Options and Convertible Securities

1
8-1

• Chapter 8
• Options and Convertible Securities

2
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.

3
Real Options
8-3

• The ability to alter a project during
  construction or development.
• The ability to breach a contract and pay damages.
• A debtors ability to default and sell assets to
  creditors.
• A debtors 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).

4
Value of Long Position
8-4

• Value of Long
  
  position
• 150
• 100
• 50
• 45 degrees
• 0
• 50 100
  150 Stock Prince

5
Value of a Short Position
8-5

• Value of Short
  
  Position 0 50 100 150
  Stock Price
• 45 degrees
• - 50
• -100
• - 150

6
Table 8-1 Quotations on Options on IBM Stock
8-6

• -Call- -Put-
• Option / Strike Exp Vol Last
  Vol Last IBM
• 50 Oct 68 13.40 1505 0.15
  63.92
• 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
• 70 Jan 2233 3.60 199
  10 63.92

7
Fig. 8-3 Value of European Call Option _at_ 100
8-7

• Value of
• Call
• 150
• 100
• 50
• 0 50
  100 150 Stock Price

8
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

9
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

10
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?

11
Quick Check Question 8.1 8-11

• Option Stock Stock Stock
• _at_ 100 _at_ 0 _at_200
• 2 Call Options at 100 0 (Strike
  price 0 200
• 
  Market Price)
• Short sellers position 0 (purchase price
  200 (covers at 0 -200
  Sale price) keeps sale
  price)
• Minus
• 1 put writers position 0 ( option
  price) - 100 0(OP)
• Net 0 100 0
• Compare with Put Holder 0 (loses option price)
  100 (sells _at_ 100)

12
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?

13
Quick Check Question 8.2
8-13

• Strategies on Expiration Date of European
  Call Option _at_ 100________
  
• Stock Price Rises to 110
  Stock Price Falls to 90_______
  
• Keep loan proceeds 100 Repay loan
  0
• Excercise call option (100) Let call
  option expire 0
• Value of stock purchased 110
• Less loan to be repaid (100)
• Total 10 0

14
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

15
What are main uses of options? 8-15

• 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 companys outcomes.
• Stock payments to executives have to be accounted
  for as an expense, at the value of the stock.
• This reduces earnings.

16
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.

17
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.

18
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 youre worried that
  it may decline.

19
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, youll 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.

20
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.

21
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 doesnt 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.

22
Hedging 8-22

• Do directors have to care about hedging?

23
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).
•  

24
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?

25
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 theres 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?

26
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.

27
Fig. 8-10 Value of American Call Option _at_ 100
8-27

• Value of
• Call
• 150
• 100
• 50
• Value of
  American Value of
  European
  Option Option
• 0 50
  100 150 Stock Price

28
Table 8-2 Expected Values of Stock
8-28

• Value .
  Expected Value
  .
• Stock A Stock B x Probability Stock
  A Stock B
• 90 0.5 45
• 110 0.5 55
• 70 0.5 35
• 130 0.5 ____ 65
• Totals 100 100

29
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

30
Binomial Option Valuation Model 8-30

• Assumptions Current stock price
  100
• 1-year European call option _at_
  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 _at_ 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.

31
Scientific Atlantas Option Disclosures
8-31

• Stock Options
• The following tables set forth certain
  information in the prescribed formats with
  respect to options granted under
  Scientific-Atlantas 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
  Individual
  Grants  Appreciation for Option Term (1)
  
  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. McDonald 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
• 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. McIntyre 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

32
8-32

• 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.

33
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-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.

34
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 SECs 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.

35
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.

36
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
• CEOs Gain as
• of All
• Shareholders Gain
  .407 .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.

37
Questions 8-37

1. What is the difference in disclosure requirements
   for stock options under Regulation S-K for
   executive officers and non-employee directors?

38
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.

39
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)

40
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.

41
Questions 8-41

• 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 didnt require any
  showing about values.

42
Questions 8-42

• Symbol was a Delaware corporation. Malone v.
  Brincat, 722 A.2d 5 (Del. 1998), stated that
  the directors of a Delaware corporation are
  required to disclose fully and fairly all
  material information within the boards 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).

43
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.

44
Protecting Options 8-44
45
Protecting Options 8-45
46
Protecting Options 8-46
47
Protecting Options 8-47
48
Protecting Options 8-48
49
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.

50
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
  dont 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 bondholders right is subject to the
  condition that the corporation shall not have
  vanished. - page 577.
• Where a corporation isnt contractually bound to
  preserve its existence for the option holders,
  its free to reorganize in a way that destroys
  the stock.
• The consolidation didnt keep the Highland Street
  Railway so far alive as to impose any duties on
  its successors with respect to the options.

51
John Parkinson v. West End Street Railway Company
8-51

• What happened to the boards duty to shareholders
  here?

