8-1
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Chapter 8
Options and Convertible Securities
Definitions
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8-2
An Option is a contract giving the holder the right to buy or
sell an asset at (or before) a future date at a specified price.
.
A Call Option is a contractual right to buy an asset at a
specified price on (or before) a specified date.
.
A Put Option is a contractual right to sell an asset at a
specified price on (or before) a specified date.
.
The Expiration Date is the last date on which the option
may be exercised; after that it carries no rights.
.
An American Option is a contract that allows the holder to
buy or sell an asset on or before the Expiration Date.
.
A European Option is a contract that allows the holder to
buy or sell an asset only on the Expiration Date.
.
Exercise or Strike Price is the price at which the holder of
an option can buy or sell the asset.
.
A Warrant is a call option issued by a company with
respect to its own securities.
Real Options
8-3
• The ability to alter a project during construction or development.
• The ability to breach a contract and pay damages.
• A debtor’s ability to default and sell assets to creditors.
• A debtor’s ability to pay off debt and “buy” assets from
creditors.
• Oil & gas leases.
• Options to purchase real estate (often pending rezoning or
assembling of a larger tract, or a loan).
Value of Long Position
• Value of Long
position
• $150
• $100
• $50
•
45 degrees
• 0
•
$50
$100
$150 Stock Prince
8-4
Value of a Short Position
• Value of Short
Position $0
•
•
- $50
•
-$100
•
- $150
$50
45 degrees
$100
$150
Stock Price
8-5
Table 8-1 Quotations on Options on IBM Stock
•
•
-Call-
8-6
Exp
Oct
Vol
68
Last
13.40
-PutVol
1505
– 50
Nov
54
13.60
1925
0.85
63.92
– 55
Oct
1061
8.90
5883
0.40
63.92
– 55
Nov
1037
10.10
5576
1.50
63.92
– 60
Oct
7646
4.80
12074
1.05
63.92
– 60
Nov
2952
6.30
4333
2.65
63.92
– 65
Oct
11041
1.60
4089
2.90
63.92
– 65
Nov
4127
3.50
1832
4.70
63.92
– 65
Jan
2510
5.70
908
6.90
63.92
– 70
Oct
3687
0.35
717
6.90
63.92
– 70
Nov
5292
1.45
341
8.20
63.92
Option / Strike
– 50
Last
0.15
IBM
63.92
Fig. 8-3 Value of European Call Option @ $100
• Value of
• Call
•
$150
•
$100
•
$50
•
$0
$50
$100
$150 Stock Price
8-7
Fig. 8-4 Value of Position of Call Writer at Expiration
• Value of
• Position
•
•
$0
•
•
-50
• -$150
• -$200
$50
$100
$150
$200 stock price
8-8
Fig. 8-5 Value of Put Option to Holder at Expiration
8-9
• Value of
• Call
•
$150
•
$100
•
$50
•
$0
$50
$100
$150 Stock Price
Quick Check Question 8.1
8-
10
Using long and short positions in the
other financial instruments, can you
synthesize the position of the writer of
a put option, to achieve the position
shown in Figure 8-5?
Quick Check Question 8.1
• Option:
•
• 2 Call Options at $100
•
• Short seller’s position
•
•
•
•
Stock
@ $100
Stock
@ $0
$0 (Strike price= $0
Market Price)
$0 (purchase price + $200 (covers at $0
= Sale price)
keeps sale price)
8-11
Stock
@$200
+$200
-$200
Minus:
1 put writer’s position
$0 (+ option price) - $100
$0(+OP)
Net:
$0
+$100
$0
Compare with Put Holder: $0 (loses option price) + $100 (sells @ $100)
Quick Check Question 8.2
8-12
• How can you replicate a call option on the stock?
Our investor can borrow $100 in cash (the
equivalent of selling a zero coupon bond short),
and buy a European call option to purchase IBM
stock at $100. If the stock rises above $100, the
investor exercises the option using the borrowed
funds. If the stock falls below $100, the investor
lets the call option expire and repays the loan with
the borrowed $100 (ignoring interest for the
moment). Can you demonstrate this in a payoff
matrix? Can you diagram it?
Quick Check Question 8.2
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8-13
Strategies on Expiration Date of European Call Option @ $100________
Stock Price Rises to $110
Stock Price Falls to $90_______
Keep loan proceeds
Excercise call option
Value of stock purchased
Less loan to be repaid
Total:
$100
($100)
$110
($100)
$10
Repay loan
Let call option expire
$0
0
$0
Diagram of Quick Check Question 8.2
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Value of
Position
110
100
90
90
70
60
50
40
30
20
10
0
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Stock Price
8-14
What are main uses of options? 8-15
1. Compensation. You can pay people in
dollars. Or you can pay them in stock.
• Believed to creates better incentives
because they now have a stake in the
company’s outcomes.
• Stock payments to executives have to
be accounted for as an expense, at the
value of the stock.
• This reduces earnings.
What are main uses of options? 8-16
• Until recently, neither accounting standards
nor the SEC required qualified stock options
to be treated as an expense at the time the
options were given.
• On Dec. 4, 2004, the Financial Accounting
Standards Board issued revisions to
Statement No. 123, Accounting for StockBased Compensation, which required public
companies to treat as an expense the fair
value of stock option awards as of the grant
date.
What are main uses of options? 8-17
• The SEC has ruled that registered
companies must begin to use this method
for fiscal years beginning after June 15,
2005.
What are main uses of options? 8-18
2. Options can also be used for hedging.
• Suppose that you are invested in 10
shares of IBM, selling at $63.92, but
you’re worried that it may decline.
What are main uses of options? 8-19
• You could sell the stock today at
$63.92, less commissions, and
repurchase it at a lower price later, plus
commissions, if it declines.
• But if it rises, you’ll have to pay more
to repurchase it, plus commissions.
• Note that if you want to be an investor
in IBM long term, you pay two
commissions to trade in and out of the
stock.
What are main uses of options? 8-20
• An alternative is to hedge, by
purchasing put options to sell the
stock. See Slide 8-6
• You could purchase put options to sell
at $60 up to the end of:
– October
for
– November for
$1.05
$2.65
• This is a modest insurance cost for
protecting against losses. - A “hedge.”
What are main uses of options? 8-21
• You could also sell short, using
borrowed shares, which you could
either cover with your own shares or
with newly purchased shares at a lower
price if the stock goes down.)
• But this doesn’t cap your risk in the
same way – if the stock price rises,
your cost of covering your short
position can be much higher than the
cost of letting put options expire.
Hedging
• Do directors have to care about
hedging?
8-22
Hedging
8-23
• Do directors have to care about
hedging?
• Yes. They can be found liable for
breach of duty if they ignore it. Brane v.
Roth, 590 N.E.2d 587 (Ind. App. 1992)
(liable for failure to supervise hedging
of a grain elevator).
•
Problem, Page 556
8-24
The Freeze-Out at Zero Value.
• A business with a history of losses for several years,
which is typical in this business.
• At this time we can assume that the balance sheet net
worth of the business is very low, if not negative.
• The majority stockholder has been guaranteeing bank
loans while your client, the minority stockholder, has not
been participating.
• The majority stockholder has obtained an opinion from a
financial expert that suggests the business is worthless.
• And the majority proposes to freeze your client out in a
reverse stock split for a nominal sum.
• What arguments can you think of that might suggest a
positive value for the stock?
Problem, Page 556
8-25
• This situation is clearly an option argument.
• We have information that the market for Menhaden
is highly cyclical, and that the cycles can often be
several years long.
• This means there’s a reasonable expectation of
profits some day.
• Perhaps the best evidence of this is that the
majority stockholder continues to guarantee bank
loans.
• Our majority stockholder, by guaranteeing the
loans, has purchased an option to buy the assets
from the bank, suggesting the option value is
significant. How do you value it?
Elements of Call Option Values
8-26
• The current price of the underlying asset (the price of stock, in
the case of stock options);
• The exercise price;
• The time to the expiration date;
• The variance of the price of the underlying asset; and
• The risk-free interest rate.
Fig. 8-10 Value of American Call Option @ $100
8-27
• Value of
• Call
•
$150
•
$100
•
$50
•
•
Value of American
Option
$0
$50
$100
Value of European
Option
$150 Stock Price
Table 8-2 Expected Values of Stock
•
• Stock A
•
$90
• $110
•
•
• Totals:
Value
Stock B
$70
$130
.
x Probability =
0.5
0.5
0.5
0.5
Expected Value
Stock A
Stock B
$45
$55
____
$100
$35
$65
$100
8-28
.
