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Weil, Gotshal & Manges LLP
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Post-Merger Employment Agreements With Target Management And SEC Rule 14d-10: A Trap For The Unwary?
Dutka, Paul
(December 2002, Business & Securities Litigator)
By Paul Dutka and Sirin Thada
As the curtain has rung down in recent years on hostile tender offers,
negotiated acquisitions have seized center stage, propelled by perceived
synergies between acquiror and target. Because the merger’s success
often depends on retaining the target’s senior management, understanding
the impact of Securities and Exchange Commission Rule 14d-101 (the “All-Holders,
Best-Price” rule) on an acquiror’s ability to negotiate post-merger employment
agreements with target management during the tender offer carries increased
urgency.
Recently, in Gerber v. Computer Associates International, Inc., 303 F.3d
126 (2d Cir. Sept. 4, 2002), the Second Circuit held that the acquiror’s
payment to the target’s chief executive officer under a post-merger non-compete
agreement, when the CEO also owned a block of the target’s stock, violated
Rule 14d-10, although the payment was made after the tender offer closed.
The Second Circuit concluded that part of the consideration the CEO
received constituted unlawful additional payment for his shares, and ordered
that the plaintiff class of tendering shareholders receive the same increased
price for their shares.
This article focuses first on Gerber,
then turns to other leading cases illustrating how the courts have split
over the application of Rule 14d-10.
The “All Holders, Best Price” Rule
In adopting Rule 14d-10 in 1986, the SEC announced that the Rule’s all-holders
and best-price requirements were necessary to implement the investor protection
purposes of the Williams Act. Thus, Rule 14d-10 preclude[s] bidders
from discriminating among holders of the class of securities that is the
subject of the offer, either by exclusion from the offer or by payment
of different consideration. Without the all-holders and best-price
requirements, the investor protection purposes of the Williams Act would
not be fully achieved because tender offers could be extended to some security
holders but not to others. Such discriminatory tender offers could
result in the abuses inherent in “Saturday Night Specials,” “First-Come
First Served” offers and unconventional tender offers since security holders
who are excluded from the offer may be pressured to sell to those in the
included class in order to participate, at all, in the premium offered.
These excluded security holders would not receive the information
required by the Williams Act, would have their shares taken up on a first-come
first-served basis and would have no withdrawal rights.2
Rule 14d-10 states that “[n]o
bidder shall make a tender offer unless: (1) the tender offer is open to
all security holders of the class of securities subject to the tender offer;
and (2) 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.”3
But, as Gerber illustrates, Rule 14d-10 has in turn engendered controversy
because of the ambiguity attaching to the phrase “during such tender offer.”
Some courts, including the Second Circuit, use a “functional” approach,
broadly interpreting the word “during” and inquiring whether additional
payment made outside the tender offer period nonetheless furthered the
acquiror’s goal of merging and thus violated Rule 14d-10. Other
courts have adopted a “formal” or “bright-line” approach, under which
a violation of Rule 14d-10 occurs only if the additional payment is literally
paid “during” the tender offer.
This split among the courts promises continuing difficulty in structuring
post-merger employment agreements with target management, a difficulty
which is exacerbated by the disastrous financial consequences that violations
can carry because any “increased consideration” must be paid to all tendering
shareholders.4
Gerber v. Computer Associates
Int’l, Inc.
