In Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), the Delaware Court of Chancery addressed a novel issue of Delaware law: whether backdating stock option grants violates one or more fiduciary duties. From 1998 through mid-2002, the board of directors of Maxim Integrated Products, Inc. (“Maxim” or the “Company”), and, in particular, the Company’s Compensation Committee, granted options for the purchase of millions of shares to the Company’s founder, chairman and CEO John F. Gifford (“Gifford”). Those options were granted pursuant to stockholder approved stock option plans filed with the U.S. Securities and Exchange Commission (“SEC”). According to the stock option plans, the exercise price of options granted thereunder had to 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.
Plaintiff, Walter E. Ryan (“Plaintiff”), continuously held shares of Maxim since April 11, 2001, when his shares of Dallas Semiconductor were converted to Maxim shares in connection with Maxim’s acquisition of Dallas Semiconductor. The alleged option backdating commenced as early as 1998; however, because Plaintiff did not become a Maxim stockholder until April 11, 2001, the Court of Chancery held that he lacked standing to challenge instances of backdating prior to that date. The impetus for Plaintiff’s action, and numerous other stockholder challenges to option dating and timing at various companies throughout the country, was a March 2006 report issued by Merrill Lynch. In the report, Merrill Lynch conducted a statistical analysis of the timing of stock option grants during the period 1997-2002 by the companies that comprise the Philadelphia Semiconductor Index. The report found a substantial divergence between stock price performance subsequent to options pricing events versus stock price performance over a longer period of time. As to Maxim, in particular, “Merrill Lynch found the twenty-day return on option grants to management averaged 14% over the five-year period, an annualized return of 243%, or almost ten times higher than the 29% annualized market returns in the same period.” Although the Merrill report did not conclude any actual backdating, it noted that if backdating did not occur, then Company management must have had an uncanny ability to time options pricing events.
Less than three months following the Merrill Lynch report, Plaintiff filed a derivative action alleging breach of fiduciary duty against six current and former members of the Company’s board of directors: Gifford; three other directors who comprised the Company’s compensation committee at all times relevant to the action, Bergman, Hagopian, and Wazzan; Karros, a director from 2000-2002; and Sampels, a director from 2001-2002 (collectively, “Defendants”). Maxim was named a nominal defendant. Plaintiff alleged that nine specific stock option grants were backdated between 1998 and 2002 because they seemed too fortuitously timed to be coincidence. Each of the grants corresponded with low (or the lowest) trading days of the years in question, or on days immediately preceding precipitous increases in the Company’s stock price.
Before turning to the central issue, it is important to note that Defendants sought to dismiss the complaint based on the fact that similar actions were first filed in other jurisdictions. The court declined to exercise its broad discretion to dismiss Plaintiff’s complaint in favor of the first filed actions, in part because the Court of Chancery was presented with a novel question of Delaware corporate law that is best resolved by a Delaware court. Defendants also argued that Plaintiff’s complaint was subject to dismissal because the applicable three-year statute of limitations had run. The Court also rejected this affirmative defense, holding that the directors’ failure to disclose the backdating, in light of the affirmative representations to the contrary in the option plans, amounted to fraudulent concealment sufficient to toll the statute of limitations. The Court refused to hold Plaintiff to the burden of conducting a statistical analysis based on publicly available information in order to uncover the alleged backdating.
The critical defenses asserted by the Defendants was that Plaintiff failed to make demand or demonstrate demand futility. When a stockholder seeks to maintain a derivative action on behalf of a corporation, Delaware law requires that stockholder to first make demand on the board of directors. The purpose of the demand requirement is to afford the directors an opportunity to examine the stockholder’s grievance and the related facts and determine whether pursuing the action is in the best interest of the corporation. This process allows the directors to determine whether the company should maintain control of the derivative litigation, the very purpose of which is to obtain a recovery for the benefit of the company, as opposed to a direct recovery for the benefit of the stockholder plaintiff. The demand requirement is, however, excused if a plaintiff can raise a reason to doubt that: (i) a majority of the board is disinterested and independent or (ii) the challenged acts were the product of the board’s valid exercise of business judgment. This test for demand excusal, referred to as the Aronson test [derived from the 1984 case of Aronson v. Lewis, 473 A.2d 805 (Del. 1984)] applies when the challenged decision is a decision of the board in place at the time the complaint is filed.
As a threshold matter, the Court had to determine whether it was appropriate to apply the Aronson test. Maxim’s board consisted of six members at all relevant times. Three of those members, Bergman, Hagopian, and Wazzan, constituted the compensation committee. Thus, three of the board’s six members approved each challenged option grant. When at least one half or more of the board in place at the time the complaint is filed is also in place at the time the underlying transactions being challenged were approved, the Aronson test applies.
For purposes of the demand futility test, three out of six directors (i.e., the compensation committee) constitutes a majority. Based on this, Plaintiff argued that their approval of the challenged option grants, under the circumstances alleged in the complaint, called into question whether such acts were valid exercises of business judgment under the second prong of Aronson. The Court agreed:
Specifically, plaintiff states that the terms of the stock option plans required that “[t]he exercise price of each option shall be not less than one hundred percent (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. Altering the actual date of the grant so as to affect the exercise price contravenes the plan. Thus, knowing and intentional violations of the stock option plans, according to the plaintiff, cannot be an exercise of business judgment. I conclude that the unusual facts alleged raise a reason to doubt that the challenged transactions resulted from a valid exercise of business judgment. (Emphasis in original).