Fig. 8-11 Payoffs from Options on A & B
8-29
• Payoffs on
• Call Options
•
•
Payoff on A
Options
•
•
•
•
Payoff on B
Options
$70
$90
$100
Exercise Price
$110
$130 Stock Price
Binomial Option Valuation Model
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8-30
Assumptions: Current stock price
$100
1-year European call option @
$100
Stock price has equal chance of being at $80 & $120 in 1 year.
(10% interest rate)
Alternative 1 (Call Option):
Buy 1 option, which in 1 year will be worth $0(low) or $20 (high)
Alternative 2 (Leveraged Stock Purchase):
Borrow discounted present value of low bound ($80): $72.73
Buy 1 share @ $100 now (your net investment =
$27.27
Outcomes:
Low ($80) stock value – minus loan repayment ($80) = $0
High ($120) – minus loan repayment ($80)
= $40
Payoff on levered investment is 2 times the payoff on 1 call option.
Two call options = leveraged purchase investment ($27.27)
Value of one call option = $13.63.
Scientific Atlanta’s Option Disclosures
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•
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Stock Options
The following tables set forth certain information in the prescribed formats with respect to options
granted under Scientific-Atlanta’s various stock option plans during fiscal year 2002. No Named
Executive Officer exercised any options during fiscal year 2002.
Option Grants in Last Fiscal Year
•
Potential Realizable Value at
Assumed Annual Rates of Stock
Price
Appreciation for Option Term (1)
Individual Grants
Number of
Securities
Underlying
Options
Granted (2)
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8-31
Name
James F. McDonald
400,000
125,000
H. Allen Ecker
50,000
20,000
Conrad J. Wredberg, Jr. 75,000
75,000
40,000
Dwight B. Duke
57,000
20,000
Robert C. McIntyre
40,000
15,000
% of Total
Options
Granted to
Employees
FY 2002
8.8
2.8
1.1
0.4
1.7
1.7
0.9
1.3
0.4
0.9
0.3
Exercise
or Base
Price
Expiration
($/sh)
Date
$22.10
$22.10
$22.10
$22.10
$22.65
$22.65
$22.10
$22.10
$22.10
$22.10
$22.10
2/16/2012
2/16/2012
2/16/2012
2/16/2012
12/19/2011
12/19/2011
2/16/2012
2/16/2012
2/16/2012
2/16/2012
2/16/2012
5%($)
$5,559,429
1,737,321
694,929
277,971
1,068,335
1,068,335
555,943
792,219
277,971
555,943
208,479
10%($)
$14,088,683
4,402,714
1,761,085
704,434
2,707,370
2,707,370
1,408,868
2,007,637
704,434
1,408,868
528,326
8-32
(1) The dollar amounts in these columns were determined using assumed
rates of appreciation set by the SEC and are not intended to forecast future
appreciation, if any, in the market value of Scientific-Atlanta common stock.
Such amounts are based on the assumption that the named persons hold
the options for their full ten-year term. The actual value of the options will
vary in accordance with the market price of Scientific-Atlanta common
stock.
(2) All of these stock options were awarded under the LTIP. If a change of
control occurs (as defined in the LTIP), all options become exercisable
immediately. These options may be exercised within a period of three years
following a termination by reason of retirement, within one year following a
termination by reason of death or disability, and within thirty days following a
termination for other reasons, except for cause, in which case such options
expire immediately upon the giving of the notice of such termination.
(3) Vests in four equal installments beginning on the date of grant.
(4) Vests 100 percent on the sixth anniversary of the date of grant, but may vest
earlier based generally upon the cumulative compound annual percentage
increase in net revenues over three years.
(5) Vests in four equal installments beginning on the first anniversary of the
date of grant.
SEC Office of Economic Analysis Comments
8-33
• “In a memo dated March 18, OEA advised that the valuation
methods for the expensing of stock options are well known and
the issues that may arise in implementing FAS 123R are not
unusual since they also occur in other areas of accounting and
finance. Current methods for valuing employee stock options
are reliable and appropriate for compleing with FAS 123R,
according to OEA.
• * * *
•
“OEA cited evidence that the modified Black-ScholesMerton approach provides reliable estimates of option value.
The lattice, binomial and Monte Carlo approaches have
advantages that make them more suitable for some
companies.”
Herbert Resnik v. Jerome Swartz
8-34
• The board approved the 2000 Directors Stock Option Plan, with
options exercisable at the higher of the market price (1) on the
date of board approval or (2) the date of shareholder approval.
• Options on 50,000 shares exercisable over 4 years, with ¼
vesting annually.
• Proxy statement disclosed full terms of plan, and included the
SEC’s required chart showing valuations if the value of the
stock compounds at 5% and 10%.
• The Proxy statement also made the following value disclosures:
“The actual value, if any, an executive will realize will depend
on the excess of the market price over the exercise price on the
date the option is actually exercised. The value actually realized
by an executive or any shareholder may not be at or near the
values estimated in this table.”
• The shareholders approved the plan.
Herbert Resnik v. Jerome Swartz
8-35
• Plaintiff alleges that the Black-Scholes valuation of the option
grants on the date of grant was $2,868,000. - page 570.
• Was the Proxy Statement materially misleading because it did
not disclose the grant date Black-Scholes value of the options?
No.
Symbol Technologies’ Option Disclosures
8-36
•
•
•
•
•
•
Individual Grants in 1999
Potential Realizable Value as Assumed Annual
Number of
% of Total
Rates of Stock Price Appreciation for Option Term(A)
Securities
Options
Underlying
Granted to
Exercise
5%
10%
Options
Employees in or Base Expiration Stock Dollar
Stock
Dollar
Granted (No.)
Fiscal Year
Price
Date
Price (I) Gain
Price
Gain
•
•
•
•
•
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•
Name
* * *
Jerome Swartz 120,000 3.88% $38.67 2/17/09
195,000 6.31% $35.54 2/17/09
CEO’s Gain as
% of All
Shareholders Gain
•
A.
Total dollar gains based on the assumed annual rates of appreciation
of the exercise price of each option. The gain derived by all shareholders is
based on the outstanding number of shares at December 31, 1999. The actual
value, if any, an executive will realize will depend on the excess of the market
price over the exercise price on the date the option is actually exercised. The
value actually realized by an executive or any shareholder may not be at or
near the values estimated in this table
$62.98 $2,918,074
$57.89 $4,358,637
.407%
.
$100.29 $7,394,971
$92.19 $11,045,641
.407%
Questions
8-37
1. What is the difference in disclosure requirements for stock
options under Regulation S-K for executive officers and nonemployee directors?
Reg. S-K, Item 402(g)
8-38
• (g) Compensation of Directors -•
• (1) Standard arrangements. Describe any standard
arrangements, stating amounts, pursuant to which directors of
the registrant are compensated for any services provided as a
director, including any additional amounts payable for
committee participation or special assignments.
•
• (2) Other arrangements. Describe any other arrangements
pursuant to which any director of the registrant was
compensated during the registrant's last completed fiscal year
for any service provided as a director, stating the amount paid
and the name of the director.
Reg. S-K, Item 402(c)
•
c) Option/SAR Grants Table. (1) The information specified in paragraph (c)(2) of this
item, concerning individual grants of stock options (whether or not in tandem with
SARs) and freestanding SARs (including options and SARs that subsequently have been
transferred) made during the last completed fiscal year to each of the named executive
officers shall be provided in the tabular format specified as follows:
•
•
•
•
•
•
•
•
8-39
OPTION/SAR GRANTS IN LAST FISCAL YEAR
• [Individual Grants]
Name Number of Percent of total options/
securities
SARs granted to
employees
underlying
in fiscal year
options/SARS
granted (#)
(a)
(b)
(c)
Exercise or base Expiration date
price ($/Sh)
(d)
(e)
•
OPTION/SAR GRANTS IN LAST FISCAL YEAR
•
Name
•
•
•
(a)
Potential realizable value at
assumed annual rates of stock
price appreciation for option
term
5% ( $ )
10% ( $ )
(f)
(g)
Alternative to
(f) and (g):
grant date
value
Grant date
presentvalue $
(f)
Questions
8-40
2. Rule 408 under the Securities Act of 1933, which governs
disclosures in registration statements (also governed by
Regulation S-K) states:
In addition to the information expressly required to be included
in a registration statement, there shall be included such further
material information, if any, as may be necessary to make the
required statements, in the light of the circumstances under
which they are made, not misleading.
Would this rule make a difference if suit had been brought by a
securities buyer in a public offering?
Probably not. The SEC has probably resolved that issue,
even for executives, by providing disclosures in the
alternative – either the 10 year appreciated values, or the
grant date present value.
Questions
8-41
3. Should the sheer magnitude of the value of the present value
of the option grants alleged by Resnik make a difference in
the determination of whether the disclosures of contract terms,
without more, was misleading?
• The court rejects that argument by noting that no claims were
made about the value of the options on the grant date.