In July 1991, Computer Associates’ chairman Charles Wang approached
On-Line chief executive officer Jack Berdy about acquiring On-Line. Eventually
they agreed upon the terms of a tender offer and back-end merger. Computer
Associates offered to purchase On-Line stock for $15.75 per share, and
contracted to give Berdy $5 million for his agreement not to compete.5
Plaintiff Joel Gerber, an On-Line shareholder, later filed a purported
class action on behalf of tendering shareholders, principally alleging
that the $5 million was in reality increased consideration for Berdy’s
1.5 million On-Line shares.6 Computer Associates moved to dismiss,
arguing that the non-compete agreement was made before the tender offer
began, and, thus fell outside Rule 14d-10.7 The district court denied
the motion, concluding as a matter of law that the tender offer had commenced
five days before Berdy’s non-compete agreement was signed, when the companies
issued a press release announcing the terms of the offer, subject to a
number of conditions, including board and regulatory approvals and the
execution of definitive agreements.8
The court then certified the plaintiff
class,9 and Computer Associates moved for summary judgment.10 The
court granted summary judgment in part, but denied the motion with respect
to the Rule 14d-10 claim because the court found genuine issues of material
fact concerning the nature and purpose of the $5 million payment to Berdy.11
The case eventually went to trial, and the district court instructed
the jury to “consider whether the payment of 5 million dollars under the
so-called Berdy agreement was paid to Dr. Berdy for his On-Line shares,
or his agreement not to compete, or partly for the shares and partly for
the agreement not to compete.”12
The jury returned a special verdict for the plaintiff class, finding that
$2.34 million of the $5 million was unlawful additional payment for Berdy’s
shares, while the rest was legitimate compensation for his non-compete
agreement. The court entered judgment totaling $5.67 million, representing
an additional $1.46 per share of On-Line common stock for the class, plus
interest.13 Computer Associates moved for judgment notwithstanding the
verdict, or a new trial, which was denied.14 Computer Associates
appealed.
The Appeal
On appeal, Computer Associates argued that the Rule 14d-10 claim was insufficient
as a matter of law because, even if the Berdy agreement was signed during
the tender offer, Berdy was not paid until five days after the tender offer
had closed. But, true to the functional approach, the Court of Appeals
looked beyond the tender offer’s “self-prescribed expiration date” and
rejected Computer Associates’ timing argument. “While Rule 14d-2
governs the determination of when a tender offer commences,” reasoned
the Court of Appeals, “no pertinent rule or statute addresses when a tender
offer concludes.”15 Given this, “the phrase ‘during the tender
offer’...is flexible enough to include [Computer Associates’] payment
to Berdy....”16
In reaching this conclusion, the Court emphasized that Computer Associates
paid Berdy before paying any other shareholders, so “if Berdy was not
paid ‘during the tender offer,’ then neither was any other On-Line shareholder.”17
Taking a bright-line approach and simply equating the end of the
tender offer with its self-proclaimed expiration date “would make it all
too easy to contract around the Best Price Rule” and would render the
rule “toothless.”18
The Court relied on its earlier
decision in Field v. Trump, 850 F.2d 938 (2d Cir. 1988), where defendants
commenced a tender offer, then “withdrew” it to purchase a dissident’s
shares at a higher price, and then launched a “new” tender offer thevery next day at the original price.19 Instead of accepting defendants’
characterizations, the Field Court examined the surrounding circumstances
to determine whether the formally separate offers should be considered
a single, integrated transaction. Because the defendants never “abandoned
the goal of the original tender offer,” the Field Court concluded that
they had not effectively terminated the initial tender offer, and that
the “second” tender offer was merely a continuation of the first.20 Given
this, the purchase of the dissident’s shares violated Rule 14d-10.
The Gerber Court found that Computer Associates, like the defendants in
Field, had “continuously pursued the goal of its tender offer.”21 Because
the Berdy agreement was signed during the tender offer and payment was
made “in support of [Computer Associates’] continuous goal” of acquiring
On-Line, the Court concluded that the payment also occurred “during the
tender offer” for purposes of Rule 14d-10, and held that Gerber’s claims
were sufficient as a matter of law.22
On appeal, the Second Circuit also
considered whether the district court erred in instructing the jury that
it could find Computer Associates paid $5 million to Berdy “partly for
the shares and partly for the agreement not to compete.”23 Computer
Associates argued that there was no evidentiary basis for this apportionment,
and that the jury’s finding that $2.34 million was payment for Berdy’s
shares represented an impermissible compromise verdict. The Court
of Appeals reviewed the jury instructions de novo and found sufficient
evidence to support the jury’s finding, based on the testimony of Computer
Associates’ own expert witnesses. One witness testified, for example,
that, if Berdy competed, the expected loss to Computer Associates could
range from $0 to $5 million. The Court of Appeals held: (a) this
was sufficient evidence for a jury to find that some, but not all, of the
$5 million was consideration for Berdy’s On-Line shares; and (b) the verdict
was not an impermissible compromise because it was supported by the trial
evidence.24
The Functional Approach:
Other Decisions
Other courts adopting the functional approach include the Court of Appeals
for the Ninth Circuit, and United States District Courts in Tennessee and
Pennsylvania. The Ninth Circuit adopted the functional approach in
Epstein v. MCA, Inc., 50 F.3d 644 (9th Cir. 1995).25 The litigation
grew out of Matsushita Electrical Company’s tender offer for MCA, and
its entering into employment agreements with MCA executives Lew Wasserman
and Sidney Sheinberg.
