Smith v. Van Gorkom
[Word] [WordPerfect] [html]

In September 1980, the CEO of Trans. Union ( rail leasing company) approached Jerome Pritzker (the head of Hyatt Hotels) to suggest a sale of Trans Union. Pritzker, an experienced corporate dealer, immediately sought an option to buy 1.75 million Trans Union shares (about 13%) from the company "at market."

In response, the Trans Union board got Pritzker down 1.00 million shares (approximately 7.5%). On a fateful Saturday in September 1980, the board approved the merger, along with the grant of this option to Pritzker. The option was to expire 134 days later, on February 1, 1981. Its exercise price was set at $ 38 per share, or $ 0.75 above the then-market price of Trans Union stock. Pritzker did not hold the option to its exercise date, but instead exercised it on October 9, 1980, nineteen days after Pritzker received it. He bought one million shares of Trans Union stock for $ 38 per share, for $ 38 million. When the shareholders approved the $ 55 merger in February 1981, Pritzker's one million shares had appreciated by $ 17 million, nearly fifty percent.

Trans Union stock's price increased from the $ 38 range to the $ 50 range immediately following the board's approval of the merger agreement on September 20, 1980. News of the board's approval obviously was reflected in the market's price. Then, for several weeks, the stock actually traded above the $ 55 merger price. Apparently, traders must have been anticipating an offer for Trans Union stock with a price higher than $ 55. Interestingly, Pritzker's exercise of the option on October 9 may have driven up the stock price. Trans Union closed at $ 53 1/8 on October 9 and at $ 56 on October 10.

The Delaware Supreme Court ultimately ruled that the Board's decision to approve the merger was not the product of an informed business judgment, and remanded the case on damages. The case later was settled for $ 23 million, with $ 10 million paid by director insurance and $ 11 million paid by Pritzker.

---

Corporate Finance: Adding Derivatives to the Corporate Law Mix
Frank Partnoy [Professor of Law, U of San Diego School of Law]
34 Ga. L. Rev. 599 (2000)

Given the above facts, how can option valuation contribute to an understanding of the case? First, it is important to note that Pritzker's option was quite valuable when granted. Its value can be calculated with some precision using the Black-Scholes option pricing model. Only a handful of data points are required, and it is not necessary to understand the intricacies of the model in order to intuit and use its results.

Some of the data required are given in the case; the other data are available elsewhere. The six required variables are: the stock price at the time the option was granted, the exercise price of the option, the time remaining before expiration, the risk-free interest rate, 70 the stock's dividend yield, and the stock's volatility. The value of a call option increases as the stock price increases, the exercise price decreases, the risk-free interest rate increases, the dividend yield decreases, or the volatility increases.

First, the stock price at the relevant time is given in the opinion as $ 37.25. Second, the exercise price of the option also is given, $ 38. Third, the time remaining before expiration is 134 days, the number of days from September 20, 1980, until February 1, 1981. Fourth, the risk-free interest rate in effect until the date of maturity of the option can be estimated, based on available data for the yields on comparable maturity United States treasury bills, to be 10.17%. Fifth, Trans Union paid an annual dividend of $ 2.36 per share during 1980; therefore, the dividend yield was approximately 6.3%.

The remaining variable, volatility, is more difficult to estimate. The most accurate method of estimating volatility would be to calculate the volatility implied by the prices of Trans Union options being traded in September 1980; however, there were no such options traded at the time. The next most accurate method is to calculate volatility using historical prices of Trans Union stock. The court provides some data about the stock price history. An accurate estimate, however, requires more frequent and recent data. I estimated volatility based on Trans Union's closing stock price values for the seventy-five business days prior to and including September 20 to be approximately 25.4%.

Given these data, the Black-Scholes estimate of the value of Pritzker's option on September 20 is approximately $ 2.49 million.

[Table 1 summarizes these results.]

At least three important new insights arise from this information. First, the grant of one million options to Pritzker on September 20, 1980, was extremely valuable ($ 2.49 million). Moreover, this value does not include several million dollars of value associated with the increase in the price of the stock as a result of the board's approval of the merger agreement. In fact, the price of Trans Union stock rocketed to $ 51.50 the next day of trading, 81 and the option would have been much more valuable then. [In fact, even without adjusting for any change in the volatility of the stock the value of the option on Monday, September 22, would have been approximately $ 13.8 million, based on a stock price of $ 51.50 and a time to expiration of 132 days.] Because this increase was virtually certain to occur once the merger agreement was disclosed, the option arguably was worth much more than the conservative estimate of $ 2.49 million.

Suppose that instead of granting Pritzker an option, the board had given him a suitcase filled with several million dollars of cash. One can imagine that the board would have considered a grant of such size with greater deliberation. It is possible that the board properly understood the value of the option intuitively, based on the directors' experience with the stock's performance over time. In any event, a simple option valuation would have assisted the board's deliberation. Moreover, if the court had been presented with such a valuation, it likely would have included this value as support for its conclusion that the directors violated their duty of care.

