Stock Option Backdating - How Does The Court Of Chancery Determine Breach Of Fiduciary Duty?

Spawned by the research conducted by University of Iowa professor, Dr. Erik Lie, and the article that first appeared in The Wall Street Journal in March of 2006, stock option backdating has become an increasingly important issue for all public companies. The granting of stock options to executives and directors began as a method by which a company could award those that managed its future. This concept created more of a level playing field between directors and stockholders since, with the granting of stock options, both directors and stockholders were working toward the same end - namely, overall success of the company.

With the discovery of stock option backdating, directors and stockholders are not necessarily on the same footing since the backdating of options bestows upon those receiving them "in the money" grants. Stock option backdating, of course, refers to the practice of publicly traded companies issuing stock option grants retroactively in order to coincide with low points in the company's stock price. The goal behind such option practices is to boost the recipient's potential windfall. Given the suspect nature of grants of this type, it is not at all surprising that the stock option backdating scandal of 2006 continues to thrive well into 2007. Remarkably, the number of internal or federal investigations currently underway tops 200, with more than half of those companies acknowledging that they must restate their financial results.1 As a consequence of these investigations, more than 90 executives and board members have either resigned, retired or been fired in the wake of discovery of various stock option practices.2

In addition to those ongoing investigations, a new crop of derivative and class action complaints has sprung up asserting allegations of breaches of fiduciary duty by directors and officers of companies involved in the backdating scandals. But what factors are the courts considering when evaluating these derivative and class action complaints? Specifically, what behavior on the part of board members seemingly makes a difference? Given the Delaware Court of Chancery's prominence in adjudicating disputes relating to companies incorporated in the State of Delaware, it comes as no surprise that several decisions from that Court provide some insight into how claims alleging breach of fiduciary duty based on backdating of stock options may be viewed. In fact, touting its public policy interest in deciding the law on the stock option backdating issue, the Court of Chancery recently displayed its reluctance to relinquish its authority to decide such claims and refused to stay a derivative action challenging purported stock option backdating practices.3

Against this backdrop, several key factors in the inquiry into possible corporate malfeasance relating to stock option backdating have emerged. Most of the issues addressed by the Court of Chancery include: (1) an examination of the type of stock option grants permitted through the company's stock option plan; (2) an assessment of the knowledge possessed by the directors and officers responsible for approving the issuance of backdated stock options; (3) an inquiry into the vesting time period, if any, accompanying the stock options; and (4) an analysis of the adequacy of the company's disclosures to regulatory agencies and the company's own stockholders relating to the issuance of stock options.

What Are The Terms Of Any Stockholder-Approved Stock Option Plan?

A primary focus in adjudicating the validity of stock option backdating includes the mechanism by which directors have authority to grant various stock options. Obviously, to the extent a formalized stock option plan exists, its very terms will be the subject of much scrutiny, particularly where the plans were subject to stockholder approval. For example, in those instances where stockholders have approved plans outlining the procedures for the issuance of stock options, those procedures should be followed in order to avoid even the slightest appearance of corporate impropriety. In the context of stock option backdating, however, following the protocols contained in a stockholder-approved option plan may prove problematic, especially when those plans require a strike price to be set at no less than the fair market value on the date on which the option is granted by the board. Any deviation in setting the strike price equal to the fair market value under this scenario could subject the directors' actions to scrutiny.

Conceivably, the most benign stock option plan would provide directors with the discretion to set the exercise price of options as they saw fit, even if that meant that options could be granted at below-market-value prices. Even with this added "protection," however, directors and officers may still be exposed to potential liability. Whether or not stock option practices consistent with this type of low-risk plan evade examination depends largely upon the disclosures made in public filings and, thereby, to the company's stockholders. Since it appears that most stock option backdating took place under the cover of darkness, a company's failure to adequately inform its own stockholders about its stock option practices inevitably negates the protections afforded by a stock option plan that permits below-market-value pricing for stock options.

Another consideration in evaluating the nuances of a stock option plan involves the timing for issuance of stock options. If a stock option plan included a requirement that stock options would be issued annually on a certain date or after the happening of a specified event, any claim attacking the viability of stock option grants based on the implication of backdating would not necessarily pass muster. Clearly, such a non-discretionary plan would allow the recipients of the option grants to enjoy the upside of a deflated strike price while at the same time ensure that they participated in any down swing of the stock price.

