Client Alert

In two separate cases, the Delaware Court of Chancery recently refused to dismiss complaints against directors who were allegedly involved in option backdating or spring-loading. Although the decisions related to whether the shareholders’ claims should be dismissed (rather than a trial on the merits) -- and although the court recognized that a board’s decisions regarding executive compensation generally are entitled to great deference -- the court’s holdings emphasize that directors may face fiduciary liability for their actions -- or inaction -- related to option grant practices. These decisions are the latest developments in the well-publicized option timing scandal.¹

In the first case, Ryan v. Gifford², the plaintiff alleged that the directors of Maxim Integrated Products, Inc. breached their duties of due care and loyalty by actively allowing the company to backdate at least nine option grants issued to the company’s founder, chairman and CEO. Each of the nine grants was allegedly made at the lowest monthly or yearly market price.

The Court denied the defendants’ motion to dismiss the action, stating that the facts alleged raised a doubt as to whether the board’s actions were the result of the exercise of valid business judgment. According to the plaintiff’s allegations, the directors (1) affirmatively represented to Maxim’s shareholders that the exercise price of any option grant would be no less than 100% of the fair market value of the shares on the date the option was granted; (2) deliberately attempted to circumvent their duty to price the shares at the fair market value on the grant date by "surreptitiously changing" the dates on which the options were granted and (3) failed to disclose this conduct to the shareholders and instead permitted the company to make false representations regarding the grant dates in its public disclosures. The Court stated that "[t]he intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosure regarding the directors’ purported compliance with that plan, constitute conduct that is disloyal to the corporation and is therefore an act in bad faith."

The second case, In re Tyson Foods, Inc. Consolidated Shareholder Litigation³, decided the same day as Ryan v. Gifford, involved allegations of spring-loading. The plaintiffs alleged that the Tyson board acted in bad faith in violation of their fiduciary duties by granting "spring-loaded" options, or options that were priced at market value on a date closely preceding an announcement that was likely to drive stock prices higher. The court noted that "[i]t 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." Comparing the case at hand to option backdating, the Court stated that spring-loading involves a "much more subtle deception" that may suggest bad faith or disloyalty even if the board adheres to the "strict letter" of shareholder-approved plan terms regarding the option price or grant date. In denying the motion to dismiss, the Court stated that "a director who intentionally uses inside knowledge not available to shareholders in order to enrich employees while avoiding shareholder-imposed requirements cannot…be said to be acting loyally and in good faith as a fiduciary."

In addition to private litigation such as the Ryan and Tyson Foods cases regarding option grant practices, the SEC’s Division of Enforcement is currently investigating approximately 130 matters involving option grant practices, particularly option backdating. Yesterday, the SEC charged the former general counsel and corporate secretary of McAfee, Inc., with securities fraud for allegedly wrongfully repricing option grants to himself and others. This action comes on the heels of other SEC actions brought in the last month regarding alleged backdating by Monster Worldwide, Inc. and Engineered Support Systems Inc. A representative of the Division of Enforcement has stated that in evaluating stock option backdating cases, the Division will consider factors such as the egregiousness of the conduct, the number of instances of backdating, the quantitative materiality of unrecorded compensation expense, whether a restatement was necessary, the existence of scienter and evidence of concealment, obstruction or lying. Other regulators, such as the Department of Justice and the Internal Revenue Service, are also investigating option grant practices.

Although the recent Ryan and Tyson Foods rulings did not result in findings of director liability, the final outcome in each case remains uncertain. At a minimum, the recent rulings may be expected to result in more shareholders filing suit in Delaware regarding allegedly deceptive option grant practices. The cases put directors on notice that, at least in Delaware, courts can be expected to carefully scrutinize a board’s actions in cases involving alleged option backdating, spring-loading or other questionable equity award grant practices. Accordingly, boards should exercise particular care to adhere to plan terms when granting equity awards and to accurately disclose plan and grant terms in public filings.

¹ Please see our Client Alerts dated September 28, 2006, July 27, 2006 and November 29, 2005 discussing option backdating and related issues, accessible here.
² 2007 WL 416162 (Del.Ch., Feb. 06, 2007) (NO. CIV.A. 2213-N).
³ 2007 WL 416132 (Del.Ch., Feb. 06, 2007) (NO. CIV.A. 1106-N).