• The company did what was required for non-executive
directors, which didn’t require any showing about values.
Questions
8-42
4. Symbol was a Delaware corporation. Malone v. Brincat, 722
A.2d 5 (Del. 1998), stated that “[t]he directors of a Delaware
corporation are required to disclose fully and fairly all material
information within the board’s control when it seeks
shareholder action.” Id. at 12. Could plaintiff have successfully
pleaded a state law claim? What arguments would you make
on behalf of the plaintiff?
• Yes, that the board had breached its fiduciary duty of
disclosure of the value directors’ compensation at the time
granted.
• This is inherently a conflict of interest situation, which places
the burden on directors to show the entire fairness of their
actions.
• One could argue at state law that the directors failed to make
fair disclosures to the shareholders (see Weinberger v. UOP for
rules about fair dealing and disclosures).
Protecting Options
8-43
1. Anti-Destruction: Language to protect against the destruction
of the property to be received on exercise or conversion.
2. Anti-dilution: protecting the pro rata value of the property to be
received on exercise or conversion.
Protecting Options
8-44
Protecting Options
8-45
Protecting Options
8-46
Protecting Options
8-47
Protecting Options
8-48
John Parkinson v. West End Street Railway Company
8-49
• Highland Street Railway issued bonds.
• Later, a statutory amendment of the charter authorizing a new
issue of securities provided that the bondholders could convert
their bonds into preferred stock as the bonds matured.
• It subsequently consolidated with the Middlesex Street Railway,
and later with West End Street Railway.
• In each case the surviving corporation was made subject to “all
the duties, restrictions and liabilities” of the predecessor
corporation.
• Is plaintiff entitled to preferred stock for his bonds? No.
John Parkinson v. West End Street Railway Company
8-50
• The option is “simply an option to take stock as the stock may
turn out to be when the time for choice arrives.” - page 576.
• If the issuing corporation goes out of existence before the
conversion date, the conversion rights don’t stand in the way.
• “The option gives him merely a spes (hope), not an undertaking
that the corporation will continue for the purpose of making it
good.”
• The bondholder’s right is subject to the condition that the
corporation shall not have vanished. - page 577.
• Where a corporation isn’t contractually bound to preserve its
existence for the option holders, it’s free to reorganize in a way
that destroys the stock.
• The consolidation didn’t keep the Highland Street Railway so
far alive as to impose any duties on its successors with respect
to the options.
John Parkinson v. West End Street Railway Company
• What happened to the board’s duty to shareholders here?
8-51
John Parkinson v. West End Street Railway Company
• What happened to the board’s duty to shareholders here?
• You are not a shareholder until you convert. The only
duties to bondholders are in the agreement. If the
agreement iddn’t prvent this merger than it is allowed.
8-52
Simons v. Cogan
8-53
• Knoll issued debentures convertible into common stock @
$19.20 per common share.
• In 1987 Knoll & its controlling shareholders caused a
tender offer for the common at $12, followed by a cash-out
merger that eliminated the minority shareholders.
• Knoll and the indenture trustee amended the indenture to
substitute $12 cash rather than one share of Class A
common stock.
• Did Knoll and the controlling shareholders breach a
fiduciary duty to the debentureholders by cashing out the
common at an unfairly low price and amending the
indenture? No.
• Motion to dismiss the complaint is granted.
Simons v. Cogan
8-54
• No duty to bondholders beyond the contract.
• Exceptions exist for fraudulent inducement and, in limited
cases, for breaches of an implied covenant of good faith
and fair dealing. - page 578.
• Bondholders are “outside” the firm, and must use contract
for protection. - page 581
• The few opinions that have suggested some fiduciary
duties have not been adopted by any court.
• While a conversion right creates an economic interest in
the stock, until exercised it’s still just an option, and the
holder remains a creditor.
Simons v. Cogan
8-55
1. Why doesn’t Chancellor Allen treat debt covenants as
contracts of adhesion? Underwriters are hired by the
issuer to market the debt securities. Why would they
provide protection to investors?
• On page 578, Chancellor Allen states:
“Such documents are typically carefully negotiated at
arms-length. In a public offering, the underwriter of the
debt, and to some extent the indenture trustee, have an
interest in negotiating in that fashion”
• Which raises the question of why the underwriter has an
interest in negotiating at arms-length?
Simons v. Cogan
8-56
2. Does the right to convert each $19.20 of principal amount
of debenture into the merger consideration have any value
to debenture holders?
• Not on the surface – trading $19.20 for $12.00 can’t make
sense.
• But if bonds were trading at a very low rate 10c on the
dollar it might.
Simons v. Cogan
8-57
3. In footnote 3 Chancellor Allen notes that the debentures were trading
at $86 before announcement of the cash-out merger, and allegedly
declined in value upon the announcement of the supplemental
indenture to $73¼. If the bonds were formerly convertible into
common stock at $19.20 per share, what value does that attribute to
the conversion right per share? If you were the defendant, what kind
of evidence might you offer that the entire decline was not attributable
to the announcement of the supplemental indenture?
• Recall that bonds usually sell in $1,000 units, so this was the right to
convert into:
$1,000
= 52.08 shares
$19.20
• If the $12.75 price drop was caused entirely by the loss of the
conversion right, this means each option for one share was worth:
$12.75
= $0.244
52.08
Simons v. Cogan
8-58
3. If you represent the defendant, you would want to show
some adverse effects that caused the price drop:
• Bad news about Knoll’s earnings that might call into
question its ability to redeem the bonds when due.
• The buyout of the minority common shareholders might
have reduced the cash available for redemption (but
typically bond covenants will protect against excessive
payouts of cash to shareholders).
• A general rise in interest rates would reduce the value of
any outstanding bond with a fixed rather than a variable
interest rate
Simons v. Cogan
8-59
4. If you represented Knoll and Cogan, what response might
you make to plaintiff’s assertion that the cash-out merger
“was effected at a particularly disadvantageous time from
the point of view of the minority shareholders”?
• There is no such thing.
• If stock prices are generally depressed, then they can use
their $12 to buy other depressed stocks.
• Here they got a premium of $2.75 per share over the $9.25
market price on the day of announcement.
Simons v. Cogan
8-60
5. Chancellor Allen holds that holders of convertible debentures aren’t entitled to
the benefit of fiduciary duties until they exercise their conversion rights. Is
this pure formalism, or can you think of other reasons that might justify such a
rule? Are there real differences in the situations of shareholders and holders
of convertible debentures? What would happen if directors owed duties to
both shareholders and convertible debenture holders?
• Chancellor Allen points out that the rights of bondholders are elaborately
specified, while those of shareholders are not.
• Second, recall the stockholder-bondholder conflict – their interests are
naturally adverse.
• No fiduciary can vigorously serve two competing beneficiaries.
Andaloro v. PFPC Worldwide, Inc.
•
•
•
•
8-61
PFPC Worldwide was merged with an acquisition vehicle of its parent, in a
short - form merger.
Petitioners were executives before the merger.
They claim PFPC breached the option agreement by not giving them notice of
the proposed merger to allow them to convert and receive the merger
consideration.
Can holders of options seek appraisal under Del. G.C.L. § 262? No.
–
Their claim is in contract for breach of duty to notify not for appraisal rights.
Typical Anti-Destruction Language
8-62
• In case at any time the Company shall be a party to any
transaction . . . in which the previously outstanding Capital
Stock shall be changed into or exchanged for different
securities of the Company or common stock or other securities
of another corporation . . . then, as a condition of the
consummation of the Transaction, lawful and adequate
provisions shall be made so that each holder of Conversion
Rights, upon the exercise thereof at any time on or after the
Consummation Date,
shall be entitled to receive, and
such Conversion Rights shall thereafter represent the right to
receive, in lieu of the Capital Stock issuable upon such exercise
prior to the Consummation Date, the highest amount of
securities or other property to which such holder would actually
have been entitled as a shareholder upon the consummation of
the Transaction if such holder had exercised such Conversion
Rights immediately prior thereto . . . .
Background to Marriott Deal
8-63
• This could be characterized as an attempt to
transfer wealth from bondholders to stockholders.
• Marriott Corporation had invested heavily in hotels
during the 1970s and 1980s, and had expanded
rapidly.
• The expansion was financed with large amounts of
borrowing.
• In the late 1980s real estate values declined
nationwide, including hotel values.
• This increased debt service began to reduce net
profits for the stockholders.
Background to Marriott Deal
8-64
• By the early 1990s real estate values were
depressed, and lenders were only interested in
high quality borrowers.
• Marriott, with its large debt load on its hotels,
wasn’t a high quality borrower able to borrow
more to expand its management and services
business.
• Marriott couldn’t sell the hotels and pay off the
debts they carried.
• Solution: To think of debt as an option to sell the
company.
