The Delaware Chancery Court issued two rulings earlier this month that suggest the nation’s most influential tribunal on corporate law is going to be tough on companies embroiled in litigation over stock option backdating.
The two cases, one against chip manufacturer Maxim Integrated Products and the other involving Tyson Foods, rejected the argument that companies are shielded from backdating-related complaints under the business judgment rule. The Tyson case also allowed complaints to proceed against specific officers and directors and squarely put “springloaded” grants—where options are issued ahead of good news that pushes a stock price higher—in the same disapproving light as options backdated to inflate their value artificially.
Muck
Both rulings are merely preliminary, allowing civil litigation to proceed. But Kevin Muck, a partner with the law firm Fenwick & West, cautions that “the tone of some of the language” used by the court was “perhaps unduly sweeping.” In particular, Muck notes a passage in which the court says that “all” backdated options “involve a fundamental incontrovertible lie.”
The Delaware court is the first in the country “to clearly come down on the side of the plaintiffs,” says Peter Blume, of the law firm Thorp Reed & Armstrong. “I don’t believe any prior court decisions on backdating came out squarely in favor of the plaintiffs.”
Blume
Particularly notable is the ruling on springloaded options. A split has emerged on the Securities and Exchange Commission about whether springloading is illegal, with Commissioner Paul Atkins arguing that it isn’t, while SEC Chairman Christopher Cox likens it to insider trading.
“Now we have at least one court saying that backdating and springloading are deceptive practices,” says Fiona Philip, a partner with the Howrey law firm.
The Maxim Case
The case directly involving backdated stock options centers on Maxim Integrated Products, a Silicon Valley maker of integrated circuits. From 1998 to mid-2002, Maxim’s board of directors and compensation committee granted stock options for millions of shares of Maxim common stock to John Gifford, the company’s founder, board chairman, and CEO, pursuant to shareholder-approved stock option plans filed with the SEC.
Under the terms of those plans, Maxim contracted and represented that the exercise price of all stock options granted would be no less than the fair market value of the company’s common stock, measured by the publicly traded closing price for Maxim stock on the date of the grant. After corporate backdating practices came under scrutiny in 2006, Maxim was hit with litigation in various forums over alleged backdating practices. The Delaware derivative suit asserted that the defendants breached their fiduciary duties to the company and its shareholders.
Court Chancellor William Chandler rejected the defendants’ contention that they were protected from liability by the business judgment rule.
“I am convinced that the intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the directors’ purported compliance with that plan, constitute conduct that is disloyal to the corporation and is therefore an act in bad faith,” Chandler wrote.
The judge noted that the complaint alleges that Maxim’s directors “affirmatively represented to Maxim’s shareholders” that the exercise price of any option grant would not be less than the fair-market value of the shares the day the options were granted. “Maxim shareholders, possessing an absolute right to rely on those assurances when determining whether to approve the plans, in fact relied upon those representations and approved the plans,” Chandler wrote.
“To make matters worse,” he continued, once allegations of backdating emerged, “the directors allegedly failed to disclose this conduct to their shareholders, instead making false representations regarding the option dates in many of their public disclosures.”
Springloading: The Tyson Case
RULING
An excerpt follows from the court’s ruling in Tyson on Count III, which claims that the entire board may be challenged for the compensation committee’s decision.
2. Substantive Claims
Plaintiffs concede that the sole authority to grant these options rested in the Compensation Committee, but argue that the entire board may be challenged because the Committee was required to consider the
recommendations of the Chairman and Chief Executive Officer, each of whom were recipients of options themselves. This argument is inconsistent with Delaware law.
A committee of independent directors enjoys the presumption that its
actions are prima facie protected by the business judgment rule. That the Committee was required to consult with other corporate officers is irrelevant: the committee admittedly retained independent authority and discretion to
approve or modify whatever it received as a recommendation. Plaintiffs’
complaint should properly target only the members of the compensation
committee at the time the options were approved: Vorsanger, Massey,
Cassady, Allen, Hackley, Jones and Smith.
As plaintiffs’ allegations against these directors are insufficient to
suggest a lack of independence, plaintiffs must demonstrate that the grant of
the 2003 options could not be within the bounds of the Compensation
Committee’s business judgment. A severe test faces those seeking to
overcome this presumption: “[W]here a director is independent and
disinterested, there can be no liability for corporate loss, unless the facts are
such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty.”
Whether a board of directors may in good faith grant spring-loaded
options is a somewhat more difficult question than that posed by options
backdating, a practice that has attracted much journalistic, prosecutorial, and
judicial thinking of late. At their heart, all backdated options involve a
fundamental, incontrovertible lie: directors who approve an option dissemble
as to the date on which the grant was actually made. Allegations of spring-
loading implicate a much more subtle deception.
Granting spring-loaded options, without explicit authorization from
shareholders, clearly involves an indirect deception. A director’s duty of
loyalty includes the duty to deal fairly and honestly with the shareholders for
whom he is a fiduciary. It is inconsistent with such a duty for a board of
directors to ask for shareholder approval of an incentive stock option plan and
then later to distribute shares to managers in such a way as to undermine the
very objectives approved by shareholders. This remains true even if the board
complies with the strict letter of a shareholder-approved plan as it relates to
strike prices or issue dates.
