Recently, much has been made of stock options — backdating, spring-loading and misdating. While academic papers have identified practices that are now the subject of scrutiny, the legal profession has operated in the absence of judicial precedent. Recently, the Delaware Court of Chancery issued two opinions, each involving shareholder derivative suits, which, while largely dealing with procedural motions in advance of the discovery process, shed light on the Chancery Court's views on the practices of stock option backdating and spring-loading.
Ryan v. Gifford: The Backdating Case
Chancellor Chandler of the Delaware Court of Chancery issued an opinion on February 6, 2007, denying the defendants' motions to stay and to dismiss a derivative action involving alleged options backdating in the case of Ryan v. Gifford, C.A. No. 2213-N (Del. Ch. Feb. 6, 2007). The decision addresses many issues likely to recur in other stock options backdating cases, though the Court limited its holding to the "unique facts" of the case.
The case arose shortly after Merrill Lynch published an analysis of Maxim Integrated Products, Inc. ("Maxim"), pointing out the "fortuitously timed stock option grants" made to Maxim's executives. Suits on behalf of Maxim were then filed in federal court, California state court and Delaware Chancery Court. In the Delaware suit, the plaintiff named four current and two former members of the board of directors as defendants, claiming that the defendants had breached their fiduciary duties of due care and loyalty.
The plaintiffs challenged nine separate stock option grants between 1998 and 2002 to Maxim's founder, chairman of the board and chief executive officer, John F. Gifford, pursuant to two shareholder-approved stock option plans filed with the Securities and Exchange Commission. Under the terms of the two 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."
The plaintiff contended that the six defendants breached their fiduciary duties to Maxim and its shareholders in that the two stock option plans bound the board of directors to set the exercise price according to the terms of the plans. "As a result of the active violations of the plan and the active deceit, plaintiff contends that Maxim received lower payments upon the exercise of the options than would have been received had [the stock options] not been backdated. Further, Maxim suffers adverse effects from tax and accounting rules." The plaintiff also alleged unjust enrichment on the part of Gifford.
The Court first rejected defendants' motion to stay the Delaware action in favor of the earlier filed federal case, finding that "novel and substantial issues of Delaware corporate law are best resolved in Delaware courts." (A California state court had already stayed the California action.) The Court also found that the existence of the parallel federal action did not justify a stay on forum non conveniens grounds.1
The Court also rejected defendants' motion to dismiss for failure to allege demand futility with particularity. At the time the complaint was filed, Maxim had a six-person board of directors. Three of the six board members were on the Compensation Committee that awarded the allegedly backdated options. The Court found that the plaintiff had sufficiently alleged that the Compensation Committee's actions, in knowingly approving backdated options, failed to fall within the business judgment rule. In so ruling, the Court took into account statistical data suggesting that the options had been backdated. The Court also presumed that the directors granting the options knew the "actual" date on which the options had been granted.
For similar reasons, the Court rejected the motion to dismiss for failure to state a claim, finding that where a plaintiff "alleges particularized facts sufficient to prove demand futility under the second prong of Aronson [that is, where the alleged wrongdoing is not protected by the business judgment rule], that plaintiff a fortiori rebuts the business judgment rule for the purpose of surviving a motion to dismiss pursuant to Rule 12(b)(6)." The Chancery Court noted that the terms of the stock option plans required that the exercise price of each option be not less than 100% of the fair market value of the stock subject to the option on the date the option is granted. The board had no discretion to contravene the terms of the stock option plans. Thus, the Chancery Court "concluded that the unusual facts alleged raise a reason to doubt that the challenged transactions resulted from a valid exercise of business judgment."
In discussing the futility of making a demand on the board, the Chancery Court noted that "[a] director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders (regarding his violations of a shareholder-approved plan, no less) and satisfy his duty of loyalty. Backdating options qualifies as one of those 'rare cases [in which] a transaction may be so egregious on its face that the board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.'" Citing Aronson, 473 A.2d at 815.
