Fox v. CDX Holdings: Delaware Court of Chancery Disallows Escrow Holdback from Stock Options Due to Terms of Incentive Plan

Practical Law Legal Update w-000-4915 (Approx. 8 pages)

Fox v. CDX Holdings: Delaware Court of Chancery Disallows Escrow Holdback from Stock Options Due to Terms of Incentive Plan

by Practical Law Corporate & Securities

Background

The merger in question was one component of a broader transaction whose effect resembled a Morris Trust transaction. The target company in the merger was Caris Life Sciences, Inc. (Caris), a privately held Delaware corporation founded by David Halbert, who at the time of the merger owned 70.4% of the company's fully diluted equity. JH Whitney VI, L.P., a private equity fund, owned another 26.7%. Most of the remaining approximately 2.9% of Caris's fully diluted equity took the form of stock options that were cancelled in connection with the merger.

Before the merger, Caris was the ultimate parent company of three subsidiary businesses:

Caris Diagnostics, a profitable company in the business of anatomic pathology (the diagnosis of disease through the examination of cells, fluids, and tissues).
TargetNow, a revenue-positive but not yet profitable business that specialized in profiling genetic and molecular changes unique to a cancer patient's tumor and identifying treatments based on that profile.
Carisome, a business in the developmental stage that was aimed at developing blood tests that could detect specific cancers and other complex diseases.

Halbert believed that the Carisome business held enormous promise and sought to ways to secure financing for it and TargetNow. On the advice of its financial advisor Citigroup Global Markets (Citi), Caris settled on a deal structure in which it would spin off the TargetNow and Carisome businesses to its existing stockholders and then, with only the Caris Diagnostics business remaining under Caris, merge with a third-party buyer. The advantage of this structure was that it avoided double taxation: instead of selling Caris Diagnostics to a third party, which would generate tax liability on both the sale and the dividend of the cash proceeds to the stockholders, the spin-off of the two businesses would be tax-free, while the merger of the remaining Caris Diagnostics business would generate only a single layer of tax on the distribution of cash from the buyer to the stockholders. Using this structure, Caris, as the parent of the Caris Diagnostics business alone, agreed in October 2011 to a merger with Miraca Holdings, Inc. for total consideration of $725 million.

For the spin-off to be tax-free to Caris, however, the fair market value of the TargetNow and Carisome businesses had to be lower than their tax basis. If their fair market value was higher, Miraca, as the acquirer of Caris, would owe tax on the difference. Because Miraca understandably refused to pay tax on businesses that it was not buying, Caris agreed to indemnify it for any tax liability it may incur. This created an incentive for Caris's stockholders to manipulate the determination of the businesses' fair market value in order to avoid paying taxes on the spin-off. Acting on that incentive, Halbert and the company's CFO and COO, Gerard Martino, engineered a process in which the company's tax advisors settled on a fair market value of the spun-off businesses of $65 million.

The "collateral damage," as the court put it, of the artificially low valuation of the businesses was the holders of stock options in Caris. Under Caris's stock option plan, stock options being cancelled in a merger were to be cashed out at their fair market value, as determined in good faith by the plan administrator, minus their exercise price. Consequently, a low valuation would simultaneously benefit the stockholders of Caris for tax purposes while harming the option holders.

Conflicting Valuations

Before settling on the spin/merge structure with Miraca, Citi presented the board of Caris with several strategic options. In its presentation in May 2011, Citi valued TargetNow alone at $195 to $300 million, without trying to put a value on Carisome. This valuation closely matched an estimate that Martino himself had put on TargetNow a month before, when he told the company's tax advisor PricewaterhouseCoopers (PwC) that he believed TargetNow was worth between $150 and $300 million.

Other contemporaneous evidence from the 2011 bidding process also suggested that Caris had valued the spun-off businesses at far more than $65 million. Before Caris had settled conclusively on the spin/merge structure, several potential bidders expressed interest in acquiring TargetNow. To these indications of interest, Citi suggested that Caris valued TargetNow in the range of $200 to $250 million, and one bidder expressed an interest in buying the Caris Diagnostics and TargetNow businesses together for $825 to $900 million.

