August 15, 2007
On July 20, the Delaware Chancery Court issued an important decision awarding damages to holders of "out-of-the-money" stock options that were cancelled in connection with a corporate merger. Interpreting the language of the underlying option plan, the court in Lillis v. AT&T Corp. held that the option cashout provided for in the merger agreement violated the terms of the plan. The case highlights the need for parties to corporate transactions to carefully review stock option plan provisions regarding the treatment of options and to treat optionees consistently with plan terms.
It is common in corporate transactions, especially all-cash mergers, to "cash out" all outstanding stock options. The consideration paid for each share subject to an option generally is the value of the per-share merger consideration minus the option exercise price. Under this "intrinsic value" approach, options that are out of the money typically are cancelled without any payment. Although many stock option plans do expressly allow such treatment, some plans are ambiguous in this regard, while others may explicitly require different treatment. If the parties to the transaction do not treat the options consistently with plan terms, affected optionees may, as in Lillis, bring suit post-transaction to recover what the plan provides.
The Lillis case arose in connection with Cingular’s acquisition of AT&T in 2004. The plan at issue was a stock option plan maintained by MediaOne Group, Inc., which was acquired by AT&T in 2000. In connection with the earlier acquisition, AT&T assumed the MediaOne options and converted them to options to purchase AT&T shares. These options otherwise remained subject to the terms of MediaOne’s 1994 option plan. The provision in the plan that was at issue in Lillis provided that, in the event of a merger, options granted under the plan "shall be appropriately adjusted . . . provided 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." Despite this provision, holders of MediaOne options that were "in the money" based on the Cingular-AT&T transaction price received only the "spread" on the options, and out-of-the-money options were cancelled without consideration.
The plaintiffs argued that the plan language prohibited Cingular from cashing out their options granted under the 1994 plan in this manner. The Delaware court agreed, and its opinion includes the following important conclusions:
Whether options can be cancelled in connection with a corporate transaction depends on the terms of the contract (i.e., the underlying plan and grant agreements): "option agreements like the 1994 Plan and the related option grant agreements are no more or less than contracts that must be construed in accordance with normal rules of contract interpretation."
If plan terms are ambiguous, the court will examine extrinsic evidence to determine the parties’ intent.
While acknowledging that most option plans "permit the adjustment of options into the right to receive the difference between the merger consideration and the exercise price of the options," that was not the case in Lillis. Rather, the court determined that the language quoted above was a mandatory adjustment provision.
The court determined that the term "economic position" in the 1994 plan was intended to capture the "true economic value" of the options, and that a Black-Scholes valuation methodology was appropriate. Thus, the damages the plaintiffs were entitled to receive with respect to all options granted under the 1994 plan (i.e., both in-the-money and out-of-the-money options) was based on this measure, which typically produces a value substantially in excess of intrinsic value.
The Lillis case highlights that parties to a corporate transaction must confirm that their desired treatment of stock options is permissible. All plans pursuant to which outstanding options were granted (which may include plans of previously-acquired companies) must be carefully reviewed to determine whether they permit the proposed treatment. To the extent there is any ambiguity in the plans or they appear not to permit the desired treatment, the parties will need to determine how to allocate the risk of a court decision in favor of the affected optionees.
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