Currently, most public company M&A deals are structured as a 'one-step merger' of the target company with the buyer or a shell subsidiary of the buyer. Shareholders must vote to approve these deals, which require the target company to solicit proxies using an SEC-cleared proxy statement. If the requisite shareholder approval is obtained, all the shareholders of the company receive the agreed-upon merger consideration when the merger closes, subject to statutory appraisal rights. The whole process typically takes three to four months.
'Two-step mergers' can have advantages over 'one-step mergers,' especially because they can often be completed more quickly. After the buyer and target negotiate their deal, the first step in a two-step merger is a cash tender offer (or an exchange offer, if the buyer is using its securities as some or all of the merger consideration). The buyer then publicly announces its offer to acquire target securities, subject to specified conditions. Target security holders can accept the offer by tendering their securities to the buyer. As part of this first-step, the buyer will routinely require that at least the minimum amount of voting securities be tendered to give the buyer voting control of the target. This makes the second step - a squeeze-out merger of the remaining target company shareholders - a fait accompli as the buyer already has voting control after the first step.
The SEC's tender offer rules require that the first-step offer be open for 20 business days. The Hart-Scott-Rodino Act, which applies to most public company M&A deals, requires notice and a waiting period of up to 30 days. Thus, two-step mergers can be closed in as little as a month if no other regulatory approvals are required.
By closing a deal in as little as a month, rather than the three to four months required for a one-step merger, all the principal constituencies to an M&A deal can benefit:
• Tendering shareholders get their merger consideration faster, rather than having to wait until the close of a one-step merger. Even the remaining minority shareholders who fail to tender get their merger consideration more quickly.
• There's a smaller window for adverse developments to upset the deal. Buyers fear competing offers; sellers fear 'material adverse changes.' Neither buyers nor sellers benefit from uncertainty.
• The buyer can assert control over the target company more quickly, an important factor in gaining the benefits of its deal.
SEC filings for a two-step merger are less voluminous, as the required SEC disclosures are focused more on the deal rather than on details about the buyer and target. Legal and out-of-pocket costs are typically less for two-step mergers.
So why have few M&A deals been done as two-step mergers?
The threat of class action lawsuits based on the SEC's 'Best Price Rule' is said to be the primary reason for why comparatively few deals are done as two-step mergers. The SEC has recently adopted rule changes, which should reduce and possibly eliminate this litigation risk. These rules become effective on December 8.
The Best Price Rule - which is Exchange Act Rule 14d-10 for third-party tender offers, and Exchange Act Rule 13e-4(f)(8)(ii) for issuer tender offers - was adopted by the SEC in 1986 to prevent perceived abuses from disparate financial treatment of tendering shareholders. The Best Price Rule requires bidders to pay any security holder the highest consideration paid to any other security holder in the tender offer.
More accurately, the rule used to say:
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 . (Emphasis added.)
Several shareholder class actions have been brought under the Best Price Rule, claiming that amounts paid (by the bidder or by the target) to target executives under employment arrangements, or to other related parties in contemporaneous transactions, actually constituted additional payments for target company shares. Plaintiffs claimed that, in effect, the target executives or related parties were getting paid more for their shares than the public shareholders - violating the Best Price Rule.Thus, plaintiffs argued, all of the target company's public shareholders were entitled to the same aggregate per share payout. Suits made claims for substantial damages, sometimes a multiple of the deal's total value. These claims had substantial settlement value, if they survived early dismissal.
Courts have split over whether to extend application of the Best Price Rule to contemporaneous transactions, including changes to employment arrangements. The 'bright line test' adopted by some courts often led to early dismissal of claims. The 'integral part test' adopted by other courts often led to actions surviving, with later cash settlement.
The litigation risk over this uncertainty has been a disincentive to use of two-step mergers. Most of the deals that were targets of the class action lawsuits (maybe all) could have been structured as one-step mergers and avoided the issue entirely.
The SEC amended the Best Price Rule to address this. The 'basic standard' of the rule will now say:
No bidder shall make a tender offer unless: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 . (Emphasis added.)
The SEC also made additional changes to exempt employment compensation, severance or other employee benefit arrangements, subject to conditions about the nature of the payments. The SEC added a safe harbor to deem these conditions satisfied if the compensatory arrangements are approved by the compensation committee of the target (or the compensation committee of the bidder).
The SEC believes that the changes it made will remove undue litigation risk associated with use of two-step mergers and remove any regulatory disincentive to use of two-step mergers.
Will the recent SEC changes lead to more two-step mergers?
Law firms expect so, based on recent law firm client advisories. The SEC professes to be neutral on one-step versus two-step, but clearly expects its rule change to lead to more two-step mergers.
Cash tender offers are the easy case and present a compelling alternative to a one-step cash merger.
Exchange offers, using stock for some or all of the consideration, are also a compelling alternative to stock and part-stock one-step mergers. The SEC now permits exchange offers to commence on the day of filing of the initial registration statement. Prior practice required that the registration statement be first declared effective, which took weeks and vitiated any timing advantage to the two-step structure. The SEC has said that it will review such early commencement filings within a 20-business day timeframe, so that exchange offers can be executed on a similar timeline to all-cash tender offers.
Two-step mergers aren't always preferable. If a deal faces a lengthy regulatory approval process, the timing advantage to a two-step merger can disappear. When a deal has a long gestation, the buyer can prefer having a timing advantage over competing bidders from having its proxy statement already being on file with the SEC and a shareholder meeting date set.
Buyers who need to borrow to finance their deals will need to comply with the Federal Reserve Board's margin rules. This can present challenges to some buyers - including private equity funds - but can be addressed through structuring techniques.
How do two-step mergers work?
The principal agreement in a two-step merger is a negotiated merger agreement, just as in a one-step merger, but with different provisions to reflect the two-step process. The buyer must file a Schedule TO and exhibits with the SEC and make updating amendments. One of the filed exhibits is the 'Offer to Purchase,' which includes the conditions to the buyer's offer and specified disclosures about the deal. Another is the familiar tombstone ad announcing the tender offer. The target company must file a Schedule 14D-9 (to disclose its position on the offer) and make updating amendments. Unlike the case of a hostile offer, in its Schedule 14D-9 management of the target company will recommend that shareholders accept the buyer's offer. Disclosure items for Schedules TO and 14D-9 are set forth in the SEC's Regulation M-A, a special subset of Regulation S-K.
Unlike a one-step merger, the target company doesn't need to solicit proxies for shareholder approval of the deal. This avoids the need to hold a shareholders' meeting and to file a proxy statement with the SEC, and the ensuing delay.
Buyers will often want to acquire more than 90% of the target company's voting stock in the first-step tender offer, not just the minimum for voting control. This enables the buyer to complete the second step as a short-form merger under many state statutes including Delaware's. Many deals include a 'top-up option' whereby the target company can issue more stock to the buyer to clear the 90% threshold.
Published December 1, 2006.