What Knowledge Did The Directors Possess?

Of utmost importance in determining the potential liability of those individuals responsible for approving backdated stock options is the knowledge possessed by those accused of involvement, primarily the company's officers and directors. In circumstances where directors approve, with input from trusted advisors, the granting of options without knowledge that they are being backdated in violation of a stockholder-approved stock option plan, any liability for breach of fiduciary duty remains suspect. This result is not unusual, especially in light of the fact that an astounding majority of corporations that are incorporated in jurisdictions permitting exculpatory charter provisions have included them. Under this scenario, in order to find the directors liable, one would have to demonstrate that those individuals acted with a state of mind that is divergent and disloyal to their obligations to the company. Without evidence of the director's knowing participation in what amounts to a violation of the stock option plan, hopeful plaintiffs might be unable to overcome this very difficult burden.

Conversely, if a board authorized a grant of stock options either with the knowledge that they were being backdated in violation of a stockholder-approved stock option plan or by failing to adequately inform themselves, the directors would, more than likely, subject themselves to potential liability for breach of their fiduciary duties. This holds true even if the directors possessed a reasonable basis on which to grant such awards.

Is There A Vesting Period For The Backdated Stock Options?

Equally important is determining whether or not the backdated stock options are subject to any vesting period. As previously discussed, the primary goal of backdating is to procure an enhanced return for the recipients of the stock options. If the recipient of a backdated stock grant is incapable of realizing any immediate value from the option due to a vesting period, it is less likely that the backdating at issue would be viewed as a deliberate manipulation of options by the directors and officers in order to orchestrate an instant windfall to the recipients thereof.

Was The Backdating Of Stock Options Properly Disclosed?

Another important issue touched upon by the Delaware Court of Chancery revolves around the existence (or, in some instances, a lack thereof) of appropriate disclosures contained in public filings. This issue is inextricably intertwined with the existence of a stock option plan, since the adequacy of such disclosures hinge, in part, on the controlling authority for the grant of stock options. To the extent a stock option plan requires a fair market value strike price, any effort to engage in the backdating of options would, by its very nature, violate the terms of the plan.

In some cases, this violation has been further compounded by inadequate disclosures in public filings erroneously insinuating that option grants were issued in accordance with the stock option plans. As Chancellor Chandler noted in Ryan v. Gifford , "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 duty of loyalty."4

Inadequate disclosures to stockholders would, more than likely, also spark a negative ripple effect throughout the public markets. News of corporate malfeasance, whether through backdating of stock options or otherwise, historically has had a depressing trickle down effect.

How the pending stock option backdating cases will be resolved remains to be seen. What is clear, however, is that the Court of Chancery is primed and ready to step into its trailblazing role of expanding the current corporate jurisprudence. With the first stock option backdating case set to go to trial in the Delaware Court of Chancery on November 2, 2007, only time will tell how the Court will decide the breach of fiduciary duty issues implicated in those actions.1 See Rick Stouffer , Black Box CEO's resignation amid inquiry cost him $9M, The Pittsburgh Tribune-Review, August 15, 2007 and Mark Schwanhausser , Integrated Silicon Solution, exec accused of stock-options fraud, San Jose Mercury News, August 1, 2007.

2 See Rick Stouffer , Black Box CEO's resignation amid inquiry cost him $9M, The Pittsburgh Tribune-Review, August 15, 2007.

3 Brandin v. Deason, C.A. No. 2123-VCL, 2007 WL 2088877 (Del. Ch. July 20, 2007) (noting that "[g]iven the large number of option backdating cases pending around the country, and the likelihood that many, if not most, of them raise similar issues, it is important for the Delaware courts to decide this, and all related issues, authoritatively.). Accord, Ryan v. Gifford, 918 A.2d 341, 350 (Del. Ch. 2007) (denying motion to stay Delaware proceedings on basis that "Delaware law directly controls and affects many of the option backdating cases.").

4 Ryan v. Gifford, 918 A.2d 341, 355 (Del. Ch. 2007).

Published October 1, 2007.