Pre-signing Process Manipulation

Documents from 2011 also indicated that Martino supplied PwC with projections that would generate a low enough value for the spin-off to avoid corporate-level tax. In July 2011, Caris's accountants at Grant Thornton LLP (GT) had prepared valuation reports to use for income tax and financial statement reporting related to the issuance of stock options. Martino provided PwC with the projections that he and his team had created for GT's reports. Those projections were materially lower than the projections presented to Caris' potential bidders during the sale process.

Later in the bidding process, when Miraca identified the potential tax liability arising from the spin-off, Martino instructed PwC to determine any tax liability by calculating the tax transfer liability of TargetNow and Carisome. Martino followed up with a more explicit request in which he asked PwC to land on a $40 million valuation and, to help achieve that valuation, sent PwC revised business projections that he prepared without board review or approval and that cut TargetNow's EBITDA forecasts. PwC came back with a model showing zero tax and a value of $47 million for TargetNow and $15 million for Carisome, for a total of $62 million. PwC cautioned that its valuation was a transfer pricing valuation of intellectual property and therefore may not be the same as the fair market value of a business.

Miraca's tax advisor was skeptical of PwC's valuation and sought more information, including any about comparable companies. Martino responded that there were no comparable companies, even as GT's valuation reports made use of a comparable-company analysis. Miraca's outside counsel also expressed concern about the valuation and requested back-up for the rationale and assumptions used, as well as confirmation that the projections had been reviewed and authorized by the board. Martino responded that the projections had been approved by Halbert and JH Whitney, which was untrue; the only projections reviewed by the board were the higher projections presented to the bidders.

Post-signing Process Manipulation

To satisfy Miraca's unease, Caris agreed in a side letter to indemnify Miraca for any tax liability and to obtain a second valuation from GT. With that agreement in place, the parties entered into a merger agreement for a purchase price of $4.46 per share in cash. The agreement contemplated an 18-month escrow holdback for indemnification in the amount of $40 million.

The mechanics in the merger agreement for the cancellation and cash-out of the stock options provided that each stock option would receive consideration tied to the per share payment, less the proportionate amount to be withheld in escrow. In this regard, the merger agreement conflicted with the company's stock incentive plan governing the stock options. Under the terms of the plan, each option holder was entitled to the amount by which the fair market value of the vested award exceeded the exercise price of the options. The plan required the "Administrator," which by default was the board, to determine in good faith the fair market value and to adjust the options to account for the spin-off. The board's determinations would be considered conclusive unless "arbitrary and capricious."

At its meeting to approve the merger agreement, the board acknowledged that it would need to adjust the exercise price to reflect the value of the spin-off, and it adopted a resolution stating this fact. However, the board could not adjust the price immediately because it was waiting for the second valuation opinion from GT.

The day after the announcement of the merger agreement, the stock option holders received an FAQ, which stated that the expected share price would be between $5.04 and $5.14. This range was essentially lifted from an e-mail sent from Martino to Halbert and a vice chairman of the board and managed to predict with precision where GT's valuation would eventually land.

One month later, GT completed its report, but without following the methodology that it had used in its four previous stock-option valuations. Instead, GT viewed its task as "copying PwC's report and calling it [their] own." Even with significant errors where it made its own calculations, GT still achieved a valuation result of $5.07, inside the range that Martino had predicted.

After Martino received the final versions of PwC and GT's valuations, Martino forwarded GT's report to Halbert and the vice chairman, but not to the full board. He recommended that they use the higher PwC valuation for "transaction purposes." Halbert agreed one minute later and Martino moved ahead with the PwC valuation. Shortly thereafter, the board approved the spin-off by unanimous written consent, but did not actually adjust the terms of the options as a result of the spin-off.

After the closing of the merger, management sent the option holders an e-mail, identifying the fair market value per share as $5.07. The e-mail also stated that the option holders would receive 92% of the total payout within ten days, but that 8% would be withheld and placed in escrow. The balance would then be paid out following the 18-month escrow period.

Plaintiff Allegations

The plaintiff Kurt Fox, a former salesman in the Caris Diagnostics business, sued on behalf of a class of option holders, claiming that:

Caris breached its stock incentive plan because the board did not make the fair market value determination of the value of TargetNow and Carisome. The board also failed to adjust the options to account for the spin-off.
Even if the board made the determination, the valuation was not made in good faith and the process was arbitrary and capricious.
Caris breached the plan by placing a portion of the option consideration into escrow and not paying out the full fair market value, minus the exercise price, on closing.