Debt as a Put Option for Marriott
• Assets:
• Liabilities:
•
•
Long term debt
Other debt
•
•
Preferred
Common stock
8-65
$3.8 billion
($2.1 billion)
($1.0 billion) (this is necessary to
explain the numbers)
(.2 billion)
$0.5 billion
• Assume now that the real market value of the assets is only $3.3 billion:
•
Assets:
$3.3 billion
•
Liabilities:
•
Long term debt
($2.1 billion)
•
Other debt
($1.0 billion)
•
Preferred
(.2 billion)
•
Common stock
$.0 billion
Host’s Pro Forma Income Statement
• Sales
– Expenses before interest &
corporate expenses:
– Interest expense
– Corporate expenses
– Net Loss
$1.209 billion
$152 million
196 million
46 million
(44 million)
8-66
International’s Pro Forma Balance Sheet
• Assets:
• Liabilities:
– Short-term debt (necessary to
make this balance)
• Long-term debt
• Shareholders’ equity
$3.048 billion
(1.771 billion)
(902 million)
375 million
8-67
International’s Pro Forma Income Statement
•
•
•
•
8-68
1992:
Sales
$7.8 billion
Expenses before interest & corporate expenses
(331 million)
Net income
136 million
• 1993 (projected):
• Sales
• EBIT
$8.2 billion
368 million
Background on Marriott Deal
8-69
• The price of Marriott’s common stock jumped 12% on the
date of announcement.
• Ultimately, stock rose from $17.12 the day before the
announcement to $25.75 by June 4, 1993.
• This is a 50% increase.
• One study calculated the Marriott family’s personal gains
at $225 million.
• The price of Marriott’s bonds dropped 30% in 2 days.
• One study found bondholders lost about $114 million.
• Bond rating services downgraded the Marriott bonds from
investment grade to junk bonds.
• The bonds had no covenants to prevent this distribution.
Marriott’s Settlement with Bondholders
8-70
• Host creates & owns Holdings I, which in turn owns Holdings II,
which will own most assets.
• Bondholders will get bonds in Holdings II, which will be
restricted in payments it can make to Holdings I or Host.
• International agrees to lend up to $630 million to Holdings I to
allow interest payments on the bonds, but these funds won’t be
available for dividends on Host’s preferred.
Marriott The Preferred’s Litigation
• Marriott proposes to place lodging, food services,
facilities management & senior living services
businesses in Marriott International, and spin its
shares off as a dividend.
• Old Marriott becomes Marriott Host, and owns real
estate and concessions at toll roads, airports &
stadiums & some other properties.
• Host keeps 33% of assets and 85% of debts.
• It’s alleged most cash flow goes to International.
• Host won’t be able to continue paying the
preferred dividend, and International will pay the
dividend on the common formerly paid by Host
Marriott The Preferred’s Litigation
• Was the combination of the spin-off and
suspension of the preferred dividend a coercive
act to force the preferred to convert?
• Plaintiffs argue that this spin-off is designed to assure
the Marriott family majority control of Host.
• If all the preferred were converted in Host after the
distribution, it would represent more than 50% of total
common stock.
• The preferred stock can’t presently be called or
redeemed.
• Plaintiffs argue that the special dividend is a way to
get the preferred to convert before the distribution.
Marriott The Preferred’s Litigation
• Do planned common stock dividends by
Marriott violate the Preferred’s dividend
preference?
• There is no duty not to dividend assets in a
spin-off. That’s what the protective language in
§5(e)(iv) is designed to protect against.
Marriott The Preferred’s Litigation
• Does the spin-off proposal, coupled with
suspension of preferred dividends, violate the
right of the preferred not to be redeemed before
1996?
• Plaintiffs argue that with dividend suspension they’re
forced to convert to preserve value.
• Court denies that conversion is equal to redemption.
• Preferred shareholders can lose their shares in other
ways as well - cash-out mergers, liquidations.
Marriott The Preferred’s Litigation
• Is the suspension of dividends wrongful coercion
of the preferred holders?
• Only if it is done for coercive purposes, which depends
upon existence of a fiduciary duty.
• But the Company has right to suspend dividends,
because the Preferred gets its protection from the
cumulative feature.
Marriott The Preferred’s Litigation
• Does the spin-off dividend violate section 5(e)(iv)
of the certificate of designation?
• The conversion formula adjusts the conversion price
downward when assets are distributed.
• This formula is designed “to preserve the pre-dividend
value of the preferred’s conversion right.” - page 598
• The pre-dividend announcement value of the
conversion right was for 4 million pfd. to convert into
shares of common @ $17.40 when common was
trading @ $17.125.
• This would result in receiving common stock worth $
196 million = $49.21
• 4 million
Marriott The Preferred’s Litigation
• The court rejects use of later valuation, when common
had risen to $26, which results in:
• The Preferred is receiving common stock worth
$298.5 million = $74.62
• 4 million
Marriott The Preferred’s Litigation
• “By necessary implication [§5(e)(iv) limits the boards
discretion with respect to the size of special
dividends.” - page 599
• “But that limitation is one that has its effect when it is
respected by the board of directors at the time it takes
corporate action to declare the dividend. If, when
declared, the dividend will leave the corporation with
sufficient assets to preserve the conversion value that
the preferred possesses at that time, it satisfies the
limitation that such a protective provision necessarily
implies.” - pages 599-600.
Marriott Questions
1. What is a short sale?
• Selling borrowed stock at today’s market price, with
the intent of covering the loan by buying the stock
back later, hopefully at a cheaper price.
2. What did plaintiffs expect to achieve by selling
Marriott common stock short?
Marriott Questions
• Note the court describes the convertible preferred as
having two elements of value:
– The preference rights - primarily to receive dividends;
– The conversion right - the right to convert $50
preferred shares into 2.87 shares of common (a price
of $17.40).
• Thus, a holder of convertible preferred has a claim on
common stock that has value.
• But this part of the value can decline if the common
stock declines.
• So selling common short means that the holder will
profit on its short position when it loses on its long
position.
Marriott Questions
• This means the plaintiffs have invested only in the
preference rights - to dividends.
• So when the dividends are cut off, they’ve really lost
value.
• Unlike other preferred stockholders, they can’t salvage
some value through conversion.
• Should this fact matter to the court in making its
decision?
Marriott Questions
3. If the announcement of the special dividend meant
that no dividends were likely to be paid on the
preferred stock, why did the market value of the
preferred stock increase from $62.75 to $77.00 on
June 4, 1993?
• Apparently because of the value of the conversion
privilege.
• By June 4, the value of the common had risen from
$17.125 to $25.75, or nearly 50%.
• At 2.87 shares for each preferred share, you could
instantly convert into common worth $73.90.
• But if you expect the common to increase further in value,
the conversion right could be worth even more. (Thought
of as an option.)
Marriott Questions
4.The court explains that the plaintiffs haven’t
profited very much from the rise in the value of
both the common and preferred stock of Marriott.
Why not?
• Because the covering of short sales has gotten more
expensive as the common stock’s price rose.
Marriott Questions
5. What does the court mean when it says that “the premium
that the preferred stock commanded over the common into
which it could convert (i.e., the market value of the
preferences) however, had by June 4th, shrunk, to $3.00" ?
• The day before the announcement, the common traded at
$17.125.
• The value of 2.8736 shares into which the preferred could be
converted was $49.21.
• But the preferred was trading at a price of:
$62.75
• Premium of preferred over equivalent common:$13.54
• On June 4, the common traded at
$25.75
• The value of 2.8736 shares was
$74.00
• But the preferred was trading at a price of:
$77.00
• And the premium of preferred over equivalent
common was only:
$3.00
Marriott Questions
6. The opinion states that on the last trading day before
announcement of the special dividend, the right to convert
the preferred into 11,494,400 common shares, had a value
of $196,842,000. This represents the market value of the
common. Is that the correct measure of the conversion
right’s value?
• This is a statement of the exercise value of the conversion right
– the market value ($17.125) of the common stock that would
be obtained on exercise.
• That’s not the measure of the value of the conversion right,
which existed for a longer period, during which the common
might rise in price.
Marriott Questions
6. Is it the correct measure under the certificate of
designation for the preferred?
• The Certificate of Designation states that shares are convertible
into common at $17.40 per share. - page 597.
• Is there a difference between the market value of the
conversion right of the preferred and its value on the date
of a hypothetical conversion?
• The preferred isn’t redeemable until January 15, 1996. So it’s a
conversion right for at least the next two years (and longer, if
Marriott lacks funds to redeem). - page 591.
• The longer the option, the greater its value. So a hypothetical
exercise shortens the duration and thus reduces the value.
Marriott Questions
7. Plaintiffs argue that the Marriott family wants the preferred
to convert before the dividend, because a conversion after
the dividend would give the preferred shareholders a
majority of the Host common stock, thus taking control
away from the Marriott family. How can this be?
