to refrain from actually tendering their shares, or else well-advised acquirers avoided the tender offer route entirely, and completed acquisitions through long-form mergers. These mergers required a merger proxy statement, additional legal and accounting work, more time and more expense.

SEC action
A party now tendering for a public company’s shares can easily achieve the result of excluding compensation paid to tendering executives from the calculation of “best price” paid for tendered stock. This exclusion can be achieved both for third party tenders and a company tendering for its own shares – even if the payment is integral to the transaction (as it almost always is), or is made during the course of the tender. The SEC has taken this aspect of the tender offer process out of the hands of the courts.
The SEC’s action is accomplished in a very minimalist way. One sentence of the best-price rule is amended to require inclusion, as consideration for the tender, of only those compensatory sums received by executives for “securities tendered in the tender offer.” The prior language required inclusion of payments made either “pursuant to the tender offer” or “during such tender offer.” (Emphasis added.)
How do you qualify for the exclusion of sums paid to executives in an employment context from the computation of stock tender price?
The SEC has provided a safe harbor. Although this safe harbor method is non-exclusive, it is difficult to understand why anyone would effect a tender without attempting to use the safe harbor because it is so simple.
First, the payment to the executive cannot be based upon the number of shares tendered. Second, the compensation, severance and benefit arrangements for the executive must be approved by the compensation committee of the board, or a committee of independent directors performing a similar function of the target company, or by a committee of the bidder company. Multiple choices are available: Tenderors can use a compensation committee, or a separately appointed committee, of either corporate party to pass upon the executive compensation aspect of the tender.
All the committee has to determine is that the payments are granted for services performed or to be performed, and are not based upon number of tendered shares. Once that determination is made, it is not open to appeal.
It is mandatory that the committee passing upon the compensation arrangements consist of independent directors. Existing compensation committees of companies with shares admitted to trade on an exchange already are compelled under listing requirements to maintain an independent compensation committee. Other companies may name a special committee on the spot. (There are specific provisions for foreign private issuers which are beyond the scope of this article).
What to expect
The SEC intends that many transactions that are presently structured as long-form mergers (requiring extensive merger proxy statements) will now be completed through tender. While tenders require the preparation of some disclosure documents and certain SEC filings, they generally will be less expensive, less time-consuming, and also less taxing on the Commission staff.
Little has been written about the interplay between newly revised proxy rules and recently revised disclosure requirements for executive compensation. See SEC Watch column in the October 2006 issue of New England In-House.
However, it’s likely that for executives subject to such disclosure rules the kinds of compensation paid to them in a typical case (e.g., bonuses, retention payments, compensation increases, severance or termination payments, and non-competition payments) will have to be evaluated for mandatory inclusion in appropriate schedules under the SEC’s new executive compensation disclosure regimen.
Counsel must also make sure that executive payments do not run afoul of the greatly expanded deferred compensation rules under Section 409A of the Internal Revenue Code. The risk of violating 409A is that the imperfectly deferred income is taxed, with interest and a 20 percent penalty, in the year the arrangement is made, notwithstanding that actual payment of the compensation benefit to the executive will occur only at some future date.
Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at [email protected].