The options backdating scandal has engendered a flood of shareholders’ derivative lawsuits (146 as of the last count, here). The D & O Diary has previously questioned (here) plaintiffs’ lawyers’ apparent enthusiasm for these suits given the numerous potential defenses these cases present, including, among others, statute of limitations, demand failure, and the business judgment rule. However, two February 6, 2007 opinions by Chancellor William B. Chandler III (pictured above) of the Delaware Court of Chancery, rejected defendants’ dismissal motions on these grounds, and is permitting the options manipulation cases to go forward.
The two opinions were issued in connection with an options backdating case in which Maxim Integrated Products is named as a nominal defendant (Ryan v. Gifford), and with respect to the option springloading allegations in the Tyson Foods Consolidated Shareholder Litigation. The Maxim opinion can be found here and the Tyson Foods opinion can be found here.
The Maxim case is only one of several derivative lawsuits that shareholder plaintiffs have filed alleging options backdating at the company, and the Delaware case was not even the first filed. There are other cases pending in California federal and state court. The Chancellor nevertheless declined to stay the Delaware action because the case presents questions of “great import to the law of corporations.” Because Delaware courts have not addressed these “fundamental issues” and because Delaware law controls many of the backdating cases, the Chancellor found that Delaware courts have “an overwhelming interest in resolving questions of first impression under Delaware law.”
The Maxim defendants moved to dismiss on grounds of demand failure, the business judgment rule, and the statute of limitations. Chancellor Chandler rejected the Maxim defendants’ motion to dismiss the complaint for failure of the plaintiffs to demand that the board take up the allegations. The plaintiffs allege that the board’s compensation committee (composing half of the board) had approved backdating options in contravention of the written and shareholder approved plan. The Chancellor said that that “a board’s knowing and intentional decision to exceed the shareholders’ grant of express (but limited) authority raises doubt regarding whether such decision is a valid exercise of business judgment and is sufficient to excuse a failure to make demand.” In reaching his conclusion that the alleged approval of the option grants exceeded that plan, the Chancellor reviewed the backdating allegations and concluded that the “timing, by my judgment and by support of empirical data, seems too fortuitous to be mere coincidence.”
Chancellor Chandler also rejected defendants’ motion to dismiss based on the business judgment rule. The plaintiffs’ argued that the defendants were not entitled to rely on the business judgment rule because the board acted intentionally or in bad faith. The Chancellor denied the defendants’ motion to dismiss, saying “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 options plan, is anything but an act of bad faith.”
The Chancellor also rejected defendants’ motion to dismiss based on the three-year statute of limitations, finding that the statute was tolled as a result of fraudulent concealment: “Inaccurate public representations as to whether directors are in compliance with the shareholder-approved stock option plan constituted fraudulent concealment of wrongdoing sufficient to toll the statute of limitations.”
The Chancellor did hold that the particular plaintiff in the Maxim case lacked standing to assert claims of alleged options backdating that occurred before plaintiff acquired his Maxim stock when Maxim took over a predecessor company in which the plaintiff owned shares. In other words, to have standing, a plaintiff must have owned his or her shares at the time the alleged backdating took place.
The Tyson case involves a multitude of allegations and supposed misconduct, including in particular four alleged instances of “springloading,” in which the defendants supposedly made stock options grants immediately in advance of the release of positive news (which in every instance led to a stock price hike). Chancellor Chandler rejected the statute of limitations defense based on the “doctrines of equitable tolling and fraudulent concealment.” The option grants themselves were disclosed but not that they were made while the defendants possessed material nonpublic information: “Such partial, selective disclosure – if not itself a lie, certainly exceptional parsimony of the truth – constitutes an ‘actual artifice’ that satisfies the requirements of the doctrine of fraudulent concealment.” He found that the “equitable tolling” doctrine also tolls the statute: “It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which the 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 these options would quickly be worth more.”
The Chancellor also rejected the Tyson defendants’ motion to dismiss based on the business judgment rule. Acknowledging that allegations of “options springloading” implicate a “much more subtle deception” than options backdating, Chancellor Chandler said that it is not a question whether the practice is a form of insider trading; rather the question is:
whether a director acts in bad faith by authorizing options with a market-value price, as he is required to do by a shareholder-approved incentive option plan, at a time when he knows those shares to be 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.
The Chancellor emphasized that in order to make this allegation, the plaintiff “must allege that options were issued according to a shareholder-approved employee compensation plan.”
Chancellor Chandler’s opinions in these two cases could have a significant impact on the many pending options backdating cases. As the Chancellor himself noted in deciding not to stay the Maxim case, “an answer regarding the legality of these practices pursuant to Delaware law plainly will affect not only the parties to this action, but also parties in civil and criminal proceedings where Delaware law controls or applies.” In other words, the Chancellor’s opinions reflect his awareness and his intent that his rulings will affect other proceedings – significantly, including even criminal proceedings.
In light of Chandler’s awareness that his rulings will carry influential, persuasive, and even precedential power, perhaps even beyond cases controlled by Delaware law, his censorious, even outraged tone is striking. It is clear that he takes a dark view of the alleged options manipulations, particularly where shareholders have been told that the options would be granted according to a plan that they have approved. Chandler had little trouble rejecting defenses the might otherwise protect the alleged misconduct. The potential impact on the many other pending cases could be substantial. Plaintiffs’ briefs in the other cases will now be replete with lengthy quotations from Chandler’s opinions, and defendants will be forced to try to distinguish the cases, even if Delaware law is not controlling, at least where the companies had shareholder approved options plans in place at the time the alleged options grant manipulations. Chandler’s ruling that options springloading (and, his opinion also suggest, options bullet dodging) might violate fiduciary duties could also have a very significant impact.
The Maxim opinion is discussed in a February 8, 2007 Wall Street Journal article entitled “Maxim Ruling Opens Door for Backdating Cases” (here, subscrition required). A more scholarly discussion of the Maxim opinion can be found on Professor Bainbridge’s Business Associations blog (here).
Special thanks to Broc Romanek of the CorporateCounsel.net blog (here) for providing me with copies of the opinions, thanks to Adam Savett of the Lies, Damned Lies blog (here) for forwarding me links to the opinion, and hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation blog (here) for maintaining links to the opinions on his site.
SEC Files New Options Backdating Enforcement Proceeding: On February 6, 2007, the SEC filed a new civil enforcement proceeding against two former officers of Engineered Support Systems, based on the officials’ participation in an alleged six-year options backdating scheme. The SEC’s press release can be found here. The scheme was somewhat unusual because it involved the occurence of “double backdating” where backdated options that had fallen out-of-the-money were backdated a second time. This new action is the first options backdating action since the SEC filed its earlier actions against Comverse Technology and Brocade Communications last summer. It may have taken the SEC a while to get around to this most recent action, but it surely will not be the last that the SEC files. An interesting discussion of the new action, including important differences between this action and the earlier Comverse and Brocade actions, can be found on the SEC Actions blog, here. The case is also discussed on the AAO Weblog, here.