Rather than tendering his shares, Wasserman exchanged them for preferred
stock in a wholly owned Matsushita subsidiary. The agreement was
signed moments before the tender offer commenced, and the preferred stock
changed hands about one hour after the tender offer closed. Sheinberg,
on the other hand, tendered his shares, but MCA agreed to pay him an additional
$21 million if the tender offer succeeded. Two days after Matsushita
accepted all tendered shares, MCA paid Sheinberg the promised $21 million.
The district court denied plaintiffs’ motion for summary judgment on their
Rule 14d-10 claim and instead granted summary judgment to Matsushita. Plaintiffs
appealed, and Matsushita argued that Rule 14d-10 was inapplicable because
both the payments and the agreements were made outside the formal tender
offer period. The Ninth Circuit rejected this argument, noting that
the phrase “tender offer” has never been interpreted as denoting a rigid
period of time, and that if the Court were to adopt such a rigid test,
Rule 14d-10 would be drained of all force.26
Instead, the Court held that “[a]n
inquiry more in keeping with the language and purposes of Rule 14d-10 focuses
not on when Wasserman was paid, but on whether the Wasserman transaction
was an integral part of [the] tender offer.”27 The court found
that the Wasserman transaction was integral because it was “in several
material respects conditioned on the terms of the public tender offer”:
the redemption value of Wasserman’s stock referred to the tender offer
price, and the transaction hinged upon the tender offer’s success.28
Finally, the court rejected Matsushita’s argument that the Sheinberg agreement
could not violate Rule 14d-10 because the Rule applied only to the acquiror,
whereas it was MCA, the target, that had paid Sheinberg. The court
reasoned that the mere fact that MCA issued the check just before merging
with Matsushita did not preclude the possibility that the payment was meant
to induce Sheinberg’s support of Matsushita’s tender offer.29
More recently, district courts in Tennessee and Pennsylvania have also
adopted the functional approach. In Katt v. Titan Acquisitions, Ltd.,
133 F. Supp. 2d 632 (M.D. Tenn. 2000), the court denied a motion to dismiss
Rule 14d-10 claims based on $30 million in golden parachute payments, accelerated
incentive awards, “sign on” bonuses, and accelerated performance awards
to target executives. These agreements were made and consummated
outside the tender offer period; in fact, many of these agreements had
been made months before, and the sign-on bonuses, for example, were not
paid until months after the tender offer closed.
But, under the functional approach,
the court held that the agreements could be an “integral part” of the
tender offer because: they were “executed in close connection with [the]
tender offer,” the “officers’ contractual rights [were] tied to the
success of [the] tender offer,” the “officers [were] shareholders and
these agreements [were] inextricably joined with [the] tender offer, the
success of the acquisition and these officers’ support of the acquisition.”30
Although the payments were made by the target, the court concluded
that the payments could be found to have been induced by the acquiror,
and thus remained subject to Rule 14d-10.
In Millionerrors Investment Club v. General Electric Co., 2000 U.S. Dist.
LEXIS 4778 (W.D. Pa. Feb. 8, 2000), a district court in Pennsylvania denied
a motion to dismiss Rule 14d-10 claims based on stock options granted to
executives of the target. These in-the-money options were granted
shortly before the tender offer commenced, and were cancelled, as soon
as the tender offer closed, in exchange for cash payments pegged to the
difference between the options’ strike price and the tender offer price.
