New Delaware Decisions Have Important Implications

02.12.2007

To Our Clients and Friends:

We wanted to make you aware of two recent Delaware decisions that have important implications for stock option grant practices.  One of the two cases discussed below, the Tyson decision, is particularly important for potential "springloading" cases, because up until now the SEC has not brought any enforcement actions alleging springloading.

In In Re Tyson Foods, Inc. Shareholder Litigation  (C.A. 1106-N, Feb. 6, 2007), the Delaware Chancery Court refused to dismiss a shareholder suit that claimed, among other things, that the Board had violated its fiduciary duties by granting options to executives at a time when the Board knew that material, positive information about the company had not been disclosed.   The shareholders cited several instances in which the Board had made significant option grants to senior executives a few days prior to the release of favorable information about merger transactions, or better-than-expected earnings release.   The court indicated that the practice of granting options just prior to the release of positive information, sometimes known as "springloading," might implicate the director's duty of loyalty.  Specifically, the court noted that a director who authorized option grants at a time when the director knew that the underlying shares were worth more than the market price might be deemed to have acted in "bad faith."

In Ryan v. Gifford (C.A. 2213-N, Feb. 6, 2007), the court refused to dismiss a shareholder suit that claimed that the Board of Maxim Integrated Products, Inc. had violated its fiduciary duties by intentionally backdating stock option grants.  The backdated option grants had an exercise price lower than the fair market  value on the actual grant date.   Those grants are alleged to have violated the company's stock plan, which did not permit the issuance of discounted options.  The court noted that the intentional violation of the company's stock plan, coupled with fraudulent disclosure about purported compliance with that plan, would constitute an act in bad faith.  In addition, the court observed:  "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.'" 

These decisions have important implications for our clients.

Up until now, much of the litigation involving stock option grant practices has involved allegations of SEC disclosure rules, tax and accounting rules, and, in a few cases, deliberate fraud.  These decisions, issued by a court in a state influential for corporate governance matters, establish a separate basis for potential liability for breach of a director's fiduciary duties. 

The use of the term "bad faith" in the decisions is also significant.  Under Delaware law, a director cannot be exculpated for decisions determined to have been made not in good faith.

Certain procedural portions of the decision are also worth noting.  In Ryan, the court denied defendants' request to stay the case, despite the fact that nearly identical cases had been filed earlier in federal and state courts in California.  This result exposes the company and the defendants to the burdens of duplicative lawsuits.  The court also denied a motion to dismiss based on a failure to make a pre-suit demand on the board, holding that a Board's knowing and intentional decision to exceed the limits of a shareholder-approved plan raises doubt regarding whether the decision was a valid exercise of business judgment, and was sufficient to excuse a failure to make the required demand.  In both Tyson and Ryan, the court denied motions to dismiss based on the statute of limitations, holding that, when a plaintiff has alleged intentional falsification of public disclosures, the statute of limitations does not begin to run until the falseness of the filing has been revealed.  These aspects of the decision may influence courts handling stock option cases across the country.

Both of these cases are still at a relatively early stage.  If the cases proceed to trial, the plaintiffs will still need to prove that the directors did, in fact, act with the requisite knowledge and intent to constitute bad faith. 

Nevertheless, these decisions are an important reminder that stock option grant practices are now the subject of heightened scrutiny by the courts.  Companies should review their stock option grant policies to ensure that their procedures remain consistent with evolving best practices standards.

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