Summary:
The Delaware Chancery Court has issued an opinion addressing the validity of cancelling compensatory stock options in merger transactions. The Court holds that, in a 2004 merger transaction, a target and acquiror improperly cancelled options for their "intrinsic value" (i.e., the excess of the per share price in the transaction over the exercise price of the option), and the Court instead applied a Black-Scholes valuation to the cancelled options. The opinion provides helpful guidance to parties to merger transactions and their advisors in dealing with this often-troublesome issue.
A recent decision from the Delaware Chancery Court, Lillis v. AT&T Corp., No. 717-N (Del. Ch. July 20, 2007) (Lamb, V.C.), provides helpful guidance on the often troublesome issue of the right of acquirors to cash out and cancel compensatory stock options in cash merger transactions.
In 2004, Cingular Wireless LLC ("Cingular") acquired AT&T Wireless Services, Inc. ("Wireless") in a cash merger transaction. In the merger, in-the-money options were cashed out, and the holders of these options received an amount equal to the difference between the exercise price of the option and the per share price paid to shareholders in the merger (usually called the "spread"). A substantial majority of the Wireless stock options had a strike price higher than the per share price at which Cingular agreed to purchase Wireless (that is, these options were "out of the money" or "underwater"), and Cingular and Wireless agreed in the merger documentation that all underwater Wireless stock options would be cancelled without consideration and without option holder consent. At the time, Cingular was a privately held joint venture of SBC Corporation ("SBC") and BellSouth Corporation ("BellSouth") and did not provide Cingular stock options to its employees. Wireless had previously been split off from AT&T Corporation ("AT&T") in 2001. In 2000, prior to the split-off, AT&T had acquired MediaOne Group, Inc. ("MediaOne") and had rolled over the outstanding MediaOne stock options issued under MediaOne’s 1994 stock option plan (the "1994 Plan") into AT&T stock options and agreed that these options would continue to be governed by the terms of the 1994 Plan; these former MediaOne options were a portion of the AT&T stock options converted into Wireless stock options that were cancelled in the Cingular/Wireless merger.
After Cingular’s acquisition of Wireless, former officers and directors of MediaOne sued AT&T and Wireless and claimed that Wireless’s agreement with Cingular to cancel their Wireless stock options breached the terms of the 1994 Plan. Their argument relied on the adjustment provision in the 1994 Plan. The adjustment provision required (as is customary) "appropriate" adjustments of outstanding options in merger and other transactions, except that the adjustment provision also required, in connection with adjustments, that "each Participant’s economic position with respect to the Award shall not, as a result of such adjustment, be worse than it had been immediately prior to such event."
The issue for the Chancery Court was whether the cashout in the Cingular transaction of both in-the-money and out-of-the-money options at their "intrinsic value" (that is, the spread between the exercise price and the per share price paid in the transaction, which ascribed no value to the underwater options), made "worse" the "economic position" of the former MediaOne officers and directors because the intrinsic value of their options was less than the value of their options on a Black-Scholes basis (which would ascribe value even to underwater options). The Court determined that "economic position" was ambiguous but was not in any event synonymous with intrinsic value. (In fact, the Court found that the term "economic position" had neither precedent nor customary or trade meaning.) Finding the term ambiguous, the Court instead relied on extrinsic evidence to find for the plaintiffs in the action.
Notwithstanding that it is still subject to appeal to the Delaware Supreme Court, the Lillis decision is fundamentally good news for acquirors in cash transactions that cancel underwater options without consideration. The Court twice stated the "general rule" that option plans should be read to permit such cancellations. In the Court’s view, because "the value of a derivative instrument, such as a stock option, is tied to the value of the security into which it is exercisable", the value of the instrument in a cash transaction "will ordinarily also be measured by reference to that same amount of cash" paid to shareholders. It should be noted that the MediaOne options were a small fraction of the underwater Wireless options outstanding at the time of the Cingular acquisition, and the Court’s opinion takes pains to make clear that its conclusion is based on the additional 1994 Plan provision quoted above rather than the customary adjustment language. Indeed, the Court credits a prior decision by an arbitration panel consisting of federal judges applying the general rule of cancellation to all other underwater Wireless options (although that panel’s decision was not before the Court and did not form any part of the Court’s holding).
The departure from the "general rule" by the Chancery Court in the Lillis decision is best understood in light of the particular facts presented by the MediaOne options, as reflected in the Court’s discussion:
- The Court noted that the survival of the MediaOne options was a hotly negotiated point in the acquisition of MediaOne by AT&T in 2000. Presumably, in exchange for the survival of the MediaOne options, AT&T negotiated other concessions from MediaOne. The AT&T-MediaOne merger agreement and employee communications explicitly provided for the survival of the MediaOne options and the continued application of the then-current provisions of the 1994 Plan. In this context, it is not surprising that the Court construed the ambiguous adjustment provision quoted above against cancellation of the options. The Court also relied on statements by the plaintiffs at trial that the MediaOne options had constituted a significant component of their compensation.