Although actual payment was not made until several months after the
tender offer closed, nevertheless the court denied the motion to dismiss
because the acquiror’s “agreement to cancel and cash out the [target]
executive[s] unvested stock options occurred ‘during’ the Tender Offer.”31
The court stated: “We agree with the less rigid interpretation of
Rule 14d-10 utilized by the [court] in Epstein. . . . That interpretation
is more attuned to the SEC’s . . . goal of ensuring ‘equality of
treatment among all shareholders who tender their shares.’”32
The functional approach arguably
sweeps too broadly, placing many post-merger employment agreements with
target management at risk because they may be considered “integral to,”
or executed “continuously in pursuit of,” the tender offer. Furthermore,
the factually nuanced nature of the functional approach makes it likely
that a Rule 14d-10 claim will survive a motion to dismiss and perhaps summary
judgment. Given this and given most corporations’ unwillingness
to hazard their futures on the dice roll of a jury verdict, the threat
of huge liability engendered by the functional approach creates significant
settlement leverage for plaintiffs.
The Formal Approach
Under the “formal” or “bright-line” approach, additional consideration
violates Rule 14d-10 only if it is literally paid during the tender offer.
Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996) is the foremost
bright-line case, and arose out of Quaker Oats’ acquisition of SnappleBeverage Corporation. The case involved a lucrative distribution
agreement with one of the target’s controlling shareholders, which plaintiff
alleged was a disguised additional payment for shares.
The Seventh Circuit acknowledged
that the agreement was integral to the transaction, and that its consummation
depended on the merger. Nevertheless, the Seventh Circuit upheld
the district court’s dismissal of the complaint because the challenged
agreement was signed three days before the tender offer period began. “The
difference between ‘during’ and ‘before’ (or ‘after’) is not just
linguistic,” stated the court. “It is essential to permit everyone
to participate in the markets near the time of a tender offer. Bidders
are forbidden to buy or sell on the open market or via negotiated transactions
during an offer . . . but they are free to transact until an offer begins,
or immediately after it ends.”33
More recently, the United States District Court for the District of Delaware
adopted the Lerro rationale in In re Digital Island Securities Litigation,
2002 U.S. Dist. LEXIS 17906 (D. Del. Sept. 10, 2002). In that case,
plaintiff shareholder alleged that the target’s directors and officers
received extra compensation in the form of salary and stock options packages.
The court dismissed the claim because any “extra compensation”
was negotiated and agreed to before the tender offer.34
Similarly, in Susquehanna Capital
Group v. Rite Aid Corp., 2002 U.S. Dist. LEXIS 18290 (E.D. Pa. Sept. 17,
2002), a district court in Pennsylvania also dismissed plaintiff’s Rule
14d-10 claim where both the agreement and the payment were made before
the tender offer began. Plaintiff, a market-maker in convertible
securities, entered into an agreement with defendant Rite Aid Corporation,
to exchange Rite Aid Convertible Notes for Rite Aid common stock. Less
than two weeks later, Rite Aid launched a tender offer at a higher conversion
ratio. The court cited Lerro in finding that plaintiff’s agreement
did not occur during the tender offer period, but also noted, without explanation,
that Millionerrors, Epstein and Field were not inconsistent.35
Finally, in Walker v. Shield Acquisition Corp., 145 F. Supp. 2d 1360 (N.D.
Ga. 2001), the court dismissed plaintiff’s Rule 14d-10 claims based on
various “Retention and Transition Awards” paid to target executives following
a tender offer and back-end merger. These awards were promised before
the tender offer began, but the merger agreement conditioned their payment
upon the merger’s success. Plaintiff argued that the awards were
an “integral part” of the tender offer, but the court rejected plaintiff’s
argument, holding that because the awards had been promised before the
tender offer began, and the payments were made after the tender offer closed,
the Rule 14d-10 claim failed.
Although the bright-line approach
offers predictability, it may at times not reach far enough. Under
this approach, even improper payments could theoretically skirt Rule 14d-10,
so long as no money changes hands between the beginning and end of the
tender offer.