The Court noted that Plaintiff’s position was bolstered by empirical evidence suggesting that backdating occurred. According to the Merrill Lynch report, Maxim’s average annualized return of 243% on option grants to management was almost ten times higher than the 29% annualized market returns in the same period. This “aggressiveness” in the timing of option grants militates in favor of a finding of backdating because, according to the Court, it “seems too fortuitous to be mere coincidence. The appearance of impropriety grows even more when one considers the fact that the board granted options, not at set or designated times, but by a sporadic method.”
As a final comment on its demand futility analysis, the Court stated that even if the actions of the compensation committee could not be imputed to the entire board, thus implicating the Aronson test, stockholder demand still would have been futile under the alternate Rales test [derived from the 1993 case of Rales v. Blasband, 634 A.2d 927 (Del. 1993)]. This alternate test applies when the challenged transaction is not the result of a business decision made by the board in place at the time a derivative complaint is filed. Where the board has not made a decision, demand is excused when the complaint contains particularized facts creating a reason to doubt that a majority of the directors would have been independent and disinterested when considering the demand. Directors who are sued have a disabling conflict of interest for pre-suit demand purposes when “the potential for liability is not a mere threat but instead may rise to a substantial likelihood.” The Court reasoned that a director who approves backdating of options faces a substantial likelihood of liability because the grant of options that contravenes the terms of a stockholder approved option plan is a lie to stockholders that is difficult, if not impossible, to reconcile with that director’s duty 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.” Plaintiff alleges that three members of a board approved backdated options, and another board member accepted them. These are sufficient allegations to raise a reason to doubt the disinterestedness of the current board and to suggest that they are incapable of impartially considering demand. (Emphasis in original).
Defendants next argued that Plaintiff’s complaint was subject to dismissal for failure to state a claim pursuant to Court of Chancery Rule 12(b)(6) because the complaint did not (i) contain allegations sufficient to rebut the presumptions of the business judgment rule (i.e., that the directors acted on a reasonably informed basis and in the best interests of the corporation) or (ii) allege waste. The Court disagreed, holding instead that the same facts that establish demand futility under the second prong of Aronson–the directors’ purposeful failure to honor the pricing requirement in the stock option plan–also rebut the business judgment rule for a motion to dismiss. This is because the pleading requirement for alleging demand futility is more stringent than the one for surviving a motion to dismiss. Because Plaintiff alleged particularized facts sufficient to demonstrate demand futility, a fortiori Plaintiff also rebutted the business judgment rule.
Even if this were not the case, the Court noted that the complaint alleged acts taken in bad faith. Such acts constitute a breach of loyalty and thus rebut the business judgment rule. According to the complaint, those acts were (i) the affirmative representation to stockholders that the exercise price of option grants would be not less than the fair market value of Maxim’s stock on the date of the grant; (ii) in reliance on this representation, Maxim’s stockholders approved the option plans; (iii) Maxim’s directors subsequently attempted to circumvent their duty to price options in accordance with the options plans by surreptitiously changing the dates on which the options were granted; and (iv) the directors failed to disclose this conduct to the stockholders, instead making false representations about option dates in public disclosures. Accepting as true these allegations and all reasonable inferences drawn therefrom, as it must on a motion to dismiss, the Court concluded:
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.
The burden on a stockholder plaintiff to plead demand futility is an onerous one. Although Plaintiff in this case met that burden, one cannot assume that other stockholder plaintiffs will be as successful in different derivative actions involving the dating and/or timing of stock option grants. Here, as noted repeatedly by the Court, Maxim’s stock option plans provided that “the exercise price of each option shall be not less than one hundred percent (100%) of the fair market value of the stock subject to the option on the date the option is granted.” The stock option plans of many companies, by contract, expressly permit discounted options or use less stringent language. In such cases, stockholder plaintiffs would not have the same basis as Plaintiff in this case to allege reason to doubt that the option grant at issue was the product of a valid exercise of the directors’ business judgment. Moreover, if options are granted by compensation committees or other directors constituting less than a majority of the board, there may well be a majority of disinterested and independent directors in place to consider demand on the date a complaint is filed. Finally, it is significant to keep in mind the procedural posture of the case at the time the Court rendered its decision in Ryan v. Gifford . The motions at issue were based on the pleadings. At this stage of the litigation, Plaintiff is entitled to certain presumptions and inferences regarding the verity of his allegations. Should the case go to trial, however, it will be incumbent on Plaintiff actually to prove by a preponderance of the evidence: (i) specific instances of backdating; (ii) violations of stockholder approved option plans; and (iii) fraudulent disclosures regarding compliance with such plans. Regardless of the outcome of this particular case, the Court of Chancery has signaled that on the appropriate set of facts the intentional backdating of stock options will violate the fiduciary duties of directors of a Delaware corporation.