Going Private: Rule 13e-3 and the Acquisition of Public Companies - Part 1
When a private equity fund buys substantially all of a public company’s outstanding shares in a cash offering, the acquisition may be described colloquially as “taking the company private.” From the perspective of the Securities Exchange Commission, however, the term “going private” applies specifically to situations where either the issuer of an equity security or one of its affiliates purchases the shares. When this occurs, Rule 13e-3 under the Securities Exchange Act of 1934 requires the issuer and any of its affiliates participating in the transaction to file detailed disclosures on Schedule 13E-3. At first blush, it would appear that the buyout of a public company by an unaffiliated private equity firm wouldn’t implicate Rule 13e-3. Nevertheless, as we’ll explain in Part 2 of this post, the structure of leveraged buyouts by private equity firms often triggers the additional disclosure obligations mandated by the Rule.
More often than not, private equity buyers seek to retain a public company’s executive officers to manage the company’s business operations after the transaction has closed. Private equity firms typically offer these managers so-called “sweet equity,” or shares in the new holding company that will own the public company’s business operations post-closing, as an enticement for them to remain. Owing to the way in which Rule 13e-3 defines the term “affiliate,” the issuance of equity interests to these executives frequently requires both them and the private equity fund to comply with Rule 13e-3. In today’s post, we’ll review the general requirements of Rule 13e-3. In Part 2, we’ll examine how the Rule applies to private equity buyouts where a public company’s existing managers stay on to run the business after closing.
“Going Private” Transactions
The SEC adopted Rule 13e-3 over concerns that a “going private” transaction conducted by an issuer or its affiliates may be designed to favor its own interests rather than those of unaffiliated shareholders. When a public company launches a tender offer to purchase substantially all of its own outstanding equity securities, it plays a unique role. Unlike third-party buyers who must conduct arm’s-length negotiations over the terms and conditions of an acquisition, an issuer may abuse its insider position to dictate terms – including the proposed purchase price – unilaterally.
Going private transactions tendered by an issuer or its affiliates present complex agency problems. Directors and managers of a company charged with representing the interests of a company’s shareholders may instead promote the interests of the entity acquiring the securities. The directors, for example, could choose to launch the tender offer during a period of depressed market prices, resulting in a loss to unaffiliated selling shareholders. In addition, directors and officers of the company could use coercive practices in order to secure shareholder votes approving the transaction. To protect shareholders from manipulative tactics, the SEC requires issuers and its affiliates to provide investors with extensive information about the transaction.
In order for a transaction to be considered “going private,” Rule 13e-3 demands that it meet three criteria. Specifically, it must:
- be a transaction or series of transactions resulting in the purchase of a security by the issuer or one of its affiliates, that
- has either a reasonable likelihood or the purpose of producing, either directly or indirectly,
- the effect of causing a class of equity securities of an issuer subject to Section 12(g) or Section 15(d) of the Exchange Act (a) to be held by fewer than 300 persons or (b) to be delisted or no longer authorized to be quoted on an inter-dealer quotation system of a registered national securities association (such as NASDAQ).
Rule 13e-3’s Definition of “Affiliate” and “Control”
In the context of buyouts of public companies by private equity funds, the determination of whether or not Rule 13e-3 applies turns on whether an affiliate of the issuer (that is, the public company that is the target of the acquisition) is considered to be a buyer of the target’s equity securities. Rule 13e-3 defines an affiliate of an issuer as “a person that directly or indirectly through one or more intermediaries controls, is controlled by, or is under common control of such issuer.” Although Rule 13e-3 does not specify what constitutes “control,” Rule 12b-2 of the Exchange Act, which applies generally to rules under the Exchange Act, defines “control” as “the possession, direct or indirect, or power to direct or cause the direction of the management and policies of a person, whether through ownership of voting securities, by contract or otherwise.”
This broad definition of control creates an unsettling degree of uncertainty as to who or what may be considered an “affiliate” of an issuer in a transaction involving the acquisition of a public company’s shares. In some situations, the SEC may decide that a person indeed exercises such control where he has the power to influence a company’s management and policies, even if the person holds a low percentage of the company’s voting securities.
Schedule 13E-3
Rule 13e-3’s filing and disclosure requirements apply to both the issuer and any of its affiliates engaged in the “going private” transaction. According to the SEC, the rule is designed to ensure that all holders of the class of securities subject to the transaction receive information regarding the issuer and each of its affiliates engaged in the transaction. To that end, Schedule 13E-3 requires a discussion of the purposes of the transaction, any alternatives that the company considered, and whether the transaction is fair to all shareholders. The Schedule also must inform investors whether and why any of its directors disagreed with the transaction or abstained from voting on the deal. Moreover, Schedule 13E-3 must indicate whether a majority of directors who are not company employees approved the transaction.
In Part 2 of this post, we’ll analyze the application of Rule 13e-3 in buyouts by private equity funds in which managers of the public company are offered “sweet equity” in the new holding company.
Related Post: Going Private: Rule 13e-3 and Private Equity Buyouts - Part 2
