August 23, 2006

New York Courts Take Another Stab at Underwriter-Issuer Relationships

In late June, the New York State Supreme Court, Appellate Division decided in HF Management Services LLC v Pistone (with three judges concurring and two dissenting) that, despite last year’s New York State Court of Appeals decision in EBC I v Goldman, Sachs & Co. (aka the “eToys” case), “New York courts and jurisdictions applying New York law have long recognized the non-fiduciary nature of the underwriter-issuer relationship” and “not only is a fiduciary aspect absent from the majority of underwriting relationships, such relationships are better characterized as adversarial since the statutorily imposed duty of underwriters is to investors.” We have copies of both opinions posted in our “Underwriting Arrangements” Practice Area.

Though technically the decision relates to whether plaintiff’s litigation counsel in an employment-related dispute should be disqualified, the case hinged on whether a fiduciary relationship exists between an underwriter and an issuer and such fiduciary relationship should be imputed to underwriter’s counsel. In this case, HF Management had sued two former employees and WellCare for breach of a non-solicitation agreement. HF Management’s counsel had previously acted as due diligence counsel to the underwriter of WellCare’s IPO. The lower court had granted defendants’ request to disqualify HF Management’s counsel on the grounds that the underwriter owed a fiduciary duty to WellCare and plaintiff’s counsel, as the underwriter’s agent, shared the underwriter’s fiduciary duty to WellCare.

This is a heartening decision for underwriters concerned that, in light of eToys, courts might too readily conclude that a fiduciary relationship was created by ordinary course communications and activities in connection with an underwriting. Nevertheless, there remains cause for concern, particularly in light of statements by the court that “[c]ertainly, there is no indication or suggestion that [underwriter] and WellCare enjoyed any type of pre-existing relationship, or that [underwriter] acted as an “expert advisor on market conditions” to WellCare in the same way that Goldman Sachs apparently advised eToys.” The obvious concern is that ordinary course discussions regarding market conditions and timing could be deemed “expert advise” giving rise to a fiduciary obligation rather than, as arising from a commonality of interest in achieving a successful offering.

In light of eToys, most underwriters revised their forms of underwriting agreements to, among other things, require issuers to disclaim any fiduciary relationship, but (out of an abundance of caution) such provisions should be reviewed in light of the HF Management decision to ensure that they also disclaim any advisory responsibilities relating to the offering, regardless of whether the underwriter has previously or currently providing advisory services with respect to other matters. Thanks to Kevin Miller of Alston & Bird for these thoughts.

An Interview with Alan Beller

I am a big fan of former Corp Fin Director Alan Beller, who is back to work at Cleary Gottlieb and recently gave this interview to Catch Alan talking about the new CD&A and disclosure controls & procedures for executive compensation at our upcoming Conference in two weeks!

Zions Bancorp Auctions Market-Valued Employee Stock Options

A few months ago, I blogged about Zions Bancorp planning to register securities that would mimic employee stock options for public auction. Well, not only were those securities finally registered, but the complicated instrument was auctioned off at the end of June. Here is a copy of Zion Bancorp’s final prospectus filed July 3rd – and a free writing prospectus with FAQs about ESOARs (employee stock option appreciation rights). And here is the ESOAR auction website, which includes more information about these novel securities.

Here is a Dow Jones article about the offering:

“An innovative Internet securities auction by Zions Bancorporation (ZION), set for Wednesday and Thursday, may provide an attractive opportunity to investors, but if it does, that could undermine the entire purpose of the auction. Bidding opens at 9:30 a.m. EDT for an offering of “Esoars,” a derivative security designed to mimic the value of employee stock options. Zions isn’t making the offering in order to profit directly, but instead hopes to create an accounting tool that will allow companies to reduce their reported expense for granting stock options. Zions intends to profit by selling that tool.

The Zions plan was spurred by a recent change in accounting rules that requires companies to record the expense of granting employee stock options. Opponents of the change had argued that there is no good way to assign a value to those options, but now that companies must do so, they say traditional valuation models exaggerate the expense.

