It is virtually impossible to open the business section of any newspaper today without reading about another company faced with an internal investigation, resignation of officers, or Securities and Exchange Commission (SEC) review of its stock option grant process. At last report, almost 200 public companies have launched, either on their own, or prompted by the SEC, investigations into potential backdating of their stock option grants. Criminal charges have been filed against company executives in several of these cases. And where there are investigations and criminal cases, the civil lawsuits — class actions and derivative cases — are soon to follow.
Last month, Chancellor Chandler of the Delaware Chancery Court issued two opinions directly addressing the issue of backdating and spring-loading in option grants that will likely make it easier for plaintiffs’ lawyers to bring derivative actions against companies accused of irregularities in their stock option grant process. In Ryan v. Gifford, C.A. No. 2213-N (Del. Ch. Feb. 6, 2007), the first Delaware case to address stock option backdating, Chancellor Chandler expressly ruled on the illegality of the practice. In addition, the chancellor addressed both the demand requirement under Aronson, and the substance of the backdating allegations against the company, Maxim Integrated Products, Inc. In In re Tyson Foods, Inc. Consolidated Shareholder Litigation, C.A. No. 1106-N (Del. Ch. Feb. 6, 2007), the court both rejected a statute of limitations defense to spring-loaded options and cemented the theory that spring-loading is a basis for a breach of fiduciary duty claim. Both these cases raise the specter of increased scrutiny of stock option transactions, even when the SEC or prosecutors decline involvement.
Ryan v. Gifford
Following a March 18, 2006 Wall Street Journal article discussing a statistical analysis of option grants, Merrill Lynch issued a report on stock option grants by various semiconductor companies including Maxim. Ryan, at 1. A derivative suit alleging breach of fiduciary duties against Maxim founder and CEO John Gifford soon followed. The suit alleged at least nine instances of backdated options issued to Gifford in alleged violation of the shareholder approved stock option plan. Id. at 7.
Defendants moved to dismiss the suit both for failure to make a demand upon the board of directors and for failure to state a claim for relief. The court rejected both of these arguments.
Much of the court’s discussion of backdating takes place in its extended analysis of the demand requirement under Delaware law. Under Aronson demand is excused where the plaintiff can raise a reasonable doubt that either, (a) a majority of the board is disinterested or independent, or (b) the challenged acts were the product of the board’s valid exercise of its business judgment. The court stated, however, that where the challenged action was not taken by the board, as is often the case in option grant situations, Aronson did not govern and instead, under Rales v. Blasband, plaintiffs must “create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” The court further recognized that under Delaware law the board of directors in place at the time of the grants would have been justified in relying upon the decision of a stock option or compensation committee on decisions relating to option grants.
Thus, where stock option grants were made by a compensation committee or stock option committee, the question is whether the board in place at the time the lawsuit is filed can act in a disinterested and independent manner in responding to a demand. Demand is required so long as the current board is capable of making an independent decision as to the demand.
The court, however, added a significant qualifier to this rule. The chancellor said that where, as was the case at Maxim, “at least one-half or more of the board in place at the time the complaint was filed approved the underlying challenged transactions, which approval may be imputed to the entire board for purposes of proving demand futility, the Aronson test applies.” Thus, where option grants were approved by either a full board of directors or by a committee representing half or more of current directors, the more stringent test of Aronson applies.
The analysis then turned to the substance of the backdating allegations. The court found that the complaint adequately alleged facts that raise doubt as to whether the challenged grants were a valid exercise of business judgment. The plaintiff claimed that the stock option plan in place at Maxim required that grants be made at 100 percent of the fair market price of the company’s stock at the time the option was granted. This provision of the stock option plan meant the board had no authority to grant “in the money” options as they had done. The plaintiff argued that knowing and intentional contravention of the plan could not be a reasonable exercise of business judgment.
The court agreed. The plaintiff had alleged that the nine questioned grants were made at the lowest market price in either the month or year granted. The complaint also made allegations, taken from the Merrill Lynch report, that the timing of the option grants resulted in an annualized return to the grantees of 243 percent versus a 29 percent annualized market return in the same period. The court noted that the questions raised by this data were supported by the fact that the grants were made not at regular intervals, but in a sporadic pattern. The court concluded that where the plan provided no discretion to grant options below market price the directors would violate their fiduciary duty by falsifying the date on which the options were granted in order to avoid the limits of the plan.
