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July 29 — A class of Caris Life Sciences Inc. stock option holders were awarded more than $16.2 million in damages, after a Delaware judge concluded that the medical diagnostics company purposely undervalued two of its spun-off business units to avoid tax consequences.
In a July 28 opinion, Vice Chancellor J. Travis Laster found that when Caris used a complex spin/merger structure to effectuate the sale of its pathology unit, it improperly valued two spun-off business units to minimize the taxes of controlling stockholders.
According to the court, by inaccurately valuing the spinoffs, Caris violated a stock incentive plan requiring the company to repurchase cancelled employee stock options for the amount that the stocks' “Fair Market Value” exceeded the exercise price.
After the transaction, the plaintiff, a former Caris employee option holder, argued that the share value attributed to the spinoffs was not a good-faith determination and resulted from an arbitrary and capricious process.
Laster observed that Caris Chief Executive Officer David Halbert, a 70.4 percent owner, and Chief Financial Officer Gerard Martino faced the choice of a realistic valuation of the spun-off business units, resulting in the CEO facing tax liability, or a zero-tax valuation that would generate an unrealistically low payout for options.
The court found that the company failed to make a good-faith determination because evidence introduced at trial proved that Halbert and Martino both subjectively believed the value of the spun-off business units to be much higher. Specifically, the court observed that there was evidence that the valuation process was manipulated to reduce tax liability, and that Martino and Halbert's credibility was undermined by testimony that they had “no problem giving false projections” to potential buyers of the units.
In the alternative, the court also concluded that the process Caris followed to determine the fair market value was arbitrary and capricious because it relied on a valuation prepared for a different purpose—ensuring that the spinoff would result in zero corporate-level tax.
Laster specifically took aim at a valuation prepared by Grant Thornton that admittedly copied another accounting firm's analysis prepared for the purpose of the intercompany tax transfer.
“The Grant Thornton report deserves separate mention because its contents were so flawed as to support both an inference of bad faith and a finding the process was arbitrary and capricious,” the judge wrote. “Previous Delaware decisions have criticized erroneous or seemingly motivated analyses by financial advisors, but the Grant Thornton report reached a new low.”
Moreover, the court found that the company breached the stock incentive plan in two additional ways. First, the company failed to comply with a portion of the plan obligating its board to determine the fair market value of the company's stock.
By instead treating the controlling stockholder's sign-off on the determination of how much option holders would receive as sufficient, the board did not act in accordance with Delaware's bedrock principle of “director primacy,” Laster concluded.
The company also breached its agreement with option holders by withholding a portion of their merger consideration in escrow, even though the company was required to do so under the merger agreement.
“The relationship between Caris and its option holders was governed by contract,” Laster wrote. “The operative contract was not the Merger Agreement, but rather the Plan.”
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The opinion is available at http://www.bloomberglaw.com/public/document/KURT_FOX_on_behalf_of_himself_and_all_others_similarly_situated_P.
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