Over the past two years, much attention has been focused on stock option backdating issues. Indeed, over a hundred companies have conducted some type of investigation into their own options backdating practices. 74 In 2007, we saw the filing of additional securities fraud class actions and derivative lawsuits, alleging inappropriate stock option practices.75 Such suits often coincided with the announcement of SEC investigations or enforcement actions. In fact, hundreds of companies have been or are currently under investigation by the SEC, the Department of Justice, or local authorities on these issues.76 In 2007, the SEC announced 15 enforcement actions against various companies and/or their executives on backdating issues with related settlements totaling over $518 million.77
Options backdating typically involves issuing stock options on one date, but providing documentation that indicates the options were actually issued on an earlier date, generally when the stock option grant price was lower. Several companies have also been criticized for a practice known as “spring loading,” which involves issuing options prior to the public announcement of positive news, thus allowing the owner of the options to take advantage of the increase in stock price from the good news.
Backdating or spring loading of options is not illegal. Nevertheless, shareholder plaintiffs have argued that these practices give rise to a cause of action under the federal securities laws. They contend that a company’s public statements on executive compensation or its stock option plan were false or misleading due to the failure to disclose these practices. Options backdating may also raise a number of tax and accounting issues, which plaintiffs claim resulted in the issuance of inaccurate financial statements.
To date, however, shareholder plaintiffs have faced significant legal obstacles, which have thwarted their attempts to move beyond the motion to dismiss stage. For example, plaintiffs in securities class actions have had difficulty satisfying the requirement of pleading loss causation under the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo.78 In November, backdating claims against Apple, Inc. and several of its current and former officers and directors were dismissed for this reason, among other defects identified by the court.79 The plaintiffs in that case could point to no “discernible drop in stock price” associated with any of the company’s backdating disclosures and, thus, they failed to show that the defendants’ alleged misconduct resulted in any harm to them.80 Also, because the options in question in many cases may have been issued years ago, a number of class action claims have been dismissed under the applicable statute of limitations or repose.81
Similarly, pleading scienter for federal securities law claims has proven to be problematic for plaintiffs. Many backdating complaints have been dismissed for failure to allege a strong inference of scienter as to each of the individual director and officer defendants.82 Plaintiffs have been unable to plead with the required particularity that these defendants, who were the supposed beneficiaries of backdated options, knew the options they received were backdated or were in reckless disregard of these facts. Many complaints rely exclusively on generalized allegations of knowledge and participation in a backdating scheme made collectively against a group of individual defendants that are plainly insufficient even under more liberal Federal Rule of Civil Procedure 12(b)(6) standards. Plaintiffs’ sole support is often the person’s alleged service on a particular board committee or their high-ranking position at the company at the time the option grants occurred. Several courts have found these allegations to be insufficient to plead scienter.83
Because of the perceived difficulties in pursuing class claims, many shareholder plaintiffs have chosen instead to bring derivative claims purportedly on behalf of the company at issue. The derivative suits typically allege state law claims against the directors and officers for breaches of the fiduciary duties of care, loyalty and candor, unjust enrichment, waste of corporate assets, gross mismanagement, and abuse of control.
These claims have also proven to be a challenge in that many plaintiffs have been unable to plead with particularity that the required pre-suit demand on the company’s board of directors would have been futile.84 Also, several prospective plaintiffs have lacked standing to bring derivative claims because they have been unable to show that they owned shares of the company’s stock at all times when the allegedly improper backdating practices occurred.85 Further, many putative derivative actions have been stayed until such time as a special litigation committee appointed by the company’s board of directors has had a sufficient opportunity to investigate the backdating allegations and to recommend whether the suit should be dismissed or taken over by the company.86
Over the course of this past year, we saw a decline in the number of lawsuits being filed based on options backdating. Indeed, there have been no new securities class actions on backdating brought in the last several months and the SEC has decided to close many of its investigations on these issues without pursuing any claims. This decline in filings is likely due to the fact that most companies self-reported their backdating practices and such disclosures have already occurred. Thus, there existed only a finite number of companies that were the potential targets of this type of lawsuit. Additionally, the practical difficulties associated with prosecuting these backdating claims is perhaps also a factor in the declining number of suits. Some level of backdating litigation activity, however, must continue into 2008 due to the existence of prior filings, many of which are still at the motion to dismiss stage.