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IX. SCULLY V. U.S. WATS, INC.
  A. Claims Arising From Plaintiff's Termination
    1. Plaintiff brought a diversity action claiming breach of contract, conspiracy, fraudulent and negligent misrepresentation, and violation of the Pennsylvania Wage Payment and Collection Law, 42 P.S. 260.1 et seq. ("WPCL"), arising from his discharge from employment.
    2. A two day bench trial resulted in a determination that:
      a. Plaintiff's discharge was unlawful;
      b. The defendant(s) wrongfully deprived plaintiff of stock options;
      c. Two of the individual defendants were liable under theories of conspiracy or "alter ego";
      d. The third individual defendant was not liable; and
      e. Plaintiff was not entitled to fees and liquidated damages under Pennsylvania Wage Payment and Collection Law. See e.g., Scully v. U.S. Wats, Inc., supra, 1999 U.S.Dist. LEXIS 13007, *7-8.
    3. The Third Circuit affirmed the trial court's findings that an unlawful discharge occurred and that the defendant-employer deprived plaintiff of stock options; it also affirmed the trial court's damage valuation method.
      a. The Third Circuit reversed the judgment against the individual defendants for the employer company's actions and the trial court's denial of fees and possibly liquidated damages under the Pennsylvania Wage Payment and Collection Law ("WPCL"); case remanded for further proceedings on the issue of fees and liquidated damages under the WPCL.
  B. Facts as Stated by Third Circuit Court of Appeals
    1. Plaintiff was first hired as a consultant to defendant telecommunications company to turn the company around; plaintiff was then offered a written two year employment contract as President, which he declined to sign as unnecessary. The trial court found that an oral agreement for a two year term of employment was reached in May of 1995, which finding was affirmed.
    2. As an inducement for plaintiff to remain for two years, he was offered and accepted an option to purchase 850,000 shares of restricted stock to vest over the two year period.
      a. Option granted pursuant to a written Executive Stock Option Agreement governed by defendant employer's Executive Stock Option Plan, which provided that all options extinguished upon termination of employment.
      b. During plaintiff's employment, the Executive Stock Option Plan was amended to provide that options would extinguish 30 days after termination.
      c. Upon exercise, the purchased stock could not be transferred for a period of one year.
    3. Plaintiff was replaced as President in early December of 1996, but was assured of continued employment until May of 1997.
      a. As of December 1996, plaintiff's option to purchase 600,000 restricted shares of stock had vested.
      b. Trial court found that defendants knew that plaintiff would be receiving a substantial sum of money from another investment in January of 1997, and was therefore likely to exercise his vested options at that time. Scully v. U.S. Wats, Inc., supra, 1999 U.S.Dist. LEXIS 13007, *3.
    4. Defendant terminated plaintiff without notice on December 30, 1996.
    5. Plaintiff attempted to exercise his option to purchase 600,000 shares of restricted but vested shares on January 23, 1997, but the defendants declined to honor the exercise.
    6. The trial court ruled that the real reason, or at least the principal reason, for terminating plaintiff was that the company had granted more stock options than it could possibly fulfill and that unless some of the outstanding options were eliminated before December 31, 1996, accurate filings with the Securities Exchange Commission would reveal the true state of the company's affairs.
  C. Competing Valuations of the Stock Options
    1. The trial court opined that restricted shares are generally regarded as subject to a discount from the market price because of the restrictions and concluded that the appropriate discount was 30% but chose not to apply a discount.
    2. The trial court based the damage award on the difference between the exercise price of the option ($0.75 per share) and the market price of unrestricted shares ($1.375) multiplied by all of the shares (vested and unvested) as of the date of breach, resulting in an award of $595,000 in compensation for failure to deliver the 850,000 shares.
      a. $1.375 - $0.75 = $0.625 profit per share
$0.625 x 850,000 = $531,250 plus interest
    3. Plaintiff argued that the proper valuation of the shares should be calculated as of the date the one year restriction on sale would have expired, resulting in a claim for $1,078,125.
      a. Market price of stock was $2.00 per share as of 1/28/98, one year from attempted exercise of option for the 600,000 vested shares.
      b. Market price of stock was $2.0625 as of 5/26/97, one year from date on which remaining 250,000 shares would have vested.
      c. ($2.00 - $0.75) = $1.25 profit per share
$1.25 x 600,000 = $750,000 (1/28/98)

