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Lillis v. AT&T Corp., C.A. No. 717-VCL (Del. Ch, July 21, 2008 (V.C. Lamb)

July 21, 2008

This decision followed a remand by the Delaware Supreme Court of an earlier Court of Chancery decision. In the Court of Chancery’s earlier opinion, which followed a trial, it held that certain options granted to former officers and directors of a telecommunications company were improperly adjusted in connection with a cash merger in 2004. The cash consideration that was received in the merger by the option holders, which they later challenged under the option plan, equaled the “intrinsic value” of the options (i.e., the cash merger price minus the applicable strike price) as opposed to the full “economic value” of the options (i.e., intrinsic value plus time value). Plaintiffs’ challenge to receiving only intrinsic value in the 2004 merger was based upon a provision of the option plan requiring that an option holder’s options be adjusted at the time of a merger and that the holder’s “economic position” would not be any worse after the merger than immediately before it as a result of the adjustment. In its prior opinion, the Court of Chancery held the phrase “economic position” to be ambiguous and, relying on extrinsic evidence, interpreted the phrase to require the preservation of the “full economic value” of each holder’s options in the merger. The extrinsic evidence that the Court relied upon in reaching this conclusion was (i) a course of conduct demonstrating that other adjustments in prior transactions had preserved the full economic value of the plaintiffs’ options, (ii) the fact that stock options constituted an exceptionally large percentage of the plaintiffs’ compensation, and (iii) several admissions by the defendant at the initial stages of the litigation that the provision of the option plan at issue preserved the the full economic value of the options at issue. The Court indicated clearly that it relied most heavily on the defendant’s admissions in reaching its original conclusion.

On appeal, the Delaware Supreme Court agreed with the Court of Chancery’s decision that the term “economic position” was ambiguous. The Supreme Court, however, disagreed with the Court of Chancery’s reliance upon certain extrinsic evidence and failure to consider other extrinsic evidence and remanded the case for reconsideration pursuant to its instructions. Specifically, the Supreme Court instructed the Court of Chancery (i) not to give any evidentiary weight to defendant’s admissions since those admissions did not relate to the interpretation of the option plan, and (ii) to address the significance of (a) the distinction between a stock merger and a cash merger, and (b) cash/stock election provisions in a transaction completed by the defendant prior to the 2004 merger.

On remand, the Court of Chancery reached a different result than its original opinion, concluding that the option plan at issue should be construed to permit the adjustment of the options in a cash merger into the right to receive only the amount of cash paid for the underlying stock (i.e., intrinsic value). The Court attributed the different result almost entirely to the fact that it could not, pursuant to the Supreme Court’s instruction, consider the defendant’s admissions regarding economic value, which the Court stated was “by far the most compelling support for the plaintiffs’ position.” As for the Supreme Court’s instruction relating to consideration of extrinsic evidence of the parties’ course of conduct, the Court first considered the significance of the distinction between stock mergers and cash mergers. In its consideration of this distinction, the Court commented that stock mergers by their nature preserve the “economic position” of option holders because the underlying stock is replaced, thus incorporating the expected time value of the new options. Since this preservation occurs automatically in stock transactions, the Court recognized that it could not rely upon prior stock transactions as evidence of a course of conduct of preserving “economic position” of options pursuant to the plan. With respect to the significance of a cash/stock election option in a prior transaction, the Court held that while it did provide some support for the plaintiffs’ position that this transaction was structured to preserve the time value of their options, the Court concluded that such extrinsic evidence was insufficient to overcome the interpretation of the option plan in accordance with the prevailing rule of interpreting anti-destruction provisions which is “to tie the interests of option holders to the interests of the securities into which they are exercisable.” In sum, the Court held that without the ability to rely on the defendant’s prior admissions, the remaining extrinsic evidence was insufficient to support plaintiff’s interpretation of the option plan as requiring preservation of the full economic value of the options.

The full opinion is available here