Zions, of Salt Lake City, proposes to let the market decide, and to that end it is offering the derivative, which is formally named “Employee Stock Option Appreciation Rights Securities.” Cindy Ma, who was a member of the Financial Accounting Standards Board group set up to create option valuation guidelines, questions Zions’ strategy, saying that the intimidating complexity of the Zions derivative will deter investors from offering full value.

Joel D. Hornstein, chief executive of Structural Wealth Management LLC, agrees with Ma about the complexity of Esoars — and perceives an opportunity for a savvy investor. “Auctions create significant inefficiency if you don’t have smart, sophisticated bidders,” Hornstein said. “We hope to benefit from the fact that we may be the only sophisticated (investors), or one of the very few, in this auction process, and that should be good for us.” Hornstein won’t say how much he is willing to bid, but he does have a specific number in mind.

He said he came up with a valuation by estimating how long Zions employees are likely to hold their options, and applying those estimates to the Black-Scholes model, a common tool for valuing stock options that takes into account such factors as the options’ expiration date and the underlying stock’s volatility. He said he then discounted that result to ensure “a healthy margin relative to fair value.” He said he won’t bid if he doesn’t get that margin. “Our intention is to bid only if the price is a significant discount to the value we estimated using Black-Scholes,” Hornstein said.

Hornstein argues that the normal incentives in a stock offering are turned upside-down in the Zions case, making his bidding scenario more likely. Companies, after all, have reason to seek a higher price for their securities, while Zions’ purpose is to establish a value for stock options that is below the value produced by current accounting methods.

Ma, however, said if bidders do shy away from the auction and the Esoars price is therefore too low, Zions will have a tougher time convincing regulators that the auction provided a true value for accounting purposes. “The instrument may have appeal to really sophisticated institutional investors. I am very skeptical for individual investors,” said Ma, a vice president at NERA Economic Consulting. “They don’t have that sophistication to try to analyze the data.”

Each Esoars will allow holders the right to receive payments pegged to the exercise of stock options by employees, with Esoars holders receiving the same value that employees get when they exercise their options. Returns will be affected by the amount and timing of option exercises by employees, the vesting schedule of options and the trading price of Zions common stock. Henry Wurts, a vice president at Zions subsidiary Zions Bank, acknowledged that investing in Esoars is riskier than buying the company’s stock or regular options on that stock.

Wurts said that investors will — and should — take that risk into account when they bid. Because Zions has designed a fair auction, the auction’s result — whatever it is — will be the fair value of the options, he said. “To clarify, the price will depend on the bidders,” he said. “So the bidders themselves will determine what value they give to these.”

The Securities and Exchange Commission, which will ultimately decide the validity of Zions’ proposed accounting technique, has said that a market-based method may be preferable to traditional options accounting models. “The SEC suggested they wanted a market price, and we are giving them the opportunity to see a market price,” Wurts said. “That is our goal. We are not trying to tell people how to price options. We are trying to help the SEC see a market price for these options.”

Wurts declined to estimate the value of Esoars. Evan Hill, a colleague of Wurts who helped to develop the derivative security, has said he expects the price to fall somewhere in a range of about $5 to the low teens. Using Zions’ current method for calculating option expense and taking into consideration assumptions used to value employee stock options last year, each Esoars would be worth about $16, Hill said.

The auction for 93,603 Esoars is to be hosted on the Internet Web site The auction is scheduled to open at 9:30 a.m. EDT Wednesday and close at 4:15 p.m. EDT Thursday. Zions’ Hill said that as of late Tuesday, there were 70 approved bidders for the auction. Hill said that regardless of how the auction turns out, Zions could seek SEC approval to use the result as part of an accounting method for valuing stock options. Wurts said that no matter the result, it will be a valid result for that purpose.

“We can explain any price that comes in,” he said. “If it comes in at $2, we can explain why that happened: There was a deep discount for risk. If it comes in at $15 we can explain how that happened: They didn’t take a deep discount for risk.”