Increased Focus on Partial Tender Offers and Compliance with Rule 14e-4

In recent years, the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have closely scrutinized the way broker-dealers and hedge funds comply with Rule 14e-4 under the Securities Exchange Act of 1934 when tendering into partial tender offers and are establishing a pattern suggesting that large enforcement settlements may loom on the horizon.

Though fairly straightforward on its face, certain nuances and ambiguities in Rule 14e-4’s wording, compounded by the general lack of regulatory guidance in this area, can make compliance challenging for market participants. Market participants have largely been left to review and analyze recent enforcement actions to properly structure their compliance programs for tendering into partial tender offers. Incorrect compliance can be costly: Rule 14e-4 imposes strict liability, and recent enforcement actions have indicated that disgorgement for Rule 14e-4 violations is both punitive and not capped, which will result in substantial settlements. Below, we provide a brief summary of Rule 14e-4 and identify some common pitfalls to guard against.

What Is Rule 14e-4, and When Does it Apply?

The term “partial tender offer,” for purposes of Rule 14e-4, is defined to mean (i) a tender offer or request or invitation for tender for less than all of the outstanding securities subject to the offer in which tenders are accepted either by lot or on a pro rata basis on a specified period or (ii) a tender offer for all of the outstanding shares that offers a choice of consideration in which tenders for different forms of consideration may be accepted either by lot or on a pro rata basis for a specified period. Partial tender offers involve a risk to security holders of the subject company that not all of the securities tendered will be accepted (referred to as “proration risk”). Rule 14e-4 is generally designed to preclude persons from tendering more shares than they own in order to avoid or reduce the risk of pro rata acceptance in a partial tender offer. Rule 14e-4 states that a person may tender shares into a partial tender offer for his own account only if both at the time of the tender and at the end of the proration period the person has:

(1) a “net long position” in the subject security;¹ or 

(2) an equivalent security² equal to or greater than the amount tendered into the partial tender offer.

Rule 14e-4 was last amended in 1990,³ and for years thereafter there was limited regulatory scrutiny concerning compliance with the rule. Within the past few years, however, both FINRA (which enforces Rule 14e-4 against its member broker-dealers) and the SEC (which can enforce the rule more broadly, including against buy-side firms such as hedge funds) have shown an increased focus on compliance and brought a number of enforcement actions. Regulatory investigations typically may commence by both FINRA and the SEC sending out inquiry letters shortly after the subject partial tender offer expires.

Tendering for Your Own Accounts vs. Tendering for Customer Accounts

The requirements under Rule 14e-4 are bifurcated based on who is tendering the shares into the partial tender offer. Specifically, paragraph (b)(1) sets forth the requirement for persons who tender for their own account(s) (such as private funds and broker-dealers tendering for principal accounts), and paragraph (b)(2) sets forth the requirement for persons who tender for the account(s) of another person (such as a prime/clearing broker tendering on behalf of its customer’s account).

More specifically, Rule 14e-4 prohibits persons from directly or indirectly tendering securities into a partial tender offer for their own account unless, as of the time of tender and as of the end of the proration period or period during which securities are accepted by lot (including any extensions thereof),⁴ the person has a “net long position” equal to or greater than the amount of securities tendered in: 

• the “subject security,” and will deliver or cause to be delivered such security for the purpose of tender to the person making the offer within the period specified in the offer, or 
• an “equivalent security” and, upon the acceptance of his tender will acquire the subject security by conversion, exchange, or exercise of such equivalent security to the extent required by the terms of the offer and will deliver or cause to be delivered the subject security so acquired for the purpose of tender to the person making the offer within the period specified in the offer.

The rule also prohibits persons from directly or indirectly tendering into a partial tender offer for the account of another person unless the person making the tender (i) possesses the subject security or an equivalent security or (ii) has a reasonable belief that upon information furnished by the person on whose behalf the tender is made, such person owns the subject security or an equivalent security and will promptly deliver the subject security or such equivalent security for the purpose of tender to the person making the tender.

Tendering for Your Own Account

In accordance with Rule 14e-4(b)(1), each firm is only responsible for ensuring that the amount of shares tendered into a partial tender offer from its own firm accounts is no greater than the firm’s “net long position.”⁵ The requirement to calculate the net long position under Rule 14e-4(b)(1) generally applies to the legal entity for which the tender is made and any other entities that are deemed to be acting in concert. The rule requires the person tendering shares for its own account to perform the net long position calculation, as that person is in the best position to know its complete inventory of positions, on a real-time basis, in the subject security (or an equivalent security), at the time of tender and as of the end of the proration period.

Tendering for Customer Accounts

In contrast, a firm’s obligation with respect to tenders on behalf of a customer account is set forth in paragraph (b)(2) of the rule and requires that a firm either have possession of the subject security or an equivalent security or that the firm have a reasonable belief, based on information from the customer, that the customer owns the subject security or an equivalent security.

Application of Rule 14e-4 to “Persons”

Rule 14e-4 applies to any “person” who tenders into a partial tender offer. Generally, the term “person” refers to any legal entity or natural person and is not limited to registered broker-dealers or FINRA members. There is also no reference in Rule 14e-4 or related SEC guidance that allows the “net long position” calculation, under Rule 14e-4, to be performed by separate “aggregation units” within a broker-dealer, as is permitted under Regulation SHO. As a result, it is generally understood that all accounts of a single legal entity should be aggregated in order to comply with Rule 14e-4, even if those accounts have separate trading strategies or are separated by information barriers.

