In Lillis v. A T & T Corp., 2007 WL 2110587 (Del. Ch., July 20, 2007), read opinion here, the Delaware Chancery Court reviewed issues arising from the impact of a merger on the value of stock options and related issues of interpretation of the plan. For this detailed 59 -page decision (in the original verion–and 21 pages in the Westlaw version), I will use the following summary of the case provided in the opinion, and recommend a reading of the full opinion at the above link for the extensive factual details and legal analysis involved.
This is a dispute about the terms of certain employee stock options acquired by former officers and directors of a telecommunications company as the result of a series of adjustments made to those options following a 1999 merger in which that company was acquired. At issue is a 2004 cash merger involving one of the corporations in which the former officers and directors held adjusted options. According to the terms of the merger agreement governing that transaction, all employee stock options (including those held by the plaintiffs) were adjusted into the right to receive the cash merger price minus the strike price of the option regardless of the duration remaining on the option contract. Thus, "out-of-the-money" options having years remaining but with a strike price equal to or higher than the merger price were rendered worthless. Similarly, "in-the-money" options with a remaining duration were stripped of any fair value in excess of their "intrinsic" value, i.e., the difference between the strike price and the merger consideration.
The question presented is whether the terms of the plan governing these options, that required an appropriate adjustment to preserve each plan participant’s economic position with respect to the options, prohibited this treatment and, instead, required that the former officers and directors be compensated for the full fair value of their options as of the date of the 2004 merger. 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 the 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. This general rule, however, is not invariable and can be altered by contract. After trial in this case, the court concludes that the option plan at issue is properly interpreted as being at variance with this general rule and further concludes that the terms of that plan were breached by the adjustment made to the options held by the former employees. As damages, the court will award the plaintiffs a sum of money equal to the full economic value of the options less the consideration received by them in the merger.
In closing, the court made a generic point on a procedural issue that has application for all business litigators (even if not a common situation). In footnote 89, citing to an 1899 case, the court determined that it was entitled to rely on and give great weigh to an Answer to the Complaint in this case that was later withdrawn, in light of the fact that the admissions made therein where believed to be accurate when made. Here is a summary of the prior procedural decision in this case allowing the amendment and that provides more details about the background facts surrounding the amendment.