In Conrad v. Blank, et al., 2007 WL 2593540 (Del. Ch.), the Delaware Court of Chancery addressed another alleged stock option backdating scheme, this time involving Staples, Inc. (“Staples” or the “Company”). In November of 2006, in its third quarter Form 10-Q, Staples disclosed the results of an internal review by the Company and its audit committee of the Company’s historic stock option granting practices from 1997 to the present and found “accounting errors due to the use of incorrect measurement dates.” As a result of these errors, the Company recorded a $10.8 million expense in third quarter of 2006, but was not required to restate any historical financials. The Company’s 10-Q reported that the use of incorrect measurement dates was not the result of intentional wrongdoing. The Company’s filing, however, did not elaborate further and did not mention any effort by the Company to recover value from those who received improperly dated options and did not mention any effort to hold anyone accountable for the use of incorrect measurement dates.
Plaintiff, a Staples stockholder since 1998, commenced a derivative action in December 2006, challenging an alleged 10-year scheme by which the Company illegally backdated over 7.5 million stock options that were issued to members of senior management. The complaint alleged that from 1994 to 2003 there were 51 discretionary stock option grants, 12 of which appear to have been backdated. Plaintiff alleged that her backdating claim was supported by: (i) Staples’ public filing, admitting the pricing of options at “incorrect measurement dates;” (ii) violations of the option plans, under which the options in question were granted and which required that the exercise price be equal to the fair market value of the underlying company stock on the date of the grant; and (iii) a statistical analysis showing the allegedly favorable timing of the challenged option grants.
The individual defendants, all current or former members of the Staples board of directors, and the Company as nominal defendant, moved to dismiss plaintiff’s derivative complaint on two grounds: (i) failure to plead demand futility under Court of Chancery Rule 23.1 (“Rule 23.1”); and (ii) lack of standing with respect to certain option grants. In denying the defendants’ motion to dismiss for failure to plead demand futility, the Court held that demand was excused under the test announced in Rales v. Blasband, 634 A.2d 927 (Del. 1993). Of the 10 members of the board at the time the complaint was filed, five were either recipients of the allegedly backdated options or were members of the compensation committee charged with approving the grants. Because the complaint contained allegations sufficient to raise a reasonable doubt that at least half of the board could have exercised its independent and disinterested judgment in responding to plaintiff’s demand, the Court held that demand would have been futile and plaintiff was free to bring her complaint on behalf of the Company. Interestingly, though, the Court noted that it was troubled by the fact that the same counsel represented the Company and the individual defendants alleged to have received and approved the challenged stock option grants. Specifically, the Court stated, “[g]iven the finding of erroneous dating practices (by inference, backdating), the court questions how it is that the interests of the corporation are not, or at least do not appear to be, adverse to the interests of the individual defendants."
In the course of denying the defendants’ motion to dismiss based on failure to make demand, the Court had occasion to distinguish at least one aspect of another recent case dealing with allegations of stock option backdating, Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007). Relying on Desimone, defendants argued that plaintiff had to show that the compensation committee members knew of the alleged backdating in order for her complaint to survive a motion to dismiss under Rule 23.1. Unlike the stock option plans in Desimone, the stock option plans in Staples required that all grants be made at fair market value. Moreover, in Staples, the plaintiff identified 12 specific option grants by date and alleged that the compensation committee directly authorized them. From this, the Court could infer, at least at the pleadings stage of the case, that it is fairly unlikely that that the compensation committee could have innocently or unknowingly authorized backdated options.
Although it rejected defendants’ motion to dismiss under Rule 23.1, the Court conditionally granted the defendants’ second basis for dismissal – lack of standing under 8 Del. C. § 327 as to certain option grants that pre-dated the plaintiff’s stock ownership. Section 327 prohibits a plaintiff from bringing a derivative action to challenge a transaction that does not coincide with that plaintiff’s stock ownership. The Court stated that it was constrained by recent decisions holding that the “continuing wrong” theory does not apply to a pattern of allegedly backdated stock option grants such that they can be characterized as an ongoing wrong that can be challenged by a plaintiff who purchased stock after the commencement of the pattern of allegedly backdated grants. Rather, each such grant must be viewed as an independent transaction. Accordingly, plaintiff was barred from challenging any instance of alleged backdating prior to 1998. Nevertheless, the Court did condition its dismissal on the parties submitting information to the Court as to whether another stockholder was willing to intervene to assert claims relating to alleged instances of backdating that pre-dated the plaintiff’s ownership of Staples stock.