Persons “Acting in Concert”

In addition, Rule 14e-4 requires the tendering person to aggregate its accounts with the accounts of all other persons “acting in concert” with the tendering person. Rule 14e-4 does not define “acting in concert,” and we are not aware of any SEC guidance explicitly defining the term. Nevertheless, the general understanding is that accounts for which the same person can direct trading or book positions may be deemed to be “acting in concert” and should therefore be aggregated under Rule 14e-4 (even if such accounts are in different legal entities). However, if there are no overlapping traders, investment strategies, or information being shared among the different entities (such as affiliates), it should be defensible to treat the accounts of the separate entities as separate “persons” for purposes of the rule.

Challenges and Potential Pitfalls for Rule 14e-4 Compliance

Compliance with Rule 14e-4 can pose a number of challenges to persons tendering into partial tender offers. Complex partial tender offers (e.g., exchange offers where the consideration is not cash) and ambiguity in the guidance around the rule can further exacerbate the difficulty in discerning how regulators will approach this area.

Beware Short Call Options

To prevent hedged tendering and over-tendering, Rule 14e-4 requires the short-position calculation in a partial tender offer to include the amount of subject securities that the person is obligated to deliver upon exercise of a standardized in-the-money call option sold on or after the date that a tender offer is first publicly announced or otherwise made known by the bidder to the holders of the security to be acquired. For purposes of Rule 14e-4, in-the-money call options are those options with strike prices below the highest tender offer price or stated amount of consideration offered for the subject security (i.e., which is different than the market price of the subject security). In addition, this determination can become quite tricky in situations where, for example, the highest tender offer price is not known until after the expiration of the tender offer. For example, in a typical Dutch auction partial tender offer, shareholders are given a range of prices at which they may tender, but the firm making the tender offer can decide, after the tender expiration and based on submitted tenders, to accept only tenders at or below a certain price within the range. In our experience, regulators have focused on firms’ standardized in-the-money call options to identify violations of Rule 14e-4, particularly in connection with Dutch auction partial tender offers. Moreover, different from standardized options, the number of shares underlying short over-the-counter (OTC) call options need to be included as short positions (i) even if the OTC option was written before announcement of the partial tender offer and (ii) regardless of strike price.

Acting in Concert

The SEC and FINRA have provided minimal guidance regarding when two persons are deemed to be “acting in concert” for purposes of determining the net position that may be tendered. This has required firms to assess, typically with the assistance of outside counsel, whether two persons are sufficiently intertwined that a regulator could conclude they may be deemed to be acting in concert. In such circumstances, it is prudent to make sure that both the tendering person and the combination of the tendering person and any person acting in concert have a “net long position” equal to or in excess of the amount tendered.

Broker-Dealer’s Monitoring Customer Information

For trading activity where a broker-dealer’s client executes transactions away from the tendering broker — which is common practice for institutional clients of prime/clearing brokers — the tendering broker may not be aware of these client transactions until after the tender offer deadline, particularly if the client’s trades occur on the same date as the tender offer deadline. For example, Rule 14e-4 allows a person to have a “long position” with respect to shares that it has purchased but not yet received. As a result, a client is permitted to tender the amount of securities it has purchased on the date of the tender offer deadline, even when such purchase is executed through an executing broker other than the tendering broker and has not yet settled. Conversely, if the client sells shares on the date of the tender offer deadline through another executing broker, the client would need to consider the pending sale as a “short position” for purposes of Rule 14e-4. Under these circumstances, only the client — not the prime/clearing broker — could be expected to have complete information of the customer’s net position in the tendered security at any point in time, including at the tender offer deadline.

Further, multiple clients of the broker-dealer could instruct the firm to tender shares on their behalf in partial tender offers, and such instructions may not identify whether any such clients are acting “in concert” and thus must aggregate their accounts. Again, under such circumstances, only the clients — not the broker-dealer firm — could reasonably be expected to have complete information about who is acting “in concert” for purposes of Rule 14e-4.

What This Means to You

The series of regulatory actions involving Rule 14e-4 in recent years indicates that this is an area of ongoing focus for both the SEC and FINRA, and penalties and disgorgement for noncompliance can be severe. Both persons who tender for their own account (including hedge funds and broker-dealers) and clearing firms that may tender both for firm accounts and on behalf of customers should be prepared for regulatory scrutiny concerning partial tender offers. Assistance from legal counsel who are leaders in this area, such as the undersigned Sidley attorneys, can be essential to successfully navigating the complexities of Rule 14e-4 and avoiding missteps.

¹ The term “subject security” means the security that is the subject of any tender offer or request for invitation of tenders.
² The term “equivalent security” means (i) any security (including any option, warrant, or other right to purchase the subject security), issued by the person whose securities are the subject of the offer, that is immediately convertible into, or exchangeable or exercisable for, a subject security or (ii) any other right or option (other than a standardized call option) that entitles the holder thereof to acquire a subject security, but only if the holder thereof reasonably believes that the maker or writer of the right or option has title to and possession of the subject security and upon exercise will promptly deliver the subject security.
³ Securities Exchange Release No. 28660 (Nov. 30, 1990), 55 FR 50316 (Dec. 6, 1990).
⁴ The “end of the proration period or period during which securities are accepted by lot (including any extensions thereof)” refers to the period of time during which the tender offer remains open and acceptance of tendered securities is made on a pro rata basis or by lot, including any extensions thereof, whether or not such period is required by any statute or rule (e.g., regardless of the application of Section 14(d)(6) of the Exchange Act, or Rule 14d-8 thereunder, to the offer). See Exchange Act Release Nos. 28660 at n.39 (November 30, 1990) and 26609 at n.32 (March 8, 1989).
⁵ Rule 14e-4(a)(1) defines “net long position” as “the excess, if any, of such person’s ‘long position’ over such person’s ‘short position.’”