In Kurt Fox v. CDX Holdings, Inc. (f/k/a Caris Life Sciences, Inc.), C.A. No. 8031-VCL (Del. Ch. July 28, 2015), the Delaware Court of Chancery confirmed that Delaware’s merger statutes do not effect a statutory conversion of options at the effective time of a merger. Rather, the treatment of stock options in a merger is governed by the underlying stock option plan, which must be amended in connection with a merger if the treatment of options in the merger differs from the treatment contemplated by the plan. The Court also confirmed that a standard qualification in stock option plans, requiring a corporation’s board of directors to determine the fair market value of the option for purposes of cashing out the options, could not be satisfied by informal board action or a delegation to management or a third party.
This class action arose from a 2011 spin-off/merger transaction pursuant to which Miraca Holdings, Inc. (“Miraca”) acquired CDX Holdings, Inc. (formerly known as Caris Life Sciences, Inc.) (“Caris”) for $725 million (the “Merger”). Immediately prior to the Merger, Caris spun off two of its three subsidiaries to its stockholders (the “Spin-Off”). In the Merger, each share of Caris stock was converted into the right to receive $4.46 in cash. Each option was terminated with the right to receive the difference between $5.07 per share and the exercise price of the option, minus 8% of the total option proceeds, which were held back to fund an escrow account from which Miraca could satisfy indemnification claims brought post-closing.
Under the terms of Caris’s 2007 Stock Incentive Plan (the “Plan”), in the event of a merger, each option holder was entitled to receive the amount by which the fair market value of the subject shares, as determined by the Caris board, exceeded the exercise price. The board’s good faith determinations of fair market value were to be conclusive unless arbitrary and capricious.
In this action, plaintiff alleged that Caris breached the Plan in allocating merger consideration to the option holders in three respects: (1) members of management rather than the board of directors determined the fair market value of the options; (2) the valuation per share attributed to the spun off subsidiaries was made in bad faith and resulted from an arbitrary and capricious process; and (3) a portion of the option consideration was placed in an escrow holdback. In this post-trial decision, the Court found in favor of the plaintiff on all three claims.
With respect to the first alleged breach of the Plan, the Court found that the Caris board abdicated its responsibility to determine the fair market value of the options. According to the Court, the determination was made by a single officer working in conjunction with Caris’s tax advisor, Pricewaterhouse Coopers (“PwC”), which was then given perfunctory approval by a single director. At no point did the Caris board (or a duly authorized committee of the board) properly review or determine the fair market value of the options as required by the Plan. Accordingly, the Court found that Caris breached the Plan.
With respect to the second alleged breach of the Plan, the Court found that Caris’s determination as to the fair market value of the options was either made in bad faith or arbitrary and capricious because Caris determined the fair market value using a figure manufactured by Caris to result in zero tax liability for the Spin-Off, which did not actually reflect the fair market value of the options.
With respect to the third alleged breach of the Plan, the Court found that the terms of the Plan governed Caris’s treatment of options in a merger, not the merger agreement. According to the Court, Section 251(b)(5) of the Delaware General Corporation Law permits a merger agreement to convert shares of a corporation into the right to receive consideration that incorporates the outcome of an indemnification mechanism. However, “[o]ptions are not shares, and option holders are not stockholders.” Instead, options are contractual rights granted under Section 157 of the DGCL, and “the rights and obligations of the parties to the option are governed by the terms of their contract.” Under the Plan, the Caris board was permitted to terminate the options in connection with a merger if it paid the option holders the difference between the fair market value of the common stock underlying the option and the exercise price of the option. The Plan did not provide for an escrow holdback. Caris was therefore obligated to pay the class the full amount of the difference between the fair market value and the exercise price of the options at issue.
The Court found that plaintiff’s options had a value of $6.57 per share and awarded the plaintiff class total damages in an amount equal to $16,260,332.77 plus interest.