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A reverse stock split automatically alters a pre-existing warrant to purchase shares to reflect the corporation’s new stock ownership structure and share price, the New York Appellate Division, 1st Department, ruled last week in a case of first impression under New York law. By a 4-1 margin, the panel said that a warrant holder, after a one-for-five reverse split, had the right to purchase one-fifth of the amount reflected in the warrant for five times the pre-split price per share. The adjustment is necessary, the majority said in a decision by Justice David Friedman, to preserve the “self-evident expectation” of the parties to the original warrant. But in dissent, Justice David B. Saxe said that the warrant could only be transformed if an aggrieved party showed that the deal had become tainted by fraud, unconscionable conduct by the stock issuer, or other circumstance. In Reiss v. Financial Performance Corp., 2419-2420, the defendant, Financial Performance Corporation, issued a warrant to plaintiff Rebot Corporation to purchase almost $1.2 million shares of Financial’s common stock at a price of 10 cents per share. The warrant, which was to be in effect from Oct. 8, 1993 to Sept. 30, 1998, was given in consideration of $187,000 in loan forgiveness to Financial Performance from Rebot. Plaintiff Marvin Reiss, a member of Financial Performance’s board and Rebot’s president, received a warrant to purchase 500,000 shares of Financial Performance stock at 10 cents per share. The life of Reiss’ warrant was from Nov. 11, 1993 to Aug. 31, 1998. In August 1996, Financial Performance’s shareholders approved a one-for-five reverse stock split. Each shareholder would own one-fifth of their original number of shares, with each share having five times the value of the old shares. In April 1998, Rebot and Reiss sought to exercise some of their rights under the warrants to purchase Financial Performance stock. The plaintiffs said they had the right to buy as many shares at the same price as they were entitled to under the original warrants. But Financial Performance said that it had adjusted the warrants to reflect the new structure of stock ownership after the reverse split. If the old numbers contained in the original warrant were still in effect, Financial Performance argued, the warrant holders would be entitled to buy five times more shares than the parties originally intended. In ruling in favor of Financial Performance and allowing an automatic adjustment of the outstanding warrants, the majority affirmed the ruling of Manhattan Supreme Court Justice Charles E. Ramos. Allowing the plaintiffs to buy as many shares as they would be entitled to under the original warrants would be to give them a much better bargain than they were originally entitled to, Friedman said in the appellate opinion. “[Plaintiffs argue that a] literalistic approach to the interpretation of the warrants is compelled as a matter of law,” Friedman observed. “Surely 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 the making of a contract.” PRESERVING EXPECTATIONS The majority agreed with a 1922 decision from the 1st U.S. Circuit Court of Appeals, Cofman v. Acton Corp., 958 F2d 494, which held that the lack of contractual agreement on the effect of a reverse stock split was an ambiguity, and the gap had to be filled by the court in fulfilling the expectations of the parties. The Cofman court said that to preserve the expectations of the sides in the deal, a proportional modification was required to account for the reverse stock split. Friedman explicitly adopted the Cofman approach. “We find Cofman to be dispositive of the issue presented here by force of its logic, albeit not as a matter of stare decisis,” Friedman said. The 1st Department in Reiss strongly indicated that it would also call for an automatic adjustment in the warrant to deal with the effect of a conventional stock split, in which existing shares are multiplied in number and the per-share value adjusted downward. “[T]o accept plaintiffs’ interpretation of the contract … would necessarily mean that the warrants also did not allow for a proportional adjustment if there were a [conventional] stock split,” Friedman wrote. “Flowing from that reasoning is the observation that Financial … could have eviscerated the value of plaintiffs’ warrants and escaped its contractual obligations by simply declaring a massive stock split instead of a reverse stock split. “[I]t defies all bounds of common sense to believe that plaintiffs could ever have intended such an outcome.” Joining Justice Friedman in the majority were Justices Joseph P. Sullivan, Richard W. Wallach and Israel Rubin. FOUR CORNERS Justice Saxe, writing in dissent, said traditional principles of contract law forbade the court from going outside the four corners of the document. A differing view of the warrant needed to be backed by extenuating circumstances. “The law of contracts offers relief from a hard bargain only upon a showing of fraud, duress, mistake, misrepresentation, illegality, impossibility of performance or unconscionability,” Saxe wrote. “But, when none of those grounds has been established, and the terms of the agreement under consideration are clearly set forth within the four corners of the document, courts should not alter those terms, even where the alteration achieves a more equitable result.” Joseph M. Weitzman of Manhattan represented the plaintiffs. Howard Grun, of Kaufman, Friedman, Plotnicki & Grun in Manhattan, represented the defendant, Financial Performance.

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