The Court made two other notable rulings. It rejected defendants' statute of limitations defense, finding that the running of the statute had been tolled while the company's disclosures about its options granting practices were inaccurate.
The Court did, however, strictly enforce the rule that a plaintiff must own shares of the company from the time of the transaction in question to the completion of the lawsuit. As the plaintiff in this case did not become an owner of Maxim shares until April 11, 2001, all claims based on transactions before that date were dismissed.
The Chancery Court's ruling was limited to the allegations alleged in the pleadings, and the opinion addresses a motion to dismiss, as opposed to a motion for summary judgment. Thus, neither party has had the benefits of discovery, and the plaintiffs were afforded a presumption of truth. While not a ruling on the merits of the case, the Chancery Court's language in discussing the allegations of the complaint clearly indicate that the Chancery Court views the practice of option backdating with displeasure:
Based on the allegations of the complaint, and all reasonable inferences drawn therefrom, 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. Plaintiffs allege the following conduct: Maxim's directors affirmatively represented to Maxim's shareholders that the exercise price of any option grant would be no less than 100% of the fair value of the shares, measured by the market price of the shares on the date the option is granted. Maxim shareholders, possessing an absolute right to rely on those assurances when determining whether to approve the plans, in fact relied upon representations and approved the plans. Thereafter, Maxim's directors are alleged to have deliberately attempted to circumvent their duty to price the shares at no less than market value on the option grant dated by surreptitiously changing the dates on which the options were granted. To make matters worse, 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.
I am unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith. It certainly cannot be said to amount to faithful and devoted conduct of a loyal fiduciary. Well-pleaded allegations of such conduct are sufficient, in my opinion, to rebut the business judgment rule and to survive a motion to dismiss. [Footnotes omitted.]
Chancellor Chandler reaches this conclusion after discussing the bad faith language written recently by the Supreme Court of Delaware in Stone v. Ritter. Chandler writes:
In Stone v. Ritter, the Supreme Court of Delaware held that acts taken in bad faith breach the duty of loyalty. Bad faith, the [Supreme] Court stated, may be shown where "the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of known duty to act, demonstrating a conscious disregard for his duties."
However, it is unclear whether the Chancery Court is taking issue with the failure to disclose the violation of the shareholder-approved stock option plans, or the violation of the terms of the stock option plans themselves. As noted by Professor Stephen Bainbridge,2 "[p]resumably, the violation itself - rather than the accompanying failure to disclose the violation - is to be viewed as 'an act of bad faith.'" As Professor Bainbridge notes, "[t]he implication is that the board had the power to violate a shareholder approved stock option plan, but that its action to do so is an act of bad faith. Where the board of directors does something that violates an article of incorporation or bylaw, which like the plan here are deemed contracts with shareholders, the remedy is to simply invalidate the act," citing Emerald Partners v. Berlin, 1988 WL 25269 (Del. Ch.).
One practical implication of the Ryan v. Gifford decision is that by placing the act of backdating stock options into the bad faith/breach of a duty of loyalty category, Chancellor Chandler eliminates the protections afforded by §102(b)(7) of the Delaware Business Code that allow for director indemnification.
In re Tyson Foods: The Spring-loading Case
On the same day as the Ryan v. Gifford decision, Chancellor Chandler of the Delaware Court of Chancery issued a second decision regarding stock options. In re Tyson Foods, Inc. Consol. S'holder Litig., C.A. No. 1106-N (Del. Ch. Feb. 6, 2007). The Tyson decision denies a motion to dismiss nine separate claims against various defendants, including four instances of alleged option "spring-loading."
The Tyson decision arose from several compensation arrangements, including several post-employment consulting contracts, a number of related party transactions, and stock option awards to executives and directors. The Tyson stock incentive plan required that the exercise price of any stock option awarded (including both incentive stock options and nonqualified stock options) be not less than the fair market value of Tyson's Class A Common Stock on the date of the grant. The plaintiffs alleged that four stock option awards made to senior executives and directors were granted "days before Tyson would issue press releases that were very likely to drive stock prices higher." In denying a motion to dismiss these allegations, the Chancery Court concluded that spring-loading, if done intentionally, "involves an indirect deception" and constitutes a breach of the duty of loyalty:
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.[Footnotes omitted.]
