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Good News for Dealmakers

By Robert S. Reder and Nicholas A. Venditto

One of the more difficult decisions that dealmakers and their legal advisors must face in the course of negotiating an M&A transaction involving public companies is whether, and if so when, public disclosure of those negotiations may be required under the federal securities laws. This is an issue faced not only by SEC-registered companies, but also by any of their significant stockholders who participate in discussions.

In Levie v. Sears Roebuck & Co., N.D. Ill., No. 04 C 7643 (N.D. Ill. Dec. 18, 2009), set against the backdrop of the 2005 merger between retail giants Sears and Kmart, the United States District Court for the Northern District of Illinois recently provided useful guidance for determining whether such disclosures are required to be made, both by the constituent corporations and by significant stockholders, under the federal securities laws.

Background of the Transaction

In February 2004, Sears Chief Executive Officer Alan J. Lacy began to explore the potential acquisition of his competitor, Kmart. To that end, Lacy engaged in discussions with Kmart's Chairman, Edward S. Lampert. Lampert, who also controlled ESL Partners, L.P., an entity owning more than five percent of Sears' stock, pointedly engaged in these discussions solely on behalf of Kmart, and not on behalf of ESL.

By April 2004, after a series of discussions, both sides agreed that Sears would not acquire Kmart. Instead, the parties pursued an "alternative transaction" involving Sears' acquisition of certain stand-alone Kmart stores. On June 30, 2004, the companies announced that Sears would purchase 54 Kmart stores.

On July 1, 2004, ESL filed a Schedule 13G with the Securities and Exchange Commission. The Schedule 13G disclosed ESL's ownership of Sears stock and, as required by that Schedule, certified that the shares of Sears stock held by ESL "were not acquired and are not held for the purpose of or with the effect of changing or influencing control" of Sears.

Several months passed during which no discussions took place between the two companies. Then, on October 31, 2004, Lacy and Lampert (again, solely in his capacity as Kmart's Chairman) met to discuss – for the first time – the possibility of Kmart's acquiring Sears. Over the next two weeks, the two companies retained financial and legal advisors and held internal discussions regarding possible strategic combinations.

On November 10th, the two companies entered into a confidentiality agreement that allowed Kmart to examine confidential information pertaining to Sears. An initial draft of a merger agreement was sent to Sears by Kmart on November 12th, and a second draft was re-circulated a day later. The second draft contained the first mention of an agreement pursuant to which ESL would vote its Sears shares in favor of a Kmart-Sears combination.

In the afternoon of November 15th, Lacy and Lampert reached a "handshake deal" to present to their respective boards of directors, who approved the merger the next day. The transaction was publicly announced on November 17th and ESL filed a Schedule 13D with the SEC disclosing its agreement to support the merger.

The Class Action Lawsuit

Various Sears stockholders filed a class action lawsuit, alleging violations by Sears of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The plaintiffs alleged that Sears and Kmart were engaged in merger negotiations from February 2004 until the merger was formally announced in November, and that this negotiation was a "material fact" that should have been disclosed in order to make certain statements made by Sears during the purported class period – from September 9th through November 16th – not misleading.

Sears countered that the merger negotiations did not begin until October 31st, well after the beginning of the class period, and further, that it was never under a duty to disclose the merger negotiations, even after they became material.

The plaintiffs also alleged that ESL violated Section 10(b) of the Exchange Act and Rule 10b-5 by failing to timely file a Schedule 13D disclosing that it "had formulated an intent to effect a change in control of Sears." The plaintiffs claimed that this filing should have been made prior to the commencement of the class period. ESL countered that its filing upon announcement of the transaction in November was sufficient. The Court granted defendants' motion for summary judgment on all counts.

The Court's Analysis: Claim Against Sears

Duty to Disclose. The court began its analysis by citing the landmark U.S. Supreme Court decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988), for the proposition that "there is no general duty to disclose merger negotiations even when material." According to Basic, "silence, absent a duty to disclose, is not misleading under Rule 10b-5."

Accordingly, the court explained that "plaintiffs' case is premised entirely on the omission to disclose the merger negotiations in order to make the statements made [by Sears] during the class period non-misleading."

The plaintiffs relied on five statements made by Sears as the bases for creating a duty on the part of Sears to disclose the merger negotiations under the Exchange Act. The court noted that three of these five statements were made before October 31, 2004, the date on which Sears and Kmart first discussed the possibility of Kmart acquiring Sears.

As such, the court held that "these statements could not create a duty to disclose something that had yet to occur." Implicit in this ruling was the court's rejection of the plaintiffs' contention that Kmart and Sears were engaged in continuous merger negotiations beginning in February 2004.

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