Although the opinion’s discussion of Aronson might suggest this result was dependent upon the fact that the plan required a market rate strike price, what the court did next suggests that the ruling was not intended to be that narrow. Although, affirming that Aronson applied, the court went on to consider what would have been the result under the Rales test. Noting that at least four current board members were implicated in the backdating allegations, the court said that the directors named in the complaint would have a disabling interest for demand purposes under Rales where the potential for liability rose beyond a mere threat to a substantial likelihood. The court then stated:
A director who approves 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 yet satisfy his duties of loyalty. Backdating options qualifies as one of those “rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.”
The court further went on to reject the motion to dismiss for failure to state a claim, finding that allegations of an intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the director’s purported compliance with the plan, constitute an act of disloyalty and therefore are done in bad faith for purposes of a Rule 12(b)(6) analysis of the claim. “I am unable to fathom a situation where the deliberate violation of a shareholder stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied with honestly with the shareholder-approved option plan, is anything but an act of bad faith.”
A reader of the Ryan case might initially assume that the key element of the Court’s opinion was the fact that the plan in question provided no options but market-based grants, thus not reaching instances of backdating under more flexible plans. However, the Tyson case issued the same day makes clear that the court’s overwhelming concern is not necessarily the plan violation, but the deception allegedly practiced upon shareholders.
In re Tyson’s
In a continual saga of derivative litigation involving the Tyson family’s control of Tyson Foods, the derivative plaintiffs in this case filed an action challenging a number of related party transactions and alleging that the company made grants of spring-loaded options to insiders. The plaintiffs alleged that days before Tyson would issue press releases, that were judged likely to drive stock prices higher, the compensation committee of Tyson would issues stock options to key employees. According the to the complaint, the total amount of options issued in this manner totaled 2.8 million shares.
The court first considered the defendants’ statute of limitations challenge to the allegations. The plaintiffs, conceding that the limitations period would otherwise extend back to only 2003, argued that the spring-loading could only be discovered after investors were able to observe a pattern of option grants. The court agreed with the plaintiffs that knowingly spring-loading options to key executives, while making public disclosures that such options were granted at market rates, was, “if not a lie, certainly exceptionally parsimony with the truth – constitutes an act of ‘actual artifice’ that satisfies the requirements of the doctrine of fraudulent concealment.” The court went further, however, stating that the directors’ roles as fiduciaries would, in and of itself, justify a tolling of the statute.
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.
The court also rejected arguments that the plaintiffs were on inquiry notice of the facts because portions of the relevant information was presented in proxy statements and press releases.
The court then turned to the substance of the complaint and initially found that given that the company, consistent with Delaware law, vested authority to grant options in the compensation committee, only those directors who were members of the committee approving the options could be named as defendants with respect to the option allegations.
Then turning to the facts at hand the court stated, as the members of the compensation committee were independent, in order to proceed the plaintiffs were required to meet the heavy burden of demonstrating that the option grants could not be within the bounds of the committee’s business judgment. Thus, it had to be shown that, “no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty."
Observing that the question of spring-loading was more difficult than that of backdating, the court said, “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.” Indeed, the court, referencing Ryan, stated that the backdating of options always involves a factual misrepresentation to a shareholder and, in the context of a shareholder approved incentive stock plan, amounts to a disloyal act taken in bad faith. Allegations of spring-loading, according to the court, implicate a much more subtle deception. The grant of spring-loaded options, without “authorization from shareholders, clearly involves an indirect deception.”
The decision makes plain that it is inconsistent with the duty to deal fairly and honestly with shareholders, “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,” even if the board complies with the procedures set forth in the plan.
While the issue of spring-loading remains unclear under federal securities laws, and many commentators agree that such action does not constitute insider trading, the court rejected this as a defense to the derivative claims:
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 shareholderapproved inventive option plan at a time when he knows those shares are actually worth more than the exercise price. A director who intentionally uses insider information 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.
The court did recognize that under this theory a plaintiff was required to demonstrate that the options were granted pursuant to a shareholder approved plan and that the directors approving spring-loaded option grants possessed material non-public information that would impact the company’s share price, or was otherwise seeking to circumvent shareholder approved restrictions upon the strike price granted. Nevertheless, the court’s opinion made clear that even if they escape scrutiny under federal securities laws, board’s that have spring-loaded shares, or even “bullet-dodged” their grants, are susceptible to shareholder litigation.
It would appear from these two opinions that the focus of the Delaware courts is on the deception practiced on shareholders by corporate boards that either backdate their option grants or seek to do an end-run around grant restrictions by timing their grants to the release of material information about the company while accurately dating the grants. The court has made clear such deception is inherently inconsistent with directors’ duties to shareholders. While companies under investigation for backdating and other option related issues already faced intense scrutiny from government regulators, these two decisions will likely lead to even greater scrutiny of stock option grants from the plaintiffs’ bar.