- AT&T fully conceded to the plaintiffs and to the Court that the plaintiffs’ position was the correct one. This concession by AT&T was self-serving because it had commenced an arbitration at the time seeking a much larger figure, $200 million, from Wireless for the cancellation of the Wireless options in the Cingular transaction under the split-off agreements between AT&T and Wireless. (The Court noted that the arbitration panel ultimately "entirely reject[ed]" AT&T’s claim.) After AT&T had agreed to be acquired by SBC, it withdrew these concessions, but it is, again, not surprising that the Court continued to credit AT&T’s prior "wholehearted[] agree[ment]" with the plaintiffs’ interpretation of the adjustment provision.
- The Court noted in a number of places that the Wireless options held by Wireless’s board of directors were cashed out at their Black-Scholes value.
Some of these facts are undoubtedly unusual, but others could present themselves in other cash transactions, and acquirors should be looking for them in the due diligence process. In particular, it is a key conclusion of the Chancery Court that the MediaOne options retained the rights in place when granted during all of the subsequent transformative events (i.e., the acquisition of MediaOne by AT&T, the split-off of Wireless from AT&T and the acquisition of Wireless by Cingular). Accordingly, when performing diligence on targets that have themselves been acquirors, it is vital to diligence the option plans of the target’s acquisitions, the transaction documentation and any participant communications. Statements by a target that these options have been "assumed into" a favorable target equity plan should not be relied on, and, instead, all relevant underlying documentation should be the subject of review and analysis. In the acquisition of an entity that itself has been a serial acquiror, different groups of employees may have different rights with respect to their options, and the rights of current employees may differ from the rights of former employees. Sellers should also evaluate the risk of litigation over option issues when negotiating merger agreement provisions and should, whenever possible, carve option litigation out of "material adverse effect" or other conditions to an acquiror’s obligation to close the transaction.
The Lillis decision is also a reminder that the parties to split-off and spinoff transactions should focus on the indemnities relating to the equity compensation in the spinoff documentation. The Court concluded that AT&T (which originally acquired MediaOne, in contrast to Cingular, which subsequently purchased Wireless) remained liable for its agreement with MediaOne regarding the MediaOne options notwithstanding that Wireless (and with it the MediaOne options) had been split off from AT&T prior to Cingular’s acquisition of Wireless. That conclusion has become less important (since SBC now owns all the parties to the transaction), but, if AT&T had continued to be a stand-alone company, it would have been liable for Wireless’s agreement to the cancellation of the MediaOne options notwithstanding that it had no control over, or participation in, Wireless’s agreement to cancel the options.
The Lillis decision is also the first to provide a detailed analysis of the application of the Black-Scholes methodology to the cancellation of compensatory stock options, and acquirors who are considering the cancellation of options using the Black-Scholes methodology should review the helpful and detailed analysis of the Chancery Court in connection with their own analysis. Interestingly, the Court applied the Black-Scholes valuation to options that were in the money as well as to options that were out of the money. For transactions in which a Black-Scholes value rather than an intrinsic value is applied to underwater options, acquirors should consider whether in-the-money options should also be valued on that basis (which could result in an option that is only slightly in the money having a higher value on a Black-Scholes basis than its intrinsic value). Conceivably, using the Black-Scholes methodology could lead to the unexpected result of option holders receiving more value per share in a transaction than shareholders. The Court’s application of the Black-Scholes methodology should in any event support arguments in future litigation that the appropriate remedy for an invalid cancellation of stock options is money damages, rather than the issuance of stock of the surviving corporation or injunctive relief with respect to the transaction.
As noted by the Court, option plans and agreements "are no more or less than contracts that must be construed in accordance with the normal rules of contract interpretation." Accordingly, the safest course (and also the most typical) for those who draft equity compensation arrangements is to include provisions that permit issuer stock options to be treated in a merger transaction in the manner agreed to by the issuer’s board of directors or compensation committee as set forth in the merger documentation. Strong adjustment language—that is, requiring adjustments or substitutions that the administrator of the stock option plan determines, in its sole discretion, to be equitable or appropriate (which the Court notes was the language used in the Wireless option plans other than the MediaOne plan)—may accomplish the same result. It would be preferable for the plan to specifically permit either (1) the cashout of an option’s "intrinsic value" (i.e., the spread) or (2) the cancellation of all unexercised options for no consideration at the closing of the transaction so long as the holders have been given a reasonable period, prior to closing, to exercise the options (even if not previously exercisable). Alternatively, the plan could specifically state that, in the case of a corporate transaction, option holders will receive the same consideration as other shareholders, less the applicable exercise price.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.