Publications

---

In granting the defendants’ motions for summary judgment and class decertification in the case of Levie v. Sears Roebuck & Co., et al¹, the district court in the Northern District of Illinois confirmed that Rule 10b-5 does not require parties to disclose the existence of merger negotiations, even if material, absent an affirmative duty to disclose.

Beginning in February 2004 and extending through the announcement of the acquisition of defendant Sears by Kmart on November 17, 2004, defendants Alan J. Lacy, the CEO, president and chairman of Sears, and Edward S. Lampert, chairman of Kmart, engaged in discussions surrounding various potential strategic transactions involving the two companies. Lampert was explicit with Lacy during these discussions that he was acting in his capacity as chairman of Kmart and not as the controlling person of ESL Partners, L.P., which then owned more than 5 percent of Sears.

The discussions from February to September 1, 2004 evolved from preliminary talks regarding a potential acquisition by Sears to the announced acquisition by Sears of 54 individual Kmart stores. The parties did not engage in discussions between September 1 and October 31, 2004.

In late October, Vornado Realty Trust told Kmart’s Lampert that Vornado had accumulated shares of Sears, and Lampert communicated this information to Lacy without identifying Vornado. On October 31, Lacy and Lampert began discussing a possible business combination, with Kmart as the surviving company. These discussions accelerated following the public announcement on November 5th by Vornado of a 4.3 percent position in Sears. The discussions thereafter proceeded as follows.

November 1–5: Senior management of Sears and Kmart hold internal discussions and engage advisors

November 8–9: Lampert and Lacy update their respective boards of directors on the discussions, providing information on price and a potential mix of consideration of stock and cash

November 10: The parties enter into a confidentiality agreement

November 12: The parties begin exchanging drafts of an acquisition agreement

November 13–14: The parties continue negotiations and conduct due diligence with their advisors, and a reference to a support agreement involving ESL is included in the draft merger agreement

November 15: Sears’ financial advisor predicts in an email a 50-50 probability of a deal, and Lacy and Lampert reach a handshake agreement on terms to present to the respective boards

November 16: The boards of Kmart and Sears approve the deal

November 17: The deal is announced

Plaintiffs alleged that Sears and Lacy (the Sears defendants) violated Rule 10b-5 when they failed to disclose the existence of the merger negotiations. In their motion to dismiss, the Sears defendants relied on Seventh Circuit precedent that “merger negotiations do not become ‘material’ until the price and structure of the deal” are agreed upon. Citing language from its denial of the Sears’ defendants’ motion to dismiss, the court rejected this standard, instead holding that, under Basic, Inc. v. Levinson², “the materiality of merger negotiations ‘depends upon the probability that the transaction will be consummated and its significance to the issuer of the securities. This determination is fact-specific and must be made on a case by case basis . . . .” With the undisputed facts now before it at summary judgment, the court applied this fact-specific materiality standard discussed below, ultimately finding the Sears defendants did not violate Rule 10b-5.

The court agreed with the Sears defendants that under the standard set forth in Basic the defendants were under no obligation to disclose the merger negotiations, whether or not material, absent another affirmative duty to disclose. This left the plaintiffs with the burden of proving that the Sears defendants violated Rule 10b-5 by not disclosing the merger negotiations in public statements made by the defendants throughout the extended period of the discussions.

The court rejected the allegations that any statement made prior to October 31 violated Rule 10b-5 because the merger negotiations surrounding Kmart’s acquisition of Sears had yet to occur.

The court also rejected the allegation that the following statement made by Sears on November 5 in response to Vornado’s announcement was misleading by its omission of any mention of the on-going merger negotiations:

“We are pleased that Vornado sees value in our stock. We are taking strong, concerted actions to improve our full-line store performance, continuing to expand our direct-to-customer channels and building our home services business, while simultaneously pursuing an aggressive off-mall growth strategy.”

First, the court found that there was nothing inaccurate about the statement because it did not refer to merger negotiations, nor did it imply that Sears was not involved in such negotiations or conflict with the “notion of a potential merger.” This ruling alone could have been dispositive in regard to the Vornado statement, but the court continued its analysis.

