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Corporate Quick Hit: Fraudulent Inducement and Breach of Warranty, Stock Options in Cash Mergers, Valuing Employee Stock Options, Section 409A, Fair Value in Public Markets, Liability of Service Providers, Whistleblower Act, Transgender Discrimination, Nursing Mothers in the Workplace Act, FINRA
October 2007
Authors: Irwin A. Kishner, Daniel A. Etna

Second Circuit Reinstates Fraudulent Inducement and Breach of Warranty Claims Against Seller of Business

The Federal Court of Appeals for the Second Circuit reversed a trial court's dismissal of fraudulent inducement and breach of warranty claims arising out of an investment bank's sale of an energy commodities trading business to an energy company.  The dispute arose when the energy company refused to recognize the investment bank's exercise of its right to resell the business to the energy company.

The energy company claimed it didn't have to recognize the resale right due to the investment bank's material breach of various warranties regarding the completeness and accuracy of the information it provided to the energy company. The energy company further alleged that it had been fraudulently induced by the investment bank's misrepresentations concerning the business' finances and failure to disclose that the chief executive officer of the business had embezzled and committed other fraudulent acts affecting the business.

In reinstating the breach of warranty claim, the Second Circuit cited the general rule that a buyer may enforce an express warranty even if it had reason to know that the warranted facts were untrue. On the fraudulent inducement claim, the Second Circuit ruled that the warranties imposed a duty upon the investment bank to disclose accurate and adequate facts, thereby entitling the energy company to rely on such disclosure without further investigation or sleuthing. However, the energy company would be required on retrial to offer proof that "its reliance on the alleged misrepresentations was not so utterly unreasonable, foolish or knowingly blind as to compel the conclusion that whatever injury it suffered was its own responsibility."

Merrill Lynch & Co. v. Allegheny Energy, Inc., 2007 U.S. App. LEXIS 20928 (2d. Cir. Aug. 31, 2007).

Delaware Court Addresses Cancellation of Stock Options in Cash Mergers

The Delaware Chancery Court provided guidance on the issue of the right of acquirors to cash out and cancel compensatory stock options in cash merger transactions. In the merger transaction considered by the court, "in-the-money" options were cashed out and the holders received an amount equal to the difference between the exercise price of the option and the per share price paid to shareholders in the merger. A significant portion of the options, however, were "out-of-the-money," as they had an exercise price higher than the per share price to be paid in the merger. All "out-of-the-money" options were cancelled without consideration in the merger.

The holders of the "out-of-the-money" options claimed that the cancellations of their options for no consideration breached an adjustment provision contained in the governing option plan. The adjustment provision provided, in part, that each optionee's economic position with respect to his or her option could not, as a result of any adjustment, be worse than it had been immediately prior to such adjustment. The holders of the "out-of-the-money" options argued that the cancellation of their options for no consideration placed them in a worse economic position since, under the Black-Schoeles valuation method, the value would still be ascribed to the "out-of-the-money" options.

The court ruled that the term "economic position," while ambiguous, was in no way synonymous with the intrinsic value approach of cancelling the "out-of-the-money" options for no consideration. The court ultimately relied on extrinsic evidence in finding for the holders of the "out-of-the-money" options.

This decision is fundamentally good news for acquirors in cash transactions that cancel "out-of-the-money" options without consideration. The court twice stated the "general rule" that option plans should be read to permit such cancellations. In the court's view, because "the value of a derivative instrument, such as a stock option, is tied to the value of the security into which it is exercisable," the value of the instrument in a cash transaction "will ordinarily also be measured by reference to that same amount of cash" paid to shareholders.

Lillis v. AT&T Corp., No. 717-N (Del. Ch. July 20, 2007).

SEC Permits New Approach to Valuing Employee Stock Options

In a staff letter from the Office of the Chief Accountant of the Securities and Exchange Commission ("SEC"), a bank was permitted to use an auction process to establish the fair value of stock options for purposes of FASB Statement No. 123R. In particular, the bank auctions SEC-registered securities that track the value of a reference pool of employee stock options by making payments to the holders of such securities as options in the reference pool are exercised.

Companies are required under Statement 123R to expense the estimated fair value of options and other employee stock-based awards. Companies usually employ complex pricing models to estimate the grant date fair value of stock options. These pricing models, however, may not accurately reflect the fair value due to the various assumptions underlying the calculations. In contrast, the auction process enables a company to establish the grant-date fair value of stock options based on the auction clearing price of a security intended to replicate the value of a stock option.

The text of the staff letter is available at:

Further Extension for Compliance with Section 409A Final Regulations

After issuing a limited deadline extension for amending nonqualified deferred compensation plans to comply with the final regulations issued under Section 409A of the Internal Revenue Code last month, the Internal Revenue Service modified and expanded the scope of the extension through the issuance of IRS Notice 2007-86 on October 22. Under IRS Notice 2007-86, compliance with the final regulations is not required before January 1, 2009. Prior to January 1, 2009, nonqualified deferred compensation plans must be operated in accordance with Section 409A and applicable guidance. If an issue is not covered by applicable guidance, taxpayers must apply a reasonable, good faith interpretation of Section 409A.

IRS Notice 2007-86 also extends certain transition relief that was available under prior guidance. Under the extended transition relief, amendment of payment elections as to the time and form of payment may be made prior to December 31, 2008, provided that an amendment made in 2007 only applies to amounts that would not otherwise be payable in 2007 and may not cause such amount to be paid in 2007. Furthermore, an amendment made in 2008 may only apply to amounts that would not otherwise be payable in 2008 and may not cause such amounts to be paid in 2008.

