An important consideration in structuring any change of control or merger transaction (particularly all-cash ones1), is how best to deal with outstanding options, warrants and other rights to acquire the target’s common shares, i.e., how to ensure that all such options and other rights have been exercised, cancelled or otherwise dealt with in a manner satisfactory to the acquiror on or prior to closing, this being a standard condition in merger transactions.
In the recent decision of Lilly vs. AT&T, Delaware’s Court of Chancery addressed the issue of cancelling stock options in an all-cash merger. The Court held that, in the circumstances, the stock options could not be cancelled for consideration equal only to their "intrinsic value" (i.e, the spread between the merger consideration per share and the exercise price), such that out-of-the-money options could not be cancelled for no consideration. However, this decision does not necessarily spell bad news for acquirors wishing to cancel options in cash merger transactions since:
- the decision is based on a very unique and atypical clause in the relevant stock option plan which required that any adjustment to stock options made in connection with a merger or other reorganization must preserve the optionholder’s "economic position", and
- the Court twice stated that the "general rule"2 in merger transactions is that the value of a stock option is measured by reference to "the same amount of cash that the underlying security is receiving as consideration" (i.e., intrinsic value and no more).
The facts of the case are briefly as follows: In February of 2004, Wireless announced that it had signed an agreement to merge with Cingular pursuant to which all of the Wireless outstanding shares would be purchased at $15 cash per share. The agreement provided that outstanding stock options would be valued at the spread between their exercise price and $15, so that outstanding out-of-the-money options became worthless. The plaintiff optionholders, participants in the 1994 MediaOne stock option plan which had continued in effect following MediaOne’s merger with AT&T in 2000 and the subsequent spin-off of Wireless by AT&T in 2001 (with the stock options now being exercisable for Wireless common stock), brought suite for damages on the basis of the following provision of the plan:
"In the event there is any change in the common stock by reason of a… reorganization… or other like change in the capital structure of the Company, the number or kind of shares or interests subject to an Award and the per share price or value thereof shall be appropriately adjusted by the Committee… provided that each participant’s economic position with respect to the Award shall not, as result of such adjustment, be worse that it had been immediately prior to such event" (our emphasis).
Plaintiffs argued that, on the basis of the above provisio, they were entitled to receive under the Cingular/Wireless merger the "economic value" of their options, and not just their intrinsic value. The Court noted that the proviso in question was not customary: in fact, neither party had been able to find another agreement which used the concept of "economic position", even after searches of SEC filing databases. The Court further noted that the stock options in question represented a significant portion of an optionholder’s compensation and that, unlike many option plans that are designed as an incentive bonus for management alone, these options were "conceived as a material portion of compensation for all employees, in addition to being a very large portion of compensation for the company’s executives"3. This no doubt explained, according to the Court, why the terms of the MediaOne plan were designed to be more protective of the economic interests of the optionholders than was typical.
The Court concluded that, in the circumstances, "economic position" was synonymous with the "full economic value of the options" and, as the Court explained, the economic value of options must take into account their two components of value, namely their "time value" (i.e., the chance that the underlying security will appreciate before the option expires such that market price exceeds the exercise or strike price) and their "intrinsic value" (i.e., the difference between exercise price and market price).
To determine the economic value of the stock options, the Court applied, and gives an interesting analysis of, the Black-Scholes option pricing model4. The Court noted that this model uses five inputs to value options, namely (i) current price of the underlying stock (ii) exercise price (iii) time to the expiration date (iv) volatility and (v) interest rate. As regards volatility, the Court noted that it can be calculated in one of two ways, using either "implied volatility"5 or "historical volatility"6.
The Court concluded that outstanding out-of-the-money options could not be cancelled without consideration in the circumstances, since this did not correspond to their "economic value" (computed by using an appropriate methodology, the Black-Scholes model). However, this decision may actually prove helpful in dealing with options in cash merger transactions since it seems clear that, absent the unusual and express requirement in the MediaOne option plan to preserve the "economic position" of the optionholders, the Court would have decided otherwise, based on the following "general rule" which it reiterates in the judgment:
"The Court recognizes that, as a general rule, the value of a derivative instrument such as a stock option, is tied to the value of the security into which it is exercisable. If, as result of a transaction, the underlying security is converted into the right to receive a fixed sum of cash, the value of the option will ordinarily also be measured by reference to that same amount of cash." (our emphasis)
Furthermore, it should be noted that typical Canadian stock option plans today contain express provisions that give the board wide discretion in dealing with stock options in connection with change of control transactions, whether for cash or for shares. Such provisions typically allow the board to accelerate the vesting of options on a conditional basis or otherwise, to facilitate the exercise of options by providing for their cashless exercise whether by notional loan or repurchase for cancellation, and will often specifically provide that outstanding options that have not been exercised by the effective date of a merger transaction may be cancelled without consideration.
Nonetheless, a few words of caution are in order. One wonders, first of all, whether the Delaware Court would have applied the "general rule" if the proviso, rather than referring to "economic position", had instead used a more common formulation such as that no adjustment may "impair, or be detrimental or prejudicial to the rights" of optionholders. Furthermore, it is problematic whether a Canadian court would apply the "general rule" recognized in Lilly in the case of rights governed by a contract or constating document that does not expressly give the issuer wide discretion to deal with the rights, including their cancellation, in the event of a change of control transaction,7 in light of the Supreme Court of British Columbia’s 2005 decision in ID Biomedical v. GlaxoSmithKlein.
In ID Biomedical, the Court had to determine whether ID Biomedical’s proposed plan of arrangement, pursuant to which it would be acquired by GlaxoSmithKlein at $35 cash per share, was "fair and reasonable" to securityholders, including warrantholders. Under the arrangement, the latter were to receive the spread between $35 and the exercise price, i.e., the intrinsic value of their warrants only. As in Lilly, the Court recognized that there are two components to an option’s value, namely "intrinsic value" and "time value", and distinguished between valuing options based on their "immediate exercise value" (i.e. their intrinsic value only) and their "full economic value" (i.e., their time value plus intrinsic value) noting, as in Lilly, that the most widely used method for calculating the latter was the Black-Scholes model.
In ID Biomedical, the warrants were listed and traded on the Toronto Stock Exchange. Based on the fact that warrantholders would receive under the arrangement consideration that was less than the trading price of the warrants (whereas the holders of common shares would receive a premium to the trading price of the common shares) and less than their full economic value under Black-Scholes, and that the adjustment clause in the warrant indenture (which would have effectively provided warrantholders with intrinsic value only) did not apply to an all-cash transaction8, the Court held that the plan of arrangement was not fair to warrantholders. It could not, therefore, be considered, as whole, "fair and reasonable".
It is interesting to speculate as to whether the "general rule" recognized by the Delaware Court of Chancery in Lilly might have influenced the earlier decision in ID Biomedical. Quite possibly not, but more likely had the warrants not been listed and selling at a trading price significantly higher than the "intrinsic value" being offered to warrantholders under the arrangement