Outcome

The court found for the plaintiff and granted the class damages of $16,260,332.77 plus pre- and post-judgment interest.

The court's analysis centered on principles of contract interpretation under Delaware law. To find a breach of contract claim, the plaintiff must show:

The existence of a contract.
The breach of an obligation under the contract.
The plaintiff suffered damage as a result of the breach.

The existence of a contract—the stock incentive plan—was not at issue. Only the second and third elements were in dispute.

Board Failed to Act under the Stock Incentive Plan

The company's stock incentive plan required the "Administrator" to:

Determine the fair market value of the company's common stock.
Pay out to the option holders the difference between the fair market value and the exercise price of the options.
Adjust proportionately the terms of the options in the event of a spin-off.

Under the plan, the board could have appointed a committee of one director to act as the Administrator. Because it never did, the entire board was required under the plan to perform the acts required of the Administrator. However, the evidence at trial clearly indicated that at most, only one or two directors were informally involved in taking the required actions (Martino was not a member of the board). Valid board action requires a formal meeting or unanimous written consent at which the all directors can meaningfully participate, but only the chair and one vice chairman had any involvement at all, in the form of limited e-mails with Martino.

Martino effectively made the fair market value determination himself. The figures that went into determining fair market value were not presented to the board, and one board member did not even know that the plan existed. This director also testified candidly that he believed that the board's role was simply to advise Halbert, as the controlling stockholder, but that the controlling stockholder made the ultimate decisions for the company. The court here made it a point to highlight Section 141(a) of the DGCL, which establishes the "bedrock statutory principle of director primacy," regardless of whether a company has a controlling stockholder.

Caris argued that the board did make a fair market value determination and adjusted the stock options when it approved the merger agreement and the separation agreement for the spin-off. The court rejected this argument, noting that the resolutions only identified the need for an adjustment, but did not actually make an adjustment or determine fair market value.

Fair Market Value and Adjustment Determination Not Made in Good Faith

The plan required the fair market value determination to be made in good faith. When a contract requires a good-faith determination, Delaware law interprets the standard as requiring subjective good faith on the part of the acting party. The plaintiff argued that regardless of who had made the determination, it was not made in good faith. Owing to its finding that the board did not make the required determination, the court applied the good faith analysis to Martino and Halbert to determine whether they subjectively believed that TargetNow and Carisome were worth $47 million and $18 million, respectively.

The court found that they did not, highlighting that:

Citi had estimated TargetNow's value at between $195 and $300 million.
During the bid process for Caris Diagnostics, one potential bidder expressed an interest in TargetNow at an implied value of $100 to $175 million.
Valuations prepared by GT in the ordinary course valued TargetNow at $104 million.
Assessments made by JH Whitney valued TargetNow at about $187 million.

Likewise, the court found it unlikely that Martino and Halbert had only valued Carisome at $18 million when they believed Carisome to be at least as valuable as TargetNow. While Carisome presented more risk, they clearly believed that Carisome would succeed because:

The spin/merge transaction itself was designed to provide more funding for Carisome.
Halbert and JH Whitney reinvested $100 million from the spin/merge back into Carisome and TargetNow.
Valuations prepared by GT in the ordinary course valued Carisome at a discounted value of between $116 and $199 million.
Assessments made by JH Whitney expressed optimism about Carisome's value, and the court concluded from JH Whitney's communications that they valued Carisome at least as much as TargetNow.

Given this evidence, the court held that both Martino and Halbert clearly and subjectively believed the values of TargetNow and Carisome to be significantly higher than $47 million and $18 million, respectively.

As additional support for this finding, the court highlighted that Martino manipulated the valuation numbers in order to achieve a zero-tax transaction. To meet this objective, Martino revised and lowered the projections he sent to PwC and then manufactured support for the lowered valuation that resulted after-the-fact. He also drafted conflicting memoranda on the issue of whether there were any comparable companies for a valuation. Martino also likely convinced GT to abandon its historical methodologies and instead copy PwC's report to support the lower valuation. Martino's actions were not done in good faith to determine the true value of the companies, but stemmed from the conflicting interest of achieving a zero-tax transaction.