Dilutive Effect of Conversion on Common
•
•
•
•
•
Assume:
Market price:
Conversion price:
Value of assets distributed:
Formula is:
• ($17.40)
8-88
$25.00
$17.40
$15.00
($25.00 - $15.00) = (17.40) ($10.00) =
$25.00
$25.00
($17.40) (.40) = $6.96
• Assuming the conversion formula is based on the nominal
value of the preferred ($50), you now get 7.18 shares of
common for each share of preferred, rather than 2.87.
• With 4 million shares outstanding, this would be 28,720,000
new shares of common.
• There were approximately 100 million shares outstanding, of which the
Marriott family owned 25 million.
Marriott Questions
8. Chancellor Allen holds that Marriott must leave enough
assets in Host to preserve the conversion value of the
preferred. What is the source of this holding?
• The fact that the conversion formula is supposed to protect the
preferred shareholders’ conversion rights from destruction of
their value.
• This comes from his mathematical analysis, that a large enough
dividend would destroy the value of the conversion right.
• But note that the certificate of designation requires Marriott to
give preferred shareholders written notice of its intent to
declare a dividend 15 days in advance of the record date.
• So the preferred’s protection is to convert before the record
date, so they can share in the dividend.
• This provides them with full protection against a huge
distribution that leaves the common with very little value.
Marriott Questions
9. If Chancellor Allen is correct that Marriott owes a
contractual obligation to preserve the conversion
value of the preferred, what language does he look
to in the Certificate of Designation?
• None. He implies it in!
• This seems to be almost a fraudulent conveyance type
of analysis, that confuses the value of the common’s
equity with the rights of the preferred.
– “... the issuer impliedly but unmistakably and
necessarily undertook to refrain from declaring a
dividend so large that what is left in the corporation
is itself worth less than the pre-distribution value of
the preferred stock.”
Marriott Questions
• Then he looks at the estimates of the post-distribution
market value of the common.
• Implicit in this is that if the common is worth less than
the pre-distribution conversion rights of the preferred,
it’s forbidden.
• This ignores the fact that the preferred’s equity is still
preserved - any calculation of the value of the
common has to include the prior rights of the
preferred, both to dividends and on liquidation or
redemption.
Marriott Questions
10. Could the certificate of designation [have]
provided specific protection against large
distributions that lowered the conversion value of
the preferred?
• Yes. Just provide that distributions must leave some
minimum amount of equity in the company.
• Bond covenants more commonly do this, and
preferred shareholders get to free ride on them to
some extent. BUT bondholders can waive this
provision if they are paid something.
• But much public debt lacks such covenants.
Marriott Questions
11. Why does the court pick the conversion value of
the day before the distribution was announced?
Why is that value the one that sets a ceiling on
Marriott’s distribution?
• This isn’t explained.
• He calls it a “necessary implication” of the conversion
right.
• It makes sense, because the board can only calculate
values accurately on the day it makes its decision.
• Thus, as long as there is enough to protect a conversion
value of $49.21, it’s legal.
• Notice that if the common had traded at $10 the day
before, the conversion ratio would have given each pfd.
s/h only 2.87 shares worth $28.70.
Marriott Questions
12. Some experts (namely S.G. Warburg, plaintiffs’
expert), found potential trading values of the
common stock between $179,000,000 and
$368,000,000, with the lower end below the
conversion value of $196,000,000 used by the
court as a minimum. Why doesn’t the court hold
that this breaches the implied covenant?
• Because the court uses a probability analysis.
• There is a distribution of possible outcomes in a bellshaped curve, with most above $196,000,000, and a
weighted (expected) value above $196,000,000.
• Note the median of Warburg’s estimates is about $275
million, which is probably the mean and the expected
value as well.
Marriott Questions
13.The Plaintiffs complain about how Marriott
calculated the formula for valuing the distribution.
What is the nature of their complaint?
• To determine the percentage of assets distributed,
Marriott valued the “intrinsic value” of Host and
International separately.
• Then it summed these values.
• Then it took the percentage of this sum represented
by international to determine the percentage of
Marriott’s value that was distributed.
• Then it applied that percentage to the current market
value of Marriott’s stock to determine the value of the
distribution.
Marriott Questions
• Note that if value is created for stockholders in the
spin-off, the new companies are worth more than
Marriott before the dividend.
• And if International gets the benefits of being freed
from the real estate debt, most of the value may flow
to International.
• Thus, if you simply used the value of International as a
straight percentage of the pre-announcement value of
Marriott, it would be a higher percentage.
Marriott Questions
• If Warburg’s median estimate of $275 million is
correct, if there are 105 million common shares
outstanding, how many shares will each preferred
shareholder get, and at what conversion price, if
the pre-announcement market price of the
common were $17.00, and the value of the special
dividend is $15?
($17.40) ($17 - $15) =
17
($17.40) ($2) = ($17.40) (.1176) = $2.05
17
Marriott Questions
• Thus a $50 preferred share would convert into 24.4
shares of common.
• Thus, 4,000,000 preferred shares would convert into
97,600,000 shares, or about ½ of the equity.
• With dilution, there would be 202.6 million shares of
common outstanding.
• With $275 million of equity, this means each share of
common is worth $1.36.
• This doesn’t protect the conversion feature of the
preferred.
Anti-Dilution Clause
•
•
•
•
•
•
8-99
In case the Company . . . shall declare, . . . a dividend or other distribution
(including, without limitation, any distribution of other or additional stock or other
securities or property or Options by way of dividend or spin_off, reclassification,
recapitalization or similar corporate rearrangement) on the Capital Stock, other
than
(a) a dividend payable in Additional Shares of Capital Stock or in Options
for Capital Stock or
(b) a dividend payable in cash or other property and declared out of
retained earnings of the Company,
then, in each such case, . . . the Exercise Price in effect immediately prior to
the close of business on the record date fixed for the determination of holders of
any class of securities entitled to receive such dividend or distribution shall be
reduced, . . . to a price . . . determined by multiplying such Exercise Price by a
fraction
(c)
the numerator of which shall be the Market Price in effect on such
record date or, if any class of Capital Stock trades on an ex_dividend basis, on
the date prior to the commencement of ex_dividend trading, less the value of
such dividend or distribution (as determined in good faith by the Board of
Directors of the Company) applicable to one share of Capital Stock, and
(d)
the denominator of which shall be such Market Price.
ANTI-DILUTION PROTECTION
8- 100
• Designed to protect value of conversion right when new shares issued
cheaply.
– Protects value of rights from stock splits & stock dividends (free
shares)
– Protects Company in reverse stock splits that reduce outstanding
shares
• Exceptions:
– Cheap stock issued pursuant to employee option plans or restricted
shares (up to a limit)
– Shares issued on conversion of preferred or warrants issued before
this round
• Adjustment clauses:
• Full Ratchet – If any shares are sold cheaply, the conversion price is
reduced to the cheapest price.
• Weighted Average – If any shares are sold cheaply, calculate the overall
dilution imposed by the sales, and reduce the conversion price
accordingly.
Antidilution – Weighted Average Formula
8-
101
Weighted Average formula:
(CV) ( OS + NSOP )
OS + NIS
Where:
CV
= Old Conversion Price
OS
= Outstanding Shares before new issue of cheap stock
NSOP = No. of newly issued shares that could be bought at
CV for new consideration
NIS
= Newly Issued shares
Full Ratchet & Weighted Average Compared
8-
102
Shares outstanding: 1,000,000 common; 200,000 Series A
Preferred sold @ $1.00
Conversion Price: Converts to Common @ $1.00 (1 for 1)
Sale of 1 new share of common at $.01
Full ratchet: Conversion price now $.01 (gets $250,000
$.01
= 25,000,000 shares)
Weighted Average:
$1.00 (1,000,000 + .01) = $1.00 (.999999)
1,000,001
At the new exercise price, 200,000 / $.999999 = 200,000.25 shares
COMPARISON OF FORMULAE
8-103
# Shares
Common
Outstanding
# Shares
Series A
Convert.
Pfd.
Outstanding
# Shares Price per
Common Share
Paid in
sold in
Down
Down
Round
Round
# Shs. Common
issuable upon
conversion of Pfd.
Before
After
Down
Down
Round
Round
1,000,000
250,000
1
$.01
250,000
25,000,000
Weighted 1,000,000
Average
250,000
1
$.01
250,000
250,000.25
Full
Ratchet
Stephenson v. Plastics Corporation of America 8-104
• Plastics sold plaintiffs warrants to purchase 30,000 shares of
common @ $1.00 for 5 years.
