Risk & Compliance

Backdating: Not a ”Judgment Call”

The stock-option practice qualifies as one of those "rare cases," according to the Delaware Court of Chancery, in which "a transaction may be so eg...
Sarah JohnsonFebruary 20, 2007

The stock-options scandal has snarled CEOs, CFOs, and other corporate executives in internal and government investigations, not to mention bad press. For the most part, independent directors have managed to keep clear.

Now the net seems to be widening, thanks to a pair of rulings by the influential Delaware Court of Chancery earlier this month. The decisions by Chancellor William Chandler III to allow shareholder derivative lawsuits to proceed — against directors of Tyson Foods and Maxim Integrated Products — is “extraordinary” for the traditionally business-friendly court, says law professor Charles Elson.

The allegations that directors breached their fiduciary duty “are pretty serious,” adds Elson, also the chairman of the Center for Corporate Governance at the University of Delaware’s school of business. “And the court’s patience with management is beginning to wear thin.”

Just how thin might be measured against Chandler’s criticism in 2005 of the Walt Disney board and former CEO Michael Eisner, who together granted a $130 million severance package to ousted president Michael Ovitz. Chandler ruled that even though that decision fell “significantly short of the best practices of ideal corporate governance,” it was made in good faith, and the board members were exonerated.

Directors at Maxim and Tyson might be less fortunate if shareholders can prove they backdated option grants to take advantage of historically favorable share prices or “spring-loaded” the grants by awarding them just before announcing favorable news. “A director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders…and yet satisfy his duty of loyalty,” Chandler wrote in his opinion on the Maxim case, Ryan v. Gifford.

Citing a 1980s Delaware decision, Chandler also wrote that “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.’ “

Maxim’s stock-option plan allows only at-the-money options; that is, the exercise price must be no lower than the closing price on the grant date. That’s true for most companies caught up in the current scandal, according to Paul Hodgson, a senior research associate at The Corporate Library. The Maxim lawsuit alleges that six directors who served various terms between 1998 and 2002 backdated nine stock option grants awarded to former chief executive officer John Gifford, to take advantage of an earlier (and lower) exercise price.

Attorneys for Gifford did not immediately respond to a request for comment.

Earlier this year, Maxim announced that according to a special committee, all option grants to officers of the company had been properly awarded, and no evidence had been found that outside directors engaged in wrongdoing or malfeasance regarding any stock-option awards. Nonetheless, the company restated financial results for nearly seven years, acknowledged deficiencies in its process of granting stock options, and severed ties with Gifford and chief financial officer Carl Jasper. Maxim also faces inquiries by the Securities and Exchange Commission and the U.S. Attorney for the Northern District of California.

Though Chandler also permitted the Tyson case to proceed, those allegations — that 18 current and former board members allowed spring-loaded option grants — will be tougher to prove, suggested the judge’s ruling. “All backdated stock options involve a fundamental, incontrovertible lie: Directors who approve an option dissemble as to the date on which the grant was actually made,” wrote Chandler. Allegations of spring-