Valuation Process Was Arbitrary and Capricious

The plan stated that the board's valuation determination would be deemed conclusive unless the process was arbitrary and capricious. The court held that the process was arbitrary and capricious because:

Martino clearly and repeatedly sought a valuation that would achieve a zero-tax transaction instead of a realistic valuation, which resulted in a significantly lower payout to the option holders.
Martino relied on PwC's tax transfer valuation, which PwC explicitly stated was not necessarily equal to a fair market value determination.
GT's valuation work was a blatant copy job that also contained serious flaws.

The court was particularly harsh on the work done by GT, which the court said was enough on its own to support a finding of bad faith and an arbitrary and capricious process. Harkening to its previous decisions in El Paso and Southern Peru on faulty work performed by financing advisors, the court said that "the Grant Thornton report reached a new low."

Escrow Holdback Breached the Incentive Plan

The plaintiff argued that Caris breached the plan when it withheld a portion of the option holders' merger consideration in escrow. Caris argued that it was required to withhold their proportionate share under the merger agreement.

Although it was true that the merger agreement provided for a proportionate holdback, the court explained that the relationship between the option holders and Caris was governed by the plan and not by the merger agreement. Therefore, because the plan did not permit an escrow holdback, Caris could not impose the terms of the merger agreement onto the option holders. Rather, Caris was required to pay each option holder the full amount of the difference between the fair market value and the exercise price.

Central to the court's analysis was the truism that "options are not shares, and option holders are not stockholders." The common mechanic in private acquisition agreements, in which shares are converted into a right to receive consideration that contemplates a future outcome based on an indemnification mechanism, is authorized by Section 251(b)(5) of the DGCL. That section, however, only contemplates the conversion or cancellation of shares. Section 157 of the DGCL authorizes the issuance of options. That section of the statute requires that the terms of the option, including the formula for calculating the consideration to be paid upon exercise of the option, be incorporated in a contract. As a result, the treatment of options in a merger is governed by the options contract and not by the blanket statutory authorization for cancelling shares.

In Caris's case, its incentive plan mandated that option holders receive the difference between the fair market value of the company's shares and the options' exercise price. "Fair market value" was defined only by reference to the Administrator's good-faith determination, in a manner that was not arbitrary and capricious. The plan did not include any provision permitting a portion of the consideration to be withheld in escrow pursuant to the terms of a merger agreement. The court added that the plan could have been drafted to provide for the options to be treated the same as shares in the event of a merger, but it did not.

As a result, the court held that under the terms of Caris' incentive plan, the plaintiffs were owed the full consideration at once and that any amounts withheld in escrow needed to be paid out to them.

Practical Implications

Much of the decision in CDX Holdings turns on fact-specific actions that unsurprisingly support a finding of bad faith. Clearly, unilaterally changing the numbers in a revenue forecast or copying the work of a different firm that was done for a different purpose are the kinds of acts that create an arbitrary and capricious process.

For drafters of stock option plans and award agreements, the decision provides a critical reminder to provide leeway to the board in the terms for cancellation and cashing out. If the plan provides only that the options are entitled at cancellation to their fair market value minus the exercise price, the court will parse the consideration being paid for the shares and distinguish between elements that go to value and elements that go to indemnification mechanisms. This cannot be corrected later without the option holders' consent. An incentive plan drafted years before a change of control will end up dictating how the options are to be cashed out.

The court explained that had the plan provided that holders of options cancelled in connection with a merger receive the same consideration as that received by holders of stock, less the exercise price, it would have allowed Caris to apply the escrow holdback to the option holders. Counsel drafting incentive-plan documents should therefore use language that contemplates that allowance and that does not simply award fair market value without any adjustments. Counsel advising on private acquisitions should also review the terms of the seller's or target company's plan documents. If the documents do not provide the board with flexibility to set the terms of the payout to the option holders, the acquisition agreement cannot impose an escrow mechanic on them. In that event, the escrow can only be held back from the shares, barring the consent of the option holders to a holdback.

The decision also contains a useful reminder to directors and counsel advising them that it is the board that is charged with managing the corporation under Delaware law. Even when the corporation is owned by a controlling stockholder who, as a practical matter, can remove the directors at will, the directors still owe fiduciary duties to the entire stockholder base and cannot surrender those duties to the controller.

Fox v. CDX Holdings: Delaware Court of Chancery Disallows Escrow Holdback from Stock Options Due to Terms of Incentive Plan | Practical Law