Second, the board's efforts to negotiate the grant of the option down to one million from 1.75 million shares saved Trans Union a considerable sum of money, conservatively estimated at $ 1.87 million (option on 750,000 shares at $ 2.49). [A grant of 1.75 million options would have been worth approximately $ 4.36 million on September 20 based on the pricing methodology described above (approximately $ 2.49 per share).] Including the informational value of the merger agreement, this savings was over $ 10 million. Again, the court neither stressed the importance or value of this negotiation, nor is it obvious that the board was aware of its magnitude.

Assuming the board understood the relative values of the options, it may have concluded that a substantial grant was necessary to persuade Pritzker to consider the merger agreement. If so, the board's business judgment would seem to have been better informed than the court's findings indicated. On the other hand, if the move from 1.75 million to one million was simply an arbitrary attempt to "round down" Pritzker's initial offer (which may have been based on the assumption that the board would feel the need to negotiate the offer downward), then the board's grant of even a one million share option would not have been well-considered. In any event, the size of the numbers is staggering, and the court did not address any of these issues.

Third, and perhaps more interesting, Pritzker gave up enormous time value when he exercised the option early and purchased one million shares on October 9, 1980. To see the time value Pritzker gave up, consider his alternatives on October 9. Instead of buying one million shares of Trans Union for $ 38 million, Pritzker could have sold a mirror option (in effect, sold a call) on one million shares to another option purchaser (such as an investment bank) on the same date. He would have received approximately $ 17.3 million for such a sale. Then, he could have waited until the expiration date of the option to consider how many shares of Trans Union he wanted to own at that point. Even if the shareholders ultimately had rejected the merger agreement, Pritzker could have exercised his option, delivering those shares to the bank to satisfy his short mirror position, or he could have purchased additional shares.

Pritzker was a sophisticated financier; why would he have chosen to give up this time value by exercising early? A simple answer is that Pritzker made a mistake. This answer, however, ignores several critical factors related to the market for Trans Union stock.

A more likely answer is that Pritzker was taking advantage of the fact that Trans Union stock already was trading close to the merger price of $ 55 per share at the time. As noted above, the value of the option on September 22 was approximately $ 13.8 million. On October 9, just nineteen days after the option was granted, it was worth approximately $ 17.3 million. Pritzker probably did not anticipate the option appreciating any more, given that the difference between the $ 55 per share merger price and the $ 38 exercise price was $ 17 million.

However, the above explanation still does not explain why Pritzker would leave the option's time value on the table, even if it was small relative to his overall profit. Another possible explanation for Pritzker's early exercise is that he was concerned about how his ultimate purchase of shares would affect the market price of Trans Union stock. Because Pritzker had the option to purchase treasury stock, this purchase would not necessarily affect the public market price.

Before September 1980, the average daily trading volume in Trans Union stock was in the tens of thousands of shares. A purchase of one million shares, even staggered over several days, would have been extraordinary. Again, consider Figure 2. On Monday, September 22, 1980, the next business day after the grant of the option, there were 84,400 shares traded. The next day, Tuesday, volume [*625] exploded, with 708,200 shares traded. 87 Average volumes remained high during the following weeks, but only in the 100,000 to 200,000 share range. No other single day had volume above 250,000 shares.

Still, even if Pritzker had been concerned about a large purchase moving the market (and potentially making the merger more difficult or expensive), a similar problem would have arisen later if Pritzker had decided he wanted to sell the one million shares (perhaps because the shareholders rejected the merger). There is no reason to think selling one million shares of stock would depress the price any less than purchasing one million shares of stock would increase it. Pritzker may have been concerned only about the latter cost (from purchasing) because he did not assign a high probability to his selling the stock later. He seems to have assumed either that shareholders would approve the merger or some other bidder would offer more than $ 55 for Trans Union stock. In either case, he would not be selling stock on the open market.

In sum, the options grant in Van Gorkom can be seen as adding three new insights: (1) the board gave Pritzker at least $ 2.49 million of option value (one million shares at $ 2.49 apiece) and probably much more, (2) Pritzker requested, and the board rejected, a grant with option value of at least $ 4.36 million (1.75 million shares at $ 2.49 apiece) and probably much more, and (3) after the option was granted, Pritzker immediately relinquished its time value by exercising early, presumably in exchange for the substantial benefits associated with a pre-expiration, non-public, off-market purchase of one million shares of stock.

Today, one would expect both the prospective purchaser of a company and its board to attempt to evaluate such an option using the above methodology. In such instances, lawyers advising participants in mergers need to understand the basics of option valuation. 88 Trans Union's directors, and its counsel, might have fared better if they had.