• In 1964 the Plastics Board agreed to split the company in two:
– All the thermoplastics manufacturing would be transferred to United
Fabricators (“United”) in exchange for all its outstanding stock;
– The United stock would be distributed to Plastics’ stockholders and those
warrant holders who exercised by March 16, 1965.
– The four remaining Plastics directors would transfer their United stock to
the three departing directors in exchange for their Plastics stock, so each
group would be in control.
• Feb. 24, 1965, Plastics gave notice to its warrant holders of its
plans and of the March 16 deadline for exercise.
• Plaintiffs didn’t attempt to exercise until Dec. 1965 (assumed to
be within the 5-year life of the warrants).
• When they exercised, Plaintiffs demanded a portion of the
United stock as if they had been shareholders at the time of the
distribution of the United Stock.
Plastic’s Dividend Antidilution Language 8-105
• 3(b). In case the Company shall declare a dividend upon the capital
stock payable otherwise than out of earnings or surplus (other
than paid-in surplus) or otherwise than in capital stock, the purchase
price per share in effect immediately prior to the declaration of such
dividend shall be reduced by an amount equal, in the case of a
dividend in cash, to the amount thereof payable per share of the
capital stock or, in the case of any other dividend, to the fair
value thereof per share of the capital stock as determined by the
Board of Directors of the Company. For the purposes of the
foregoing a dividend other than in cash shall be considered payable
out of earnings or surplus (other than paid-in surplus) only to the
extent that such earnings or surplus are charged an amount equal to
the fair value of such dividend as determined by the Board of
Directors of the Company. Such reductions shall take effect as of the
date on which a record is taken for the purpose of such dividend, or,
if a record is not taken, the date as of which the holders of capital
stock of record entitled to such dividend are to be determined.
Plastics’ Reorganization Language
8-106
• 3(c). If any capital reorganization or reclassification of the capital
stock of the Company, or consolidation or merger of the Company
with another corporation, or the sale of all or substantially all of its
assets to another corporation shall be effected, then, as a condition of
such reorganization, reclassification, consolidation, merger or sale, lawful
and adequate provision shall be made whereby the holder hereof shall
thereafter have the right to purchase and receive upon the basis and
upon the terms and conditions specified in this Warrant and in lieu of
the shares of the capital stock of the Company immediately
theretofore purchasable and receivable upon the exercise of the rights
represented hereby, such shares of stock, securities or assets as
may be issued or payable with respect to or in exchange for a
number of outstanding shares of such capital stock equal to the
number of shares of such capital stock immediately theretofore
purchasable and receivable upon the exercise of the rights represented
hereby had such reorganization, reclassification, consolidation, merger
or sale not taken place, and in any such case appropriate provision shall
be made with respect to the rights and interests of the holder of this
Warrant to the end that the provisions hereof (including without limitation
provisions for adjustment of the purchase price per share and of the
number of shares purchasable upon the exercise of this Warrant) shall
thereafter be applicable, as nearly as may be in relation to any shares of
stock, securities or assets thereafter deliverable upon the exercise
hereof.
Section 3(c), Continued
8-107
• 3(c). "* * * The Company shall not effect any such
consolidation, merger or sale, unless prior to or
simultaneously with the consummation thereof the successor
corporation (if other than the Company) resulting from such
consolidation or merger or the corporation purchasing such
assets shall assume by written instrument executed and mailed
or delivered to the holder hereof at the last address of such
holder appearing on the books of the Company, the obligation
to deliver to such holder such shares of stock, securities
or assets as, in accordance with the foregoing provisions,
such holder may be entitled to purchase."
Stephenson v. Plastics Corporation of America
8-108
• Was the distribution a dividend not charged to net
earnings or earned surplus, so that plaintiffs’ only
protection was a price adjustment on the warrant
exercise price?
• It’s premature to conclude this was a dividend in
reality.
• The principal purpose of the transaction was to divide
the corporation between two groups.
• But for the understanding that there would be a stock
swap, this spin-off never would have occurred.
• While a spin-off can be a dividend, in this case that
determination requires extrinsic evidence.
Stephenson v. Plastics Corporation of America
8-109
• If the transaction didn’t represent a dividend, was
it a “capital reorganization” or a sale of
substantially all assets that required Plastics to
reserve a sufficient number of United shares for
distribution to them on exercise of the warrants?
Stephenson v. Plastics Corporation of America
8-110
• Paragraph 3(c) requires the company to reserve a pro
rata share of securities obtained in a capital
reorganization so the warrant holders can obtain them
upon exercise.
• This resembles a “capital reorganization” because after
the transaction each Plastics shareholder now held
stock in two corporations.
• This is confirmed by the treatment of this transaction as
a “reorganization” in the Internal Revenue Code.
• The court rejects United’s argument the plaintiffs are
only entitled to receive its securities “in lieu of” Plastic’s
shares, which shows that the capital reorganization
provision only contemplates a completely new corp.
Stephenson v. Plastics Corporation of America
8-111
• The court says it may mean that the warrant holder is
entitled to United shares “in lieu merely of more stock
of the old corporation”....
• This makes sense if a sale of only “substantially all”
rather than “all” assets had been made, since there
would still be Plastics shares representing its remaining
assets.
• The court rejects United’s argument that this
reservation of stock is only required by a “successor
corporation” in a merger or complete asset sale.
• The court concludes that this doesn’t exclude a “capital
reorganization” that results in the birth of a new
corporation.
Stephenson v. Plastics Corporation of America
8-112
• (Presumably this means that there are several kinds of
“capital reorganization”).
• The court also suggests that this might be a sale of
substantially all assets.
Wood v. Coastal States Gas Corporation
8-113
• Coastal owned Producing, which owned Lo-Vaca.
• Lo-Vaca had contracts to supply gas at 20¢ when the
market price rose to $2.00.
• Lo-Vaca got temporary relief from Texas regulators,
who later reversed & ordered a $1.6 billion refund,
which would have bankrupted Coastal.
Coastal’s Settlement
8-114
• Customers brought breach of contract action and agreed to the
following settlement:
• 5.3% of Coastal’s stock and 13.4% of Valero’s stock would be
transferred to a trust for the benefit of customers, along with
notes and preferred stock of Valero;
• Coastal would issue $80 million of its preferred stock to Valero;
• Coastal committed to spend up to $495 million to develop gas
reserves for Lo-Vaca, and to make them available at
discounted prices;
• Coastal would spin off (dividend) the remaining 86.6% of its
Valero stock to its own stockholders, excluding the codefendant, Oscar Wyatt.
Coastal’s Settlement
8-115
1. Is this spin-off prohibited by the recapitalization
provisions of section (c)(5) of Coastal’s certificate?
No.
2. Is the spin-off covered by the adjustment provisions of
section (c)(7)? No.
•
§(c)(5) of Coastal’s Certificate
•
•
8-116
"In the event that the Corporation shall be recapitalized,
[consolidated with or merged into any other corporation or shall
sell or convey to any other corporation all or substantially all of
its property as an entirety], provision shall be made as part of
the terms of such recapitalization, . . . so that any holder of . . .
Preferred Stock may thereafter receive in lieu of the Common
Stock otherwise issuable to him upon conversion of his . . .
Preferred Stock, but at the conversion ratio stated in this Article
. . . which would otherwise be applicable at the time of
conversion, the same kind and amount of securities or assets
as may be distributable upon such recapitalization, . . with
respect to the Common Stock of the Corporation."
§(c)(5) of Coastal’s Certificate
8-117
• The Vice Chancellor held that “recapitalization” has no
generally accepted meaning.
• He held that the phrase “in lieu of” means that this section
applies when Coastal’s common stock ceases to exist.
• The court treats this as anti-destruction language to protect the
conversion right.
• While the contemplated changes involve a “reshuffling of the
capital structure,” which meets one definition, it doesn’t fit the
contract terms.
• Under (c)(5), after a “recapitalization,” the preferred shareholder
on conversion may receive not common stock, which isn’t
available, but that which the common stockholders received per
share in the recapitalization.
§(c)(7) of Coastal’s Certificate
8-118
• "No adjustment of the conversion ratio shall be made by reason
of any declaration or payment to the holders of the Common
Stock of the Corporation of a dividend or distribution payable in
any property or securities other than Common Stock, any
redemption of the Common Stock, any issuance of any
securities convertible into Common Stock, or for any other
reason, except as expressly provided herein."
§(c)(7) of Coastal’s Certificate
8-119
• This provides that no adjustment in the exchange ratio shall be
made for dividends in other than common stock.
• Plaintiffs contend that somehow the last phrase, “or for any
other reason, except as expressly provided herein,” means that
section (c)(7) doesn’t apply here.
• The court holds that the language only applies to those other
provisions that expressly provide for changes in the conversion
ratio – sections (c)(4) and (c)(6).
• Section (c)(7) states that no adjustment shall be made for
dividends in property other than Coastal common.
