Warrants and Reverse Splits

January 25, 2002

Your company has just consummated a one-for-five reverse stock split. As a result, the market price per share of the stock has increased five-fold with each stockholder now owning one-fifth of his original number of shares. A warrant holder then comes out of the woodwork seeking to purchase the number of shares set forth in his pre-split issued warrant at the lower pre-split strike price. The warrant has no adjustment provision in the event of a reverse split. Clearly, though, common sense would dictate that your company would be entitled to adjust the strike price proportionately upward and the number of shares purchasable proportionately downward. Right?

Wrong. At least according to a recent decision on this issue by the highest court in New York State. On December 18, 2001, the New York Court of Appeals held in favor of a warrant holder by refusing to imply an adjustment provision that could have been, but was not, written into the warrant. The decision underscores the importance of skillful preparation of warrant agreements and careful due diligence investigation of a company’s outstanding options, warrants and other securities prior to effecting a reverse split or similar transaction.

The Case
In Reiss v. Financial Performance Corporation, defendant Financial Performance Corporation (now known as BroadPartners Group, Inc., “FPC”) issued to Rebot Corporation and its president Marvin Reiss warrants to purchase an aggregate of 1,698,904 FPC shares at a strike price of ten cents per share. Although other warrants issued earlier by FPC to other holders were accompanied by warrant agreements containing provisions for adjustment in the wake of a reverse split, the Rebot and Reiss warrants did not incorporate the terms of any warrant agreement and did not otherwise provide for any reverse split adjustment. Prior to the expiration of the Rebot and Reiss warrants, FPC’s stockholders authorized a one-for-five reverse split of its stock, resulting in each share being worth five times the pre-split price and each stockholder owning one-fifth the number of shares originally owned. Rebot and Reiss then sought to exercise some of their warrants at the unadjusted strike price of ten cents per share. When FPC refused to honor the terms of the warrants, Rebot and Reiss sued.

In November of 2000, the Appellate Division affirmed a New York County Supreme Court decision dismissing the case, stating in a majority opinion that a court “is not required to disregard common sense and slavishly bow to the written word where to do so would plainly ignore the true intentions of the parties in making the contract”. On appeal, however, the Court of Appeals refused to imply an adjustment provision and held that the warrants are enforceable according to their terms. The main legal issue in Reiss is under what circumstances should a court imply a contractual term to address a contingency not covered in a contract. The Court of Appeals’ answer is that it would be inappropriate to do so when the evidence indicates that the uncovered contingency was foreseeable by the parties and the contract could otherwise be enforced according to its terms. The warrants in Reiss contained all the material provisions necessary to make them enforceable contracts, namely price, number of shares and date of expiration. In addition, the court noted that the warrants were drafted by “sophisticated and counseled business persons.” According to the court, the existence of the earlier warrants issued to other holders containing the reverse split adjustment provisions was evidence that a reverse split contingency was indeed foreseeable when FPC issued the warrants to Rebot and Reiss.

Different Result for Forward Split
It is worth noting that the court stated that the opposite result would have been appropriate if a forward split were at issue (i.e., the court would imply an adjustment provision) because the act of the split is generally within the company’s control. Otherwise, a company would be able to eviscerate the value of outstanding options and warrants by effecting a forward stock split, thus bringing about a reduced price per share.

Consequences to the Parties
The precise consequences to the parties in this case are unclear, but could be enormous. The court of Appeals remitted the case to State Supreme Court for a calculation of damages. Rebot and Reiss were seeking an order staying expiration of the exercise period of the warrants and argued that their attempt to exercise their warrants together with their motion for an order staying expiration reserved their rights to exercise all of their warrants upon successful conclusion of the litigation. Following the reverse split, the per share price may have peaked at approximately $16 per share. At a strike price of ten cents per share, the theoretical profit to Rebot and Reiss could have been approximately $27 million in the aggregate (1,698,940 shares multiplied by $16 = $27,182,464 minus (1,698,940 shares multiplied by $0.10 = $169,890) for a profit of $27,012,574).

Practical Lessons
The practical lessons for corporations from this case are twofold. First, warrants should be drafted carefully to provide clearly for pro rata adjustments in the event of reverse splits and other transactions resulting in a proportionate reduction in the corporation’s outstanding shares of stock. Second, corporations should be intimately familiar with the terms of all of their outstanding securities and careful due diligence investigations with respect to those securities should be performed whenever considering a reverse split or a similar transaction. These lessons are particularly relevant now that many publically traded companies are contemplating reverse splits to raise the market price of their shares in order to avoid de-listing or for any other purpose.

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