The case of AT&T Corp. v Lillis (Del. Mar. 9, 2009) considered the ramifications of the cancellation of out-ofthe- money options as part of a merger transaction on affected optionees. Specifically, it considered the effect of a clause in the plan that attempts to preserve an optionee’s “economic position” in the event of an “adjustment.”
This action was brought by former officers and Directors of MediaOne Corp. who ultimately acquired options in AT&T Corp. as part of AT&T’s acquisition of MediaOne. As AT&T was trying to build a broadband cable business in 2000, it acquired MediaOne. MediaOne was a cable company originally owned by US West providing cable and internet services in Georgia. In 1994, when MediaOne was a part of US West, it adopted an option plan that contained an “adjustment” clause which provided that, in relevant part, … in the event of certain transactions:
“the number or kind of shares or interests subject to an Award and the per share price or value thereof shall be appropriately adjusted … at the time of such event provided that each Participant’s economic position with respect to the Award shall not, as a result of such adjustment, be worse that it had been prior to such event”
This type of adjustment clause is not a common provision in option plans (more typically, option plans provide for administrative discretion in the event of a transaction). MediaOne granted options to among others, certain company officers and company Directors under the 1994 plan.
AT&T did not want to assume any of the outstanding MediaOne options. Rather, AT&T wanted to cash out any inthe- money options and cancel any underwater options. MediaOne refused and demanded that outstanding options be adjusted into AT&T options and specifically asked that they remain subject to the terms and conditions of the 1994 plan. This issue was heavily negotiated as part of the acquisition transaction and ultimately, AT&T agreed to MediaOne’s demands. AT&T also agreed that the terms of the 1994 plan would remain operative, and that no changes would be made to the Plan, without the optionees’ consent.
The optionees received a letter in April 2001 indicating that AT&T’s wireless business would be spun-off as a separate business and that outstanding AT&T options would be adjusted into options to acquire both AT&T stock and AT&T Wireless stock. In June 2001, both AT&T and Wireless delivered another letter to optionees stating that Wireless intended to adopt a new plan for all adjusted stock options, and that the new plan would not change the terms and conditions of the existing AT&T options.
AT&T then went through a complete restructuring in 2002 and spun-off AT&T Wireless. After completion of the spin-off, AT&T options (including those held by MediaOne optionees) were split to reflect the spin-off transaction pursuant to a formula that preserved the options’ intrinsic value, preservation of the remaining time-to-exercise periods and other basic characteristics. However, the new Wireless plan did not include an adjustment clause which protected the optionee’s “economic position” in the event of an adjustment due to a merger or similar transaction. Rather, the new plan provided “for such adjustment and other substitutions … as the Committee, in its sole discretion, deems equitable or appropriate.”
In 2004, AT&T Wireless was acquired by Cingular, a venture that was then jointly owned by SBC Communications and Bell South Corporation. The merger agreement provided that all Wireless in-the-money options would be cashed out at the difference between the $15 per share merger price and the option’s exercise price (the option’s “intrinsic value”). All out-of-money options were cancelled. The MediaOne optionees sued AT&T and AT&T Wireless alleging that the Cingular merger deprived them of the full “economic value” of their options. It is important to note before discussing this case further that the concept of “economic value” was not specifically defined in the original MediaOne plan and that there was no commonality of understanding among the parties in this case as to the meaning of those terms nor how it should be interpreted or applied in light of subsequent events to assure a uniform and consistent application of the concept.
AT&T answered the complaint by, among other things, admitting many of the allegations pleaded, including the allegation that “the cancellation of the out of the money option would leave the holders in a worse off position.” The Delaware Court of Chancery decided the case in July 2007. It noted that option plans and agreements are contractual in nature and ambiguous terms must be construed consistent with established rules of contract interpretation. The court found that “economic position” was at best ambiguous. Nevertheless, it looked at the parties’ prior dealings, their previous treatment of the options, and other extrinsic evidence, to conclude that “economic position” meant “full economic value,” that “full economic value” was not limited to the intrinsic value of the option, but rather included an option’s time value. This conclusion was based in part on AT&T’s admissions to the claims raised in the complaint. Therefore, the court ruled that the terms of the Cingular/AT&T Wireless merger violated the 1994 plan by not preserving the “full economic value” of the MediaOne options. The court used a Black-Scholes valuation methodology to determine the full measure of the resulting damages. The defendants appealed. The Delaware Supreme Court agreed with the Chancery Court about the ambiguity of the “economic position” concept. However, the Supreme Court disagreed with the conclusions reached related to the assessment of extrinsic evidence and, most importantly, disagreed with the Chancery Court’s reliance on AT&T’s prior admissions, which had been subsequently withdrawn. The Supreme Court remanded with instructions to disregard AT&T’s prior admissions.
On remand, the Chancery Court reversed itself and held that the MediaOne optionees had failed to demonstrate that the 2004 adjustments to AT&T options were improper. The plaintiffs then appealed this remanded decision.
On appeal from remand, the Delaware Supreme Court reconsidered its prior analysis and determined that its instructions to disregard AT&T admissions were a factual mistake. It explained that the AT&T admissions and statements made in briefs supported the plaintiff’s contention that AT&T had agreed with the plaintiff’s interpretation of “economic position,” and cancellation of the options did indeed leave the optionees “worse off” than if the options had not been cancelled. The Supreme Court therefore affirmed the Chancery Court’s original decision granting relief to the MediaOne optionees.
Lessons and Observations
These decisions highlight several important considerations for M&A practitioners. The first consideration emphasizes the importance of having a clear understanding (and reaching a common conclusion) regarding operative language in a company’s option and other equity plans. Ideally, some attempt should be made to get agreement from option holders regarding the proposed treatment of option in connection with a transaction, but even if it’s not possible to reach consensus with option holders, it is critical for sellers and buyers to understand the implications of plan language. It is also critical to insure that the plan contains appropriate discretionary language allowing for the Board of Directors or a plan’s administrative committee to address operational issues in a transactional context. It’s also crucial to clearly set out the Plan sponsor’s intent regarding the treatment of options in the event of a Change In Control in Board resolutions, Option Award documents and operational manuals.
Potential buyers will be very hesitant about assuming a significant expense related to outstanding options that considers value beyond an option’s intrinsic value. However, in light of potential litigation risk and the burden that such distractions would place on the underlying business, consideration should be given to offering some cash compensation to all option holders, even those holding underwater options, in order to get consensus and agreement on the cash-out conditions. It becomes crucial for both buyers and sellers to carefully review equity and option plans to ascertain and quantify potential costs and exposures to possible litigation, and assess these risks in light of overall transaction costs. Likewise, it becomes even more critical to properly craft an employee benefits indemnification provision which carefully sets out which liabilities and exposures are to be assumed by a Buyer and which will be left behind.
Finally, these cases highlight once again the critical nature of executive compensation and benefit liabilities to an overall transaction. They are rarely considered in a catastrophic context, but have the potential to cause severe long term pain.