• Held: The distribution isn’t prohibited by section (c)(7)
without adjusting the conversion ratio, and isn’t a
recapitalization under (c)(5).
Coastal Questions
8-120
• In footnote 7 the court distinguishes the
Stephenson case by saying that because of
language differences it (and other cases) is of little
help. Can you determine what language
differences might be critical to the court’s
decision?
• Plastics’ dividend was also of a subsidiary, so they’re
similar in that respect.
Comparing Plastics & Coastal’Clauses
8-121
• Plastics: “In case the Company shall declare a dividend upon the capital
stock payable otherwise than out of earnings or surplus (other than paid-in
surplus) or otherwise than in capital stock, ...”
• Coastal: “No adjustment of the conversion ratio shall be made by reason of
any declaration or payment to the holders of the Common Stock of the
Corporation of a dividend or distribution payable in any property or securities
other than Common Stock”
Comparing Plastics & Coastal’Clauses
8-122
• Plastics: If any capital reorganization or reclassification of the capital stock of the
•
Company, or consolidation or merger of the Company with another
corporation, or the sale of all or substantially all of its assets to another
corporation shall be effected, then, . . . lawful and adequate provision shall be
made whereby the holder hereof shall thereafter have the right to purchase . . .
in lieu of the shares of the capital stock of the Company immediately theretofore
purchasable and receivable upon the exercise of the rights represented hereby, such
shares of stock, securities or assets as may be issued or payable with respect to or
in exchange for a number of outstanding shares of such capital stock equal to the
number of shares of such capital stock immediately theretofore purchasable and
receivable upon the exercise of the rights . . . .
Coastal: "In the event that the Corporation shall be recapitalized, [consolidated
with or merged into any other corporation or shall sell or convey to any other
corporation all or substantially all of its property as an entirety], provision shall
be made as part of the terms of such recapitalization, . . . so that any holder of .
. . Preferred Stock may thereafter receive in lieu of the Common Stock
otherwise issuable to him upon conversion of his . . . Preferred Stock, but at the
conversion ratio stated in this Article . . . which would otherwise be applicable at the
time of conversion, the same kind and amount of securities or assets as may be
distributable upon such recapitalization, . . with respect to the Common Stock of the
Corporation."
Coastal Questions
8-123
• 2. Does the language governing the preferred’s
conversion rights represent a drafting error?
• It appears to be. The dividend language was too
narrowly drawn to cover all extraordinary dividends
that significantly diminish the value of the common.
Coastal Questions
8-124
3. Why does section (c)(5) cover sales of all or
substantially all of Coastal’s property (for which
Coastal would presumably receive equivalent
value), but not a dividend of stock of a
subsidiary, for which Coastal receives nothing?
What is the effect of section (c)(7)?
• Section (c)(5) covers events where Coastal’s common
might disappear, such as a sale of all assets.
• Section (c)(7) is quite explicit – there are no exchange
ratio adjustments for much other than a common stock
dividend, which has the same effect as a stock split.
• Section (c)(7) left Coastal free to make a lot of
distributions to shareholders without adjustment.
Coastal Questions
8-125
4. If you were drafting to protect the preferred
stockholders, what kind of protective language
would you suggest? Would paragraph 3(b) in the
warrants of Plastics Corporation of America
(footnote 3 in the Stephenson case, supra) have
solved the problem?
• It would have solved the problem for Coastal’s
convertible preferred, provided the spin-off dividend
was payable out of surplus or earnings.
• Footnote 7 (page 625) states that Coastal had a
substantial earned surplus to which this distribution
was to be charged.
Coastal Questions
8-126
5. These provisions, as interpreted by the court,
provide a large hole in the protection of the
preferred’s conversion rights. Why would
holders of preferred accept such provisions?
• This kind of spin-off was probably a pretty
extraordinary event for a regulated utility.
• It was only the looming threat of bankruptcy for
Coastal that led to this arrangement, by which Coastal
shifted substantial assets to other hands.
• But it’s the kind of event that could have been covered
by the type of language found in Plastics Corporation’s
warrants, and now the preferred holders have to
wonder why it wasn’t included.
Cofman v. Acton Corporation
•
8-127
As part of a settlement agreement with 12 partnerships, Acton
agreed to the following:
The Acton Agreement
8-128
The Partnership shall be entitled to receive, upon written
demand made within the three years following the execution of
the Settlement Agreement (the "Exercise Date"), the following
one time payment: the sum of "X" times a multiple of 7,500
where "X" equals the "price" of one share of Acton
Corporation's common stock on the Exercise Date less $7.00.
The "price" on the Exercise Date shall be equal to the average
closing price of one share of the common stock of Acton
Corporation on the American Stock Exchange for any period,
selected by the Partnership, consisting of thirty (30)
consecutive trading days prior to the Exercise Date. Acton
CATV shall make such payment as necessary within 30 days
after receipt of the written demand. The Partnership's rights
hereunder shall expire three years after the date of this
Agreement and shall not be assignable.
Cofman v. Acton Corporation
8-129
• This was a long shot, because the stock was trading at $1.50 to
$3.12 at the time.
• Acton then engaged in a five for one reverse stock split.
• Acton notified the Partnerships of the split, and informed the
Partnerships that the clause had been adjusted so that the
formula would be market price minus $35.00.
• Partnerships insist the formula is unchanged, so when the
market price was $20.54, you subtracted $7.00.
• Result would be claimed payments of $1,218,600 owed by
Acton.
Cofman v. Acton Corporation 8-130
• The plaintiffs argue that this agreement should be enforced
literally, with no adjustment for the reverse split.
• Even a complete expression may be ambiguous if the parties
didn’t consider something.
• If Acton had wished to escape its obligation, it could have just
split its stock to assure its price didn’t rise above $7.00, thus
destroying the value of the settlement.
• “It defies common sense” that either party could have meant
this.
• Adding an antidilution clause “is a necessity, or ‘essential to a
determination.’”
• Dismissal affirmed.
Cofman v. Acton Corporation
8-131
1. How does the court in Coffman v. Acton
Corporation distinguish its case from the
previous decisions involving conversion
rights?
• It doesn’t. It decides this case as if it stands
alone.
Cofman v. Acton Corporation
8-132
1. How does the court in Coffman v. Acton
Corporation distinguish its case from the
previous decisions involving conversion
rights?
• It doesn’t. It decides this case as if it stands
alone.
• The distinction that could have been used, if the
court had chosen, is that this was a negotiated
settlement between relatively unsophisticated
(at least in this context) parties.
Cofman v. Acton Corporation
8-133
2. How does Judge Winter’s reasoning in
Sharon Steel Corporation v. Chase
Manhattan Bank, 691 F.2d 1039 (2d Cir.
1982) in Chapter 6 about interpreting
indentures apply here?
Sharon Steel Corporation v. Chase
8-134
• “Boiler plate provisions are thus not the
consequence of the relationship of particular
borrowers and lenders and do not depend upon
particularized intentions of the parties to an
indenture. There are no adjudicative facts
relating to the parties to the litigation for a jury
to find and the meaning of boiler plate provision
is, therefore, a matter of law rather than fact.
• “Moreover, uniformity in interpretation is
important to the efficiency of capital markets.”
Cofman v. Acton Corporation
8-135
Distinguish it by:
• This agreement wasn’t the same kind of
boilerplate, drawn from the ABF Commentaries.
• Not a capital markets transaction
Cofman v. Acton Corporation
8-136
3. If you were drafting on behalf of Acton,
what kind of adjustment clause would you
want to include in these agreements?
Antidilution Clause
8-137
• (a)
(i)
In the event that, at any time . . . the Company shall:
•
(A)
declare or pay a dividend on the Common Stock payable in
shares of Common Stock,
•
(B)
subdivide the outstanding shares of Common Stock,
•
(C)
combine the outstanding shares of Common Stock into a smaller
number of shares of Common Stock,
•
(D)
issue any shares of its capital stock in a reclassification of its
Common Stock (including any such reclassification in connection with a
consolidation or merger in which the Company is the continuing or surviving
corporation), . . . .
• Then . . . the number of shares of Common Stock and the number and kind
of other securities or property, as the case may be, issuable upon the
exercise of a Right . . . shall be proportionately adjusted so that the holder
of any Right . . . shall be entitled to receive, . . . the aggregate number of
shares of Common Stock . . . that, if such Right had been exercised
immediately prior to such date . . . such holder would have owned upon
such exercise . . . .
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-138
• Plaintiffs hold warrants to purchase Telecom Common
Stock
• ART acquired Telecom through a reverse triangular
merger, in which ART’s acquisition sub merged with
Telecom, but Telecom survived.
• All the Telecom shares were exchanged for ART
shares.