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

• What happened to the boards duty to shareholders
  here?
• You are not a shareholder until you convert. The
  only duties to bondholders are in the agreement.
  If the agreement iddnt prvent this merger than
  it is allowed.

53
Simons v. Cogan 8-53

• Knoll issued debentures convertible into common
  stock _at_ 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.

54
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 its still
  just an option, and the holder remains a creditor.

55
Simons v. Cogan 8-55

• 1. Why doesnt 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?

56
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
  cant make sense.
• But if bonds were trading at a very low rate 10c
  on the dollar it might.

57
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

58
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 Knolls 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

59
Simons v. Cogan 8-59

• 4. If you represented Knoll and Cogan, what
  response might you make to plaintiffs 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.

60
Simons v. Cogan 8-60

• Chancellor Allen holds that holders of
  convertible debentures arent 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.

61
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.

62
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
  . . . .

63
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.

64
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,
  wasnt a high quality borrower able to borrow
  more to expand its management and services
  business.
• Marriott couldnt sell the hotels and pay off the
  debts they carried.
• Solution To think of debt as an option to sell
  the company.

65
Debt as a Put Option for Marriott
8-65

• Assets 3.8 billion
• Liabilities
• Long term debt (2.1 billion)
• Other debt (1.0 billion) (this is necessary
  to explain the numbers)
• Preferred (.2 billion)
• Common stock 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

66
Hosts 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)

67
Internationals 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

68
Internationals 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 8.2 billion
• EBIT 368 million

69
Background on Marriott Deal 8-69

• The price of Marriotts 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 familys
  personal gains at 225 million.
• The price of Marriotts 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.

70
Marriotts 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 wont be available for
  dividends on Hosts preferred.

71
Marriott The Preferreds 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.
• Its alleged most cash flow goes to
  International.
• Host wont be able to continue paying the
  preferred dividend, and International will pay
  the dividend on the common formerly paid by Host

72
Marriott The Preferreds 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 cant presently be called or
  redeemed.
• Plaintiffs argue that the special dividend is a
  way to get the preferred to convert before the
  distribution.

73
Marriott The Preferreds Litigation

• Do planned common stock dividends by Marriott
  violate the Preferreds dividend preference?
• There is no duty not to dividend assets in a
  spin-off. Thats what the protective language in
  5(e)(iv) is designed to protect against.

74
Marriott The Preferreds 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
  theyre 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.

75
Marriott The Preferreds 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.

76
Marriott The Preferreds 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 preferreds conversion
  right. - page 598
• The pre-dividend announcement value of the
  conversion right was for 4 million pfd. to
  convert into shares of common _at_ 17.40 when
  common was trading _at_ 17.125.
• This would result in receiving common stock worth
  196 million 49.21
• 4 million

77
Marriott The Preferreds 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

78
Marriott The Preferreds 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.

79
Marriott Questions

• 1. What is a short sale?
• Selling borrowed stock at todays 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?

80
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.

81
Marriott Questions

• This means the plaintiffs have invested only in
  the preference rights - to dividends.
• So when the dividends are cut off, theyve really
  lost value.
• Unlike other preferred stockholders, they cant
  salvage some value through conversion. 
• Should this fact matter to the court in making
  its decision?

82
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.)

83
Marriott Questions

• 4.The court explains that the plaintiffs havent
  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 stocks price rose.

84
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
  common13.54
• 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.

85
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 rights 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.
• Thats not the measure of the value of the
  conversion right, which existed for a longer
  period, during which the common might rise in
  price.

86
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 isnt redeemable until January 15,
  1996. So its 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.

87
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?

88
Dilutive Effect of Conversion on Common
8-88

• Assume
• Market price 25.00
• Conversion price 17.40
• Value of assets distributed 15.00
• Formula is
• (17.40) (25.00 - 15.00) (17.40) (10.00)
  (17.40) (.40) 6.96
• 25.00 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.

89
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 preferreds 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.

90
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
  commons 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.

91
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, its forbidden.
• This ignores the fact that the preferreds 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.

92
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.

93
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
  Marriotts distribution?
• This isnt 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, its 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.
•  

94
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 doesnt 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
  bell-shaped curve, with most above 196,000,000,
  and a weighted (expected) value above
  196,000,000.
• Note the median of Warburgs estimates is about
  275 million, which is probably the mean and the
  expected value as well.

95
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 Marriotts value that was
  distributed.
• Then it applied that percentage to the current
  market value of Marriotts stock to determine the
  value of the distribution.

96
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.

97
Marriott Questions

• If Warburgs 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

98
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 doesnt protect the conversion feature of
  the preferred. 

99
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.

100
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.

101
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
102
Full Ratchet Weighted Average Compared
8-102

• Shares outstanding 1,000,000 common 200,000
  Series A Preferred sold _at_ 1.00
• Conversion Price Converts to Common _at_ 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)