The Court allowed that spring-loading might be appropriate in some circumstances. For example, spring-loaded options might be permitted by a company's stock option plan or otherwise authorized by shareholders. Or an award of spring-loaded options might be "made honestly and disclosed in good faith" and not "with the intent to circumvent otherwise valid shareholder-approved restrictions upon the exercise price of the options."
In reaching the decisions on the substantive claim above, the Chancery Court rejected a statute of limitations defense regarding the "older" option grants. The Chancery Court found that representing to shareholders that options are granted "at market rates," while they were, as alleged, granted with knowledge "that those options would quickly be worth much more," constitutes "fraudulent concealment" sufficient to toll the statute of limitations:
Assuming every fact in the consolidated complaint to be true, plaintiffs amply demonstrate that the doctrines of equitable tolling and fraudulent concealment toll the statute of limitations. Plaintiffs allege that defendants knowingly spring-loaded options to key executives and directors while maintaining in public disclosures that such options were issued at market rates. Such partial, selective disclosure - if not itself a lie, certainly exceptional parsimony with the truth - constitutes an act of "actual artifice" that satisfies the requirements of the doctrine of fraudulent concealment. Even were this not the case, defendants' roles as fiduciaries would justify tolling the statute of limitations through the doctrine of equitable tolling. Plaintiffs were entitled to rely upon the competence and good faith of those protecting their interests. It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which a fiduciary may declare that an option is granted at "market rate" and simultaneously withhold that both the fiduciary and the recipient knew at the time that those options would quickly be worth much more. Certainly at this state of the litigation, plaintiffs are entitled to the reasonable inference of conduct inconsistent with a fiduciary duty. The Court observed that while an investor is under an obligation to exercise reasonable diligence in his affairs, shareholders are not obligated "to sift through a proxy statement, on the one hand, and a year's worth of press clippings," on the other, in order to detect "a pattern concealed by those whose duty is to guard the interests of the investor."
The Chancery Court also determined that the plaintiffs were excused from making any pre-suit demand for relief upon Tyson's board of directors. Plaintiffs adequately alleged a "conspiracy-style theory" of "quid pro quo" transactions - spring-loaded options and other perquisites were allegedly awarded to Tyson family members by directors "in exchange for their own favorable related-party transactions." The Court concluded that these allegations "raise a reason to doubt the disinterestedness and independence of the board, justifying excusal of demand."
It is important to read and understand the Ryan v. Gifford and the Tyson cases together in order to understand the Chancery Court's concerns. When read together, it is clear that the Chancery Court is concerned with acts of deception on the part of the participants. The Tyson decision contrasts the actions in the Ryan v. Gifford decision by noting that stock option spring-loading is a more "subtle form of deception" than stock option backdating. While the Chancery Court does not specify the exact act of deception at Maxim that it takes issue with — there is not a precise statement by the Chancery Court that a failure occurred in the 8-K/10-Q or 10-K disclosure concerning the terms of the stock option plans, or the proxy statement description requesting shareholder approval of the stock option plan — in Ryan v. Gifford it was the combined actions of the directors that entailed an effort to deceive Maxim's shareholders in order to lead the shareholders to believe that the stock options were granted in accordance with the terms of the stock options plans. In contrast, the Tyson decision shows the Chancery Court is still concerned with a deception practice, notwithstanding an adherence to the terms of Tyson's stock option plan. Rather, in Tyson the Chancery Court was concerned simply with the board's taking actions that undermined the objectives of the stock option plan.
One implication for practitioners from the Ryan v. Gifford and Tyson cases is that the Chancery Court's concerns are applicable not just to stock options. These issues can arise with any board action taken in conflict with a contract, a plan or accepted governance practices.