Conclusion
The SEC’s Division of Corporation Finance and the securities bar have
been discussing the interplay between post-merger employment agreements
with target management and tender offers, but whether the discussions will
result in proposed rulemaking is unclear. Absent clarification from
the SEC, it remains to be seen whether, given the Circuit split, the Supreme
Court will grant a writ of certiorari to resolve these issues.
1. 17 C.F.R. 240.14d-10.
2. Amendments to Tender Offer Rules
All-Holders and Best-Price, Securities Act Release No. 6653, 36 S.E.C.
Docket 96 (July 11, 1986).
3. 17 C.F.R. 240.14d-10.
4. See Section 14(d)(7). Consider
a target executive who tenders 10,000 shares for $50 each, and who receives
a $1 million bonus during the tender offer. If the bonus is found
to be “increased consideration,” that would amount to a $100 per share
premium – twice the tender offer price. This means that a $5 billion
tender offer could carry a $10 billion liability.
5. Gerber
v. Computer Assoc. Int’l, Inc., 812 F. Supp. 361, 363 (E.D.N.Y. 1993).
6. Plaintiff also alleged a violation
of Rule 10b-13, for which the court granted Computer Associates’ motion
to dismiss. Gerber, 812 F. Supp. at 368.
The SEC promulgated Rule 10b-13, which was later replaced by Rule 14e-5,
to further protect tendering shareholders from price discrimination in
tender offers. Generally, Rule 10b-13 prohibited side transactions involving
purchases of shares subject to a tender offer. See Field v. Trump,
850 F.2d 938, 943 (2d Cir. 1988).
7. Id. at 364.
8. Id. at 363.
9. Gerber, 1995 U.S. Dist. LEXIS 21142
(E.D.N.Y. Apr. 7, 1995).
10. Gerber, 2000 U.S. Dist. LEXIS 21726
(E.D.N.Y. March 14, 2000).
11. In April, 1993, plaintiff filed
an amended complaint alleging violations of Rule 14d-10 and Rule 10b-5.
The court granted Computer Associates’ motion for summary judgment on
the Rule 10b-5 claim. Gerber, 2000 U.S. Dist. LEXIS 21726 at *7.
12. See Gerber, 303 F.3d 127 at 131
(citing to district court trial transcript at 825).
13. Berdy
owned about 25% of the company’s outstanding shares, which helped cushion
much of the blow of the jury verdict. Once the $2.34 million – what
the jury found to be unlawful compensation – was divided among the number
of shares that Berdy tendered, the figure came out to an extra $1.46 per
share plus interest. This amounted to a total judgment for the class
of $5.67 million. Gerber, 2000 U.S. Dist. LEXIS 21727 at *7 (E.D.N.Y.
Nov. 7, 2000).
14. Id. at *4, *5.
15. Gerber, 303 F.3d at 135.
16. Id.
17. Id.
18. Id.
19. Field, 850 F.2d at 940-942.
20. Id. at 945.
21. Gerber, 303 F.3d at 136.
22. Id.
23. Id.
24. Id. at 137-138.
25. Rev’d on other grounds sub nom.
Matsushita Elec. Indus. v. Epstein, 516 U.S. 367 (1996) (holding that federal
court may not withhold full faith and credit from a state court judgment
approving a class action settlement simply because the settlement releases
claims within the exclusive jurisdiction of the federal courts).
26. Epstein, 50 F.3d at 654.
27. Id. at 655.
28. Id. at 656.
29. Id.
at 658-659.
30. Katt, 133 F. Supp. 2d at 645.
31. Millionerrors, 2000 U.S. Dist. LEXIS
4778 at *16.
32. Millionerrors, 2000 U.S. Dist. LEXIS
4778 at *14-15.
33. Lerro, 84 F.3d at 243.
34. Digital Island, 2002 U.S. Dist.
LEXIS 17906 at *36.
35. Susquehanna Capital, 2002 U.S. Dist.
LEXIS 18290 at *5.
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