The question before the Court is not, as plaintiffs suggest, whether
spring-loading constitutes a form of insider trading as it would be understood
under federal securities law. The relevant issue is whether a director acts in
bad faith by authorizing options with a market-value strike price, as he is required to do by a shareholder-approved incentive option plan, at a time when he knows those shares are actually worth more than the exercise price. A director who intentionally uses inside knowledge not available to shareholders in order to enrich employees while avoiding shareholder-
imposed requirements cannot, in my opinion, be said to be acting loyally and
in good faith as a fiduciary.
This conclusion, however, rests upon at least two premises, each of
which should be (and, in this case, has been) alleged by a plaintiff in order to
show that a spring-loaded option issued by a disinterested and independent
board is nevertheless beyond the bounds of business judgment. First, a
plaintiff must allege that options were issued according to a shareholder-
approved employee compensation plan. Second, a plaintiff must allege that
the directors that approved spring-loaded (or bullet-dodging) options (a)
possessed material non-public information soon to be released that would
impact the company’s share price, and (b) issued those options with the intent to circumvent otherwise valid shareholder-approved restrictions upon the exercise price of the options. Such allegations would satisfy a plaintiff’s requirement to show adequately at the pleading stage that a director acted disloyally and in bad faith and is therefore unable to claim the protection of the business judgment rule. Of course, it is conceivable that a director might show that shareholders have expressly empowered the board of directors (or
relevant committee) to use backdating, spring-loading, or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law. But defendants make no such assertion here.
Plaintiffs’ have alleged adequately that the Compensation Committee
violated a fiduciary duty by acting disloyally and in bad faith with regard to the grant of options. I therefore deny defendants’ motion to dismiss Count III as to the seven members of the committee who are implicated in such conduct.
Source
In Re Tyson Foods, Inc. (Court Of Chancery Of The State Of Delaware In And For New Castle County; Feb. 6, 2007)
Chandler described the springloading case against Tyson as a “lengthy and complex complaint” involving almost a decade’s worth of transactions.
Although Chandler did dismiss some defendants and determine that certain claims were barred, he allowed the plaintiffs—who are suing derivatively on behalf of the corporation—to proceed on their claim charging Tyson directors with breaching their fiduciary duties, by favoring their own personal interests and those of the Tyson family ahead of minority shareholders.
Chandler also refused to dismiss counts charging certain directors and executives with corporate waste and unjust enrichment, saying the defendants faced liability if they profited from timed option grants or improper payments.
“Whether a board of directors may in good faith grant springloaded options is a somewhat more difficult question than that posed by options backdating,” Chandler wrote. “At their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made. Allegations of springloading implicate a much more subtle deception.”
But Chandler went on to rule that granting springloaded options, without explicit authorization from shareholders, “clearly involves an indirect deception. A director’s duty of loyalty includes the duty to deal fairly and honestly with the shareholders for whom he is a fiduciary. It is inconsistent with such a duty for a board of directors to ask for shareholder approval of an incentive stock option plan and then later to distribute shares to managers in such a way as to undermine the very objectives approved by shareholders. This remains true even if the board complies with the strict letter of a shareholder-approved plan as it relates to strike prices or issue dates.”
Taking Backdating Seriously
Knapp
Toby Knapp, a partner with the law firm Jenner & Block in New York, stresses that both cases involved motions to dismiss the complaints, meaning that the court had to make inferences in favor of the plaintiffs and assume that all of the stated facts were true; other cases might be decided quite differently.
But, Knapp says, the rulings come “from a very influential judge on a very influential court … and will have some influence as other courts continue to consider these issues.” Knapp also says it’s notable that, in both cases, the judge allowed the statute of limitations to be suspended “on the theory that the shareholders could not themselves have discovered all of the facts around the option grants.”
Philip
Philip, of Howrey, says the rulings suggest that “it won’t be easy” to get such claims dismissed, “particularly where the court has determined that deceptive disclosures regarding option grants by the board of directors masks the plaintiffs’ ability to determine whether the company is being run effectively by those same directors.”
Muck says corporate defendants may have reason to worry that the court allowed the lawsuits to go forward in that state even though other litigation is pending elsewhere. “In light of these decisions, you might have plaintiffs bringing suit in Delaware even when there’s already a suit filed [elsewhere],” Muck says. “Essentially, you can have the same claims being litigated on parallel tracks 3,000 miles apart. That’s obviously less than optimal.”
Unkovic
Nicholas Unkovic, a partner with the law firm Squire Sanders & Dempsey, says there’s a long way to go in determining where the courts will ultimately come down on litigation over stock options.
“The [Maxim] case suggests that the Delaware court is going to take backdating extremely seriously, but this is just the first skirmish in the battle, not an ultimate determination of liability on the merits,” he says. “The real battle has yet to be fought.”
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