• ART acknowledges that the antidestruction language
of §6 of the Warrant entitles the warrant holders to
exercise in ART stock.
• Subsequently ART entered into dilutive transactions.
Triangular Mergers
• Bidder
Merger Consideration
8-139
Target s/h
•
Owns
own
•
100%
100%
• Acquisition Sub
•
•
•
•
Merges into
Target
Cancel shares in target & shares in Acq. Sub remain out.
Votes for merger:
(1) Board and shareholder of Acquisition Sub
(2) Board and shareholders of Target
Telecom’s Warrant Provisions
8-140
• As used herein the following terms, unless the context
otherwise requires, have the following respective meanings:
•
(a) The term "Company" includes any corporation which
shall succeed to or assume the obligations of the Company
[Telecom] hereunder.
• §7: Where the Company shall issue or sell shares of its
Common Stock after the Original Issue Date without
consideration or for a consideration per share less than the
Purchase Price in effect pursuant to the terms of this Warrant at
the time of the issuance or sale of such additional shares . . .
then the Purchase Price in effect hereunder shall
simultaneously with such issuance or sale be reduced to a price
determined by [a formula specified in the Warrant].
§6 of the Telecom Warrants
8-141
• In case the Company after the Original Issue Date shall (a) effect a
reorganization, (b) consolidate with or merge into any other person,
or (c) transfer all or substantially all of its properties or assets to any
other person under any plan or arrangement contemplating the
dissolution of the Company, then, in each such case, the holder of
this Warrant, upon the exercise hereof as provided in Section 3 at
any time after the consummation of such reorganization,
consolidation or merger or the effective date of such dissolution, as
the case may be, shall be entitled to receive (and the Company shall
be entitled to deliver), in lieu of the Common Stock (or Other
Securities) issuable upon such exercise prior to such consummation
or such effective date, the stock and other securities and property
(including cash) to which such holder would have been entitled upon
such consummation or in connection with such dissolution as the
case may be, if such holder had so exercised this Warrant
immediately prior thereto, all subject to further adjustment
thereafter as provided in Sections 5 and 7 hereof.
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-142
• Did ART Succeed to or Assume Telecom’s
Warrant Obligations? No.
• Does “the Context Otherwise Require” That
ART Be Deemed “the Company for Purposes of
Section 7 of the Warrant?” Yes.
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-143
1. How does the court determine that ART,
which was not one of the merging
corporations, “succeed[s] to or assume[s]
the obligations of the Company [Telecom]”
under the merger agreement?
• It doesn’t, technically. Telecom continues to
exist.
• Instead Vice Chancellor Jacobs finds that ART
is “the Company” under the warrant agreement.
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-144
2. Section 6 provides antidestruction
provisions so that Telecom warrant holders
will be entitled to exercise in the same
stock they would have received had they
exercised their rights prior to the merger.
What does the word “thereafter” in section
6 cover?
• About the only thing it could cover would be
transactions after the merger, and after the
warrant holders are entitled to receive ART
stock rather than Telecom stock.
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-145
3. Section 7 provides antidilution protection
where “the Company” issues or sells its
shares at a price below the “Purchase
Price” (which is surely a defined term).
How could this apply to ART after the
merger of its subsidiary with Telecom?
CL Investments, L.P. v. Advanced Radio Telecom Corp
8-146
• It doesn’t apply literally, because “the
Company” either meant Telecom or any
company that succeeds to or assumes its
obligations.
• Instead Vice Chancellor Jacobs holds that as a
matter of interpretation, to give the anti-dilution
language meaning, he must deem ART to be
“the Company.”
Last Period Financing and Down Rounds
8-
147
• Late 1990’s many technology companies went
public but then market collapsed and they could
not get further public financing.
The NASDAQ Index
•
•
•
•
•
•
•
•
•
•
•
•
•
•
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
•
NASDAQ
1998
1999
2000
2001
2002
8-148
2003
2004
PIPEs became Popular
8-149
• These investments involved convertible securities.
• The conversion rights were full ratchets, based on the market
price of the stock.
• The conversion price was initially set at a discount from the
trading price, typically around 85% of the market price.
• But the conversion price would drop to the lowest market price
the stock attained.
• The markets for these stocks were typically thin - small cap
companies with no analysts following many of them, and little
daily trading.
• This meant that substantial selling pressure could rapidly
depress the stock’s price.
PIPEs became Popular
8-150
• The allegations in some of the cases involved the following
scenario:
• First, the prospective investors would test the market by selling
short to see how rapidly they could drive the price down.
• The prospective investors would then offer the company a
package:
– An initial small investment of a few million dollars in a
convertible preferred, and a subsequent more substantial
investment in the common stock if it remained above a
target price.
– After buying the convertible preferred, the investors would
then sell the common stock short.
– This dropped the conversion price.
• The more short selling they did, the lower the common stock
price went.
PIPEs became Popular
8-151
• And the lower the conversion price, the larger the number of
shares obtained.
• When the investors elected to convert, they could “cover” their
short sales at a very low cost.
• And at the same time they might own a majority of the stock in
the company.
• The second-stage obligation would not be honored because the
condition of a high stock price would not be met.
GFL Advantage Fund, Ltd. v. Colkitt
8-152
• Case involves the typical scenario.
• It illustrates the difficulties plaintiffs currently face in
litigation in this area.
• Rule 10b-5 violation? Probably not.
– There is no creation of a false appearance of
market activity when short sales occur.
– Short sales don’t “artificially” depress share prices they’re real transactions.
– Short sales are generally lawful - See ‘34 Act,
§10(a)(1), which makes it unlawful to make a short
sale in contravention of SEC rules.
GFL Advantage Fund, Ltd. v. Colkitt
8-153
– Rule 10a-1 simply prohibits short sales below the
price of the last sale, or even at the last sale price,
unless that price was higher than the previous sale
(a “plus tick”).
• In response to criticisms that short selling had become
abusive, the SEC adopted new Regulation SHO, 17
C.F.R. 242.200 et seq., in 2004.
– Its principal function is to assure that brokers
actually borrow shares to lend to customers who
engage in short sales.
– (There had been charges that aggressive short
positions weren’t always covered by borrowed
securities.)
GFL Advantage Fund, Ltd. v. Colkitt
8-154
2. If you represented a company seeking financing
under these circumstances, what covenants
would you want from the investor about resales
of converted securities? Keep in mind that
restricting resales (and thus the lender’s
liquidity) reduces the attractiveness of the
conversion feature, and thus may raise the price
demanded by the investor, either in the form of a
higher dividend rate on the preferred stock or a
greater discount on the shares upon conversion.
GFL Advantage Fund, Ltd. v. Colkitt
8-155
• If the securities are unregistered, you are subject to
the “dribble” rules of ‘33 Act Rule 144 (one-year
holding period, plus quarterly sales of no more than
average weekly trading volume or 1% of the
outstanding shares). If the investor has a large
enough stake to be deemed an “affiliate” (to be in
control), then these rules continue indefinitely. This
imposes a large discount on the price.
• If the issuer gives a covenant to register the converted
shares for resale, which is customary, you’re freeing
up the shares for use to cover short sales.
• It would really take a covenant not to engage in short
sales to protect the issuer. These were often hedge
GFL Advantage Fund, Ltd. v. Colkitt
8-156
3. If you represented such a corporation, what other
kinds of representations and/or covenants would
you want from the prospective investor?
• If the original offering is a private placement, then the
buyer must give the investment representations
required, typically, to comply with Regulation D, Rule
502(d) – representations of investment intent, the
issuer’s written disclosure to the buyer of the limits on
resale, and placement of a restrictive legend on the
securities.
• But if the issuer has also given a covenant to register
the common stock on conversion, the buyer becomes
free to sell or use the shares to cover short positions.
GFL Advantage Fund, Ltd. v. Colkitt
8-157
5. Are facts alleged in Internet Law Library, Inc.,
supra, that would distinguish it from the holding
in the Colkitt case?
• The Internet Law Library case contains allegations
that the investors represented that they wouldn’t
engage in short-selling, which could create a 10b-5
violation if these representations were in connection
with negotiating the sale of the convertible preferred.
GFL Advantage Fund, Ltd. v. Colkitt
8-158
7. If one were obtaining covenants against shortselling, obviously an absolute prohibition of short
sales by the investors would be the best
protection. But would it protect against options
transactions that might have the same effect?
Recall our discussion of put-call parity in Part 2.C
of this Chapter. What transactions could duplicate
a short sale that should also be prohibited?
Summary of Option Outcomes at Expiration 8-159
•
• Value of Underlying Stock
Winners
Losers
• High (relative to exercise price)
•
Call Holder
Put Writer
Call Writer
Put Holder
• Low (relative to exercise price)
•
Call Writer
Put Holder
Call Holder
Put Writer