8 -1 Chapter 8 Options and Convertible

8 -1 • Chapter 8 Options and Convertible Securities

Definitions 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 8 -4 • Value of Long position • $150 • $100 • $50 • 45 degrees • 0 • $50 $100 $150 Stock Prince

Value of a Short Position 8 -5 • Value of Short Position $0 $50 $100 $150 Stock Price • 45 degrees • - $50 • -$100 • - $150

Table 8 -1 Quotations on Options on IBM Stock 8 -6 • • Option / Strike – 50 -Call -Put. Exp Vol Last IBM Oct 68 13. 40 1505 0. 15 63. 92 – 50 Nov – 55 Oct 1061 – 55 54 13. 60 1925 0. 85 63. 92 8. 90 5883 0. 40 63. 92 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

Fig. 8 -3 Value of European Call Option @ $100 8 -7 • Value of • Call • $150 • $100 • $50 • $0 $50 $100 $150 Stock Price

Fig. 8 -4 Value of Position of Call Writer at Expiration 8 -8 • • Value of Position $50 $100 $150 $200 stock price $0 • • -50 • -$150 • -$200

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. 1 810 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 8 -11 • Option: • Stock @ $100 Stock @ $0 Stock @$200 • 2 Call Options at $100 $0 (Strike price= $0 +$200 • Market Price) • Short seller’s position $0 (purchase price + $200 (covers at $0 -$200 = Sale price) keeps sale price) • 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 8 -13 • Strategies on Expiration Date of European Call Option @ $100____ • Stock Price Rises to $110 Stock Price Falls to $90_______ • • • Keep loan proceeds $100 Excercise call option ($100) Value of stock purchased $110 Less loan to be repaid ($100) Total: $10 Repay loan Let call option expire $ 0

Diagram of Quick Check Question 8. 2 8 -14 • • • • 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

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 Stock. Based 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 $1. 05 – November for $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. 2 d 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 Value of European Option • $0 $50 $100 $150 Stock Price

Table 8 -2 Expected Values of Stock 8 -28 • Value . Expected Value . • Stock A Stock B x Probability = Stock A Stock B • • • $90 $110 Totals: $70 $130 0. 5 $45 $55 ____ $100 $35 $65 $100

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 $110 $130 Stock Price • Exercise Price

Binomial Option Valuation Model 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 8 -31 • • • 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 % of Total Underlying Options Exercise Options Granted to or Base Granted (2) Employees Price Expiration FY 2002 ($/sh) Date 5%($) 10%($) • • • Name James F. Mc. Donald 400, 000 8. 8 $22. 10 2/16/2012 $5, 559, 429 $14, 088, 683 125, 000 2. 8 $22. 10 2/16/2012 1, 737, 321 4, 402, 714 H. Allen Ecker 50, 000 1. 1 $22. 10 2/16/2012 694, 929 1, 761, 085 20, 000 0. 4 $22. 10 2/16/2012 277, 971 704, 434 Conrad J. Wredberg, Jr. 75, 000 1. 7 $22. 65 12/19/2011 1, 068, 335 2, 707, 370 40, 000 0. 9 $22. 10 2/16/2012 555, 943 1, 408, 868 Dwight B. Duke 57, 000 1. 3 $22. 10 2/16/2012 792, 219 2, 007, 637 20, 000 0. 4 $22. 10 2/16/2012 277, 971 704, 434 Robert C. Mc. Intyre 40, 000 0. 9 $22. 10 2/16/2012 555, 943 1, 408, 868 15, 000 0. 3 $22. 10 2/16/2012 208, 479 528, 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 123 R 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 123 R, according to OEA. • * * * • “OEA cited evidence that the modified Black-Scholes. Merton 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 • • Name * * * Jerome Swartz 120, 000 3. 88% $38. 67 2/17/09 $62. 98 $2, 918, 074 $100. 29 $7, 394, 971 195, 000 6. 31% $35. 54 2/17/09 $57. 89 $4, 358, 637 $92. 19 $11, 045, 641 CEO’s Gain as % of All Shareholders Gain . 407% • 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 .

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) 8 -39 • 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: • • OPTION/SAR GRANTS IN LAST FISCAL YEAR • [Individual Grants] Name Number of Percent of total options/ Exercise or base Expiration date securities SARs granted to price ($/Sh) employees underlying in fiscal year options/SARS granted (#) (a) (b) (c) (d) (e) • OPTION/SAR GRANTS IN LAST FISCAL YEAR • • Name Potential realizable value at Alternative to assumed annual rates of stock (f) and (g): price appreciation for option grant date term value 5% ( $ ) 10% ( $ ) Grant date presentvalue $ (a) (f) (g) (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. 2 d 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 8 -51 • What happened to the board’s duty to shareholders here?

John Parkinson v. West End Street Railway Company 8 -52 • 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.

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 10 c 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 1970 s and 1980 s, and had expanded rapidly. • The expansion was financed with large amounts of borrowing. • In the late 1980 s 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 1990 s 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 8 -65 • Assets: • Liabilities: • • Long term debt Other debt • • Preferred Common stock $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 8 -66 • Sales $1. 209 billion – Expenses before interest & corporate expenses: $152 million – Interest expense 196 million – Corporate expenses 46 million – Net Loss (44 million)

International’s Pro Forma Balance Sheet 8 -67 • Assets: $3. 048 billion • Liabilities: – Short-term debt (necessary to make this balance) (1. 771 billion) • Long-term debt (902 million) • Shareholders’ equity 375 million

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 4 th, 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 • And plaintiffs had hedged away all the gains from the common.

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 8 -88 • • • Assume: Market price: Conversion price: Value of assets distributed: Formula is: $25. 00 $17. 40 $15. 00 • ($17. 40) ($25. 00 - $15. 00) = (17. 40) ($10. 00) = ($17. 40) (. 40) = $6. 96 $25. 00 • 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 and $368, 000, with the lower end below the conversion value of $196, 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, and a weighted (expected) value above $196, 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 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 8101 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 8102 Shares outstanding: 1, 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 shares) Weighted Average: $1. 00 (1, 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 Common sold in Down Round Price per Share Paid in Down Round # Shs. Common issuable upon conversion of Pfd. Before After Down Down Round 1, 000 250, 000 1 $. 01 250, 000 25, 000 Weighted 1, 000 Average 250, 000 1 $. 01 250, 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 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 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 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. 2 d 1039 (2 d 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 8 -139 • Bidder Merger Consideration Target s/h • Owns own • 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 8147 • Late 1990’s many technology companies went public but then market collapsed and they could not get further public financing.

The NASDAQ Index 8 -148 • • • • 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% NASDAQ 1998 1999 2000 2001 2002 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 10 b-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 10 a-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 10 b-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 • High (relative to exercise price) • Call Holder Call Writer Put Holder • Low (relative to exercise price) • Call Writer Call Holder Put Holder Put Writer Losers