The text of Notice 2007-86 is available at

Bankruptcy Court Finds Fair Value in Public Markets

The Bankruptcy Court for the Southern District of New York dismissed avoidance claims brought by creditors against a satellite communications company. The creditors supported their claims by relying on experts who performed discounted cash flow analyses based on their own independently developed projections. The court instead endorsed the use of a market-based valuation. The court relied heavily on a Federal Court of Appeals for the Third Circuit decision (as reported in the June 2007 Corporate Quick Hit edition) in declaring that the "public markets constitute a better guide to fair value than the opinions of hired litigation experts whose valuation work is performed after the fact and from an advocate's point of view."

Iridium Operating LLC v. Motorola, Inc., Adv. Pro. No. 01-02952 (Bankr. S.D.N.Y. Aug. 31, 2007).

U.S. Supreme Court to Rule on Liability of Service Providers

The U.S. Supreme Court earlier this month heard arguments regarding the liability of third party service providers for fraud committed by their public company clients. The stockholders of a public company brought a class action suit against the public company and two of its third party vendors claiming that the company defrauded investors under Section 10(b) of the Securities Exchange Act of 1934, as amended, by paying vendors money that was subsequently returned to the company in the form of advertising fees, for the purpose of inflating cash flow. The Federal Court of Appeals for the Eighth Circuit ruled that the vendors could not be held liable for the company's fraudulent acts because, at most, they were aiders and abetters. The Eighth Circuit's decision was based on a U.S. Supreme Court decision holding that the right to bring suit for aiding and abetting under Section 10(b) is reserved to the Securities and Exchange Commission, and not private plaintiffs such as the class action stockholders.

Stoneridge Inv. Partners v. Scientific-Atlanta, 443 F.3d 987 (8th Cir. Apr. 11, 2006).

New Jersey Supreme Court Extends Whistleblower Act to Independent Contractors

The New Jersey Supreme Court held that a chiropractor hired by an insurance company as an "independent contractor" is an "employee" under New Jersey's whistleblower statute—the Conscientious Employee Protection Act—thereby broadening the class of workers entitled to assert claims thereunder.

The Act prohibits an employer from taking adverse employment action against any employee who exposes an employer's criminal, fraudulent or corrupt activities. Workers are protected from retaliation and employers are deterred from activities that are illegal or fraudulent, or otherwise contrary to a clear mandate of public policy concerning the safety, health and welfare of the public.

D'Annunzio v. Prudential Ins. Co. of Am., A-119-2005 (N.J. Sup. Ct. July 25, 2007).

New Jersey Acts to Explicitly Prohibit Transgender Discrimination

The New Jersey Law Against Discrimination ("NJLAD") has been amended to explicitly prohibit transgender discrimination. The amendment creates a new protected category under the NJLAD—"gender identity and expression." The phrase "gender identity and expression" is defined to mean "having or being perceived as having a gender-related identity or expression whether or not stereotypically associated with a person's assigned sex at birth, including transgender status." The amendment protects not only employees who have undergone sex assignment surgery, but employees who identify or express themselves as members of the opposite sex. The amendment expressly addresses the latter by protecting an employee's right "to appear, groom and dress consistent with the employee's gender identity or expression."

New York Enacts "Nursing Mothers in the Workplace Act"

The State of New York, through the enactment of the "Nursing Mothers in the Workplace Act," has provided job protections for nursing mothers. The Act requires employers to "provide a reasonable amount of paid or unpaid break time during each work day to permit an employee to express breast milk for her nursing infant for at least two years following child birth." The Act further bars employers from discriminating in any way against mothers who choose to express milk in the workplace and requires employers to "provide a private accommodation suitable for the purpose of expressing breast milk, located in close proximity to the work area." This accommodation may not include a bathroom stall or a storage area. The Act does not provide nursing mothers with an absolute right to these protections. If employers can demonstrate that providing nursing mothers with break time would "seriously disrupt the operations of the employer," they will not be required to provide such break time.

NASD and NYSE Regulation Consolidate to Form FINRA

The National Association of Securities Dealers, Inc. and NYSE Regulation, Inc. consolidated regulatory functions on July 30, 2007 to form the United States' largest non-governmental regulator, known as the Financial Industry Regulatory Authority ("FINRA").

FINRA is responsible for regulating all securities firms that do business with the public, as well as the NASDAQ Stock Market, Inc., the American Stock Exchange LLC, the International Securities Exchange, LLC, and trade reporting facilities and over-the-counter operations. However, (i) NYSE Regulation, Inc. continues to control the regulation of trading on the New York Stock Exchange, and (ii) each individual exchange will continue to control the regulation of its own listed companies. At present, FINRA oversees nearly 5,100 brokerage firms and more than 665,000 registered securities representatives.

The SEC stated that the consolidation is intended to "streamline the broker-dealer regulatory system, combine technologies, and permit the establishment of a single set of rules governing membership matters, with the aim of enhancing oversight of U.S. securities firms and assuring investor protection." SEC Chairman Christopher Cox promised that the SEC will work with FINRA to the eliminate duplicative regulation that existed under the dual NASD and NYSE regulatory system.

For more information on these issues or other corporate matters, please contact:

Irwin A. Kishner at 212.592.1435 or
Daniel A. Etna at 212.592.1557 or

Copyright © 2007 Herrick, Feinstein LLP. Corporate Quick Hit is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm. Prior results do not guarantee a similar outcome.