Thus, in addition to finding that Sears’ Vornado statement was not inaccurate, the court determined that at this date the merger negotiations had not yet become material. The court noted that, at this point, “none of the factual or legal predicates for a merger were in place.” There had been no agreement on a transaction structure or on the mix of consideration, and negotiations were so preliminary that Sears had not delivered any confidential information to Kmart, the parties had not conducted any due diligence, no board resolutions had been adopted, no actual negotiations had taken place and no instructions to investment bankers to explore a merger had been given. Thus, the omission of the negotiations in the statement did not render the statement misleading in light of the circumstances under which it was made.

The court further held that Sears’ limited statements regarding its need for liquidity in its Form 10-Q, filed on November 9, did not violate Rule 10b-5. Sears’ liquidity was not relevant to the consummation of the merger, the court reasoned, and SEC regulations do not require disclosure of merger negotiations if disclosure would jeopardize the transaction.

Plaintiffs also alleged that defendants Lampert and ESL Partners violated Rule 10b-5 by failing to timely amend ESL Partners’ previously filed Schedule 13G with a Schedule 13D, which must be filed within ten days by a 5 percent or greater owner whose purpose is to influence a change in control. The court found that because the negotiations shifted from a Sears acquisition of Kmart to Kmart’s acquisition of Sears, the earliest possible date for disclosure on Schedule 13D would have been November 10, ten days after the start of the negotiations regarding Kmart’s acquisition of Sears. The court determined that Lampert’s activities prior to the negotiations surrounding Kmart’s acquisition of Sears were in his capacity as chairman of Kmart, not in his ESL Partners capacity, and that the first evidence of the involvement of ESL Partners in the transaction was a reference to the partnership in the draft merger agreement on November 13. As a result, the court held that ESL Partners had filed within the requisite 10-day period.

Practical Impact of Levie

The decision in Levie is notable in three respects. First, Levie reaffirms that Rule 10b-5 does not create a general duty to disclose ongoing merger negotiations, even if material, absent an affirmative duty to disclose.

Second, Levie provides some useful guidance on the existence or non-existence of an affirmative duty to disclose. Levie confirms that companies may rely on the SEC’s view that undisclosed preliminary merger negotiations need not be discussed in the management discussion and analysis section of a periodic report filed under the Exchange Act, if disclosure is not otherwise required and if premature disclosure would jeopardize completion of the transaction. Levie also indicates that an affirmative duty to disclose pending merger negotiations, even if material, does not arise from other public statement unless the merger negotiations “relate directly to or [are] sufficiently linked to the express statements made” so as to render those statements inaccurate or misleading if the merger negotiations are not disclosed. Under this standard, unrelated, accurate and not misleading comments about the company’s ongoing business generally should be permitted, even if ongoing merger negotiations have become material.

Finally, Levie reaffirms the probability-based “facts and circumstances” analysis applied in Basic and rejects a bright-line “price and structure” standard. The court found that the probability and magnitude standard of Basic must be determined not by a bright-line test of whether the price and structure of the transaction have been agreed upon, but on a case-by-case, fact-specific basis, in which an agreement on price and structure are contributing, but non-determinative, elements.

Applying the fact-specific standard of Basic, the Levie court found the discussions were not yet material because the statements were made at an early date, before agreement on a price or on a mix of consideration, when the target had not yet provided confidential information and the parties had not yet undertaken due diligence or actual negotiations, given instructions to investment bankers to explore a merger, or adopted board resolutions. As the court emphasized, the transaction in Levie was at an early stage at the time of the statements.

Most fact patterns confronting M&A practitioners will not be quite as clear cut as the facts in Levie, and, as a result, the Levie decision may be of limited value as a guide to materiality analysis. In many cases, disclosure and materiality issues will arise after a company has engaged bankers or counsel, provided confidential information, or engaged in some diligence or negotiations. Nothing in the Levie decision indicates that a transaction would necessarily be material at this stage, and practitioners will continue to apply the probability-based, fact-specific analysis mandated by Basic.