($2.0625 -0.75)= $1.3125 profit per share
$1.3125 x 250,000 = $328,125 (5/26/98

$750,000 + 328,125 = $1,078,125 TOTAL

      d. The trial court rejected the plaintiff's approach because it gave him the benefit of hindsight as to the market value of the stock, putting him in a better position than if the breach had not occurred.
      e. On appeal, the Third Circuit also rejected the "plaintiff's after-the-fact assertion that he would have sold the stock at a time that, in hindsight, would have been particularly advantageous", absent "express credibility finding or other convincing evidence." Id. at 513.
        (1) Plaintiff would receive more than the benefit of his bargain because the option merely reduced the risk of loss and increased the likelihood of profit. The option "never extinguished all risk, nor guaranteed a profit." Id.
    4. Defendants argued that damages should be calculated as of the date of breach (1/23/97) and on appeal, that a 30% discount should be applied to account for the one year restriction on the ability to sell the shares, resulting in a damage claim of $180,625.
      a. $1.375 - 30% = $0.9625 hypothetical value
$0.9625 - $0.75 = $0.2125 profit per share
$0.2125 x 850,000 = $180,625 TOTAL
      b. The trial court was unwilling to adopt the defendants' approach because it deprived the plaintiff of an important advantage he enjoyed, i.e., the prospect of reaping significant profit should the value of the stock rise.
  D. The Third Circuit's Analysis of Proper Valuation of Stock Options
    1. The Court began its analysis by concentrating on the competing theories of the measure of damages on which the parties focused: the conversion loss theory and the breach of contract theory.
    2. The Court characterized the conversion loss damages as based on lost profits, while the breach of contract measure of damages seeks to place the plaintiff in the same position he or she would have held absent the breach. Id. at 510. But see Galigher, supra, 129 U.S. at 200, 9 S.Ct. at 337 (the rationale for the New York Rule/conversion loss measure of damages is to allow the plaintiff "to place himself in the position he would have been in had not his rights been violated.").
    3. The Court listed the advantages and disadvantages of the conversion loss theory as follows:
      a. Advantages:
        (1) It allows the plaintiff to recover, to a limited extent, a relevant benefit of his bargain - the prospect of future profits, "the fundamental underpinning of stock options".
        (2) It does not reward the defendant for wrongful conduct.
      b. Disadvantages:
        (1) It interjects uncertainty into the damage calculation by requiring speculation as to a reasonable period by which plaintiff would have covered. Id. at 510, citing Schultz, supra, 716 F.2d at 140.
        (2) The extended cover period may give plaintiffs the improper benefit of hindsight. Id., citing Tamari v. Bache & Company (Lebanon) S.A.L., 838 F.2d 904, 907 (7th Cir. 1988)(criticizing the conversion theory as perhaps too generous in assuming that the claimant would "have had the clairvoyance" to sell when the stock hit its peak during the relevant period.)
    3. The Court listed the advantages and disadvantages of the breach of contract theory as follows:
      a. Advantages:
      (1) It is likely to lead to a more scrupulous damage calculation because it avoids uncertainty concerning future loss or future profit.
      b. Disadvantages:
        (1) It distorts the damage calculation because it fails to consider the benefit plaintiff held under the option, i.e., the reduced risk of loss and the greater likelihood of profit.
      c. The Court also observed that the breach of contract measure of damages produces the lost option's "intrinsic value", the difference between an option's exercise price and the market value for the same stock. Id. at 511, citing, Les Barenbaum, Ph.D and Walt Scubert, Ph.D, Measuring the Value of Executive Stock Options, 12 No. 12 Fair$hare 3, 3 (December 1992). See also, Hermanowski, supra, 729 F.2d at 922, Rosen v. Duggan's Distillers Products Corporation, 256 N.Y.S.2d 950, 951 (App. Div. 1965)(new trial granted where jury's verdict based on speculation in absence of evidence on which to calculate the market price of the shares of stock at issue on the date fixed for delivery).
        (1) As a general rule, the intrinsic value of an option is lower than its true value, the hypothetical price at which an option would be traded on the open market. Scully, supra 238 F.3d at 511.
        (2) The intrinsic value, however, fails to reflect the true value because "an option holder can, within contractual constraints, wait to exercise his option until the market price exceeds the exercise price."
          (a) The holder of an option, therefore, can decrease his risk of incurring loss and increase the likelihood of obtaining a future profit.
          (b) Options therefore generally sell for more than their intrinsic value because of the added benefits to investors.
    4. The Third Circuit noted that the trial court's valuation blurred the distinctions between the conversion loss and the breach of contracts measures of damages but concluded that "[d]epending upon the circumstances of the case the blurring between the conversion and breach of contract remedies may be justified." Id. at 512.
    5. The Court approved the trial court's decision to provide a remedy for the plaintiff's lost opportunity to enjoy a reduced risk of loss and greater likelihood of profit, part of the benefit of the bargain, as "consistent with a goal of damages in the breach of contract setting." Id. at 512, citing Restatement (Second) of Contracts, 344(a)(1981)("expectation interest").
      a. This was accomplished by ignoring the restrictions on the ability to sell the stock and refusing to apply a discount to account for the restrictions.
    6. The Third Circuit agreed with the trial court's decision to ignore the restricted period, to refuse to apply a discount and to award plaintiff damages for his lost opportunity.
      a. Although the Court stated that the trial court's damage calculation was "undoubtedly imprecise", so too were the calculations urged by the parties.
      b. Under the circumstances, the trial court's remedy "adequately puts the plaintiff in the position he would have occupied absent the breach." Id. at 513.
      c. The Court further observed that the law "does not command mathematical preciseness from the evidence in finding damages", all that is required is "sufficient facts be introduced so that a court can arrive at an intelligent estimate without speculation or conjecture." Id. at 515, quoting Rochez, supra, 527 F.2d at 895.
    7. The Court affirmed the trial court's damage calculation because "it properly weighed and balanced the strengths and weaknesses of competing damage calculation methods to achieve the requisite end of putting [plaintiff] in the position most closely reflecting the one he would have held absent the breach." Id.
    8. The Third Circuit also observed that absent the breach, and consistent with the trial court's findings, plaintiff would have obtained 850,000 shares at $0.75 per share by risking $637,500.
      a. The trial court's damage calculation, therefore, came close to achieving this result because it placed on defendant the added risk, caused by its breach, of obtaining the same number of shares on the open market, the only remaining source for the shares. Id. at 513.
      b. The trial court did so by taking the difference between the market price for unrestricted shares and the option price ($0.75) and multiplying the difference by the total number of shares. Id.
    9. The Court also cited "numerous decisions" agreeing with the principle that "damage calculations should reflect economic reality." Id. at 515, citing Commonwealth Associates v. Palomar Medical Technologies, Inc., 982 F.Supp. 205, 210 (S.D.N.Y. 1977); Simon v. Electrospace Corporation, supra, 28 N.Y.2d 136, 269 N.E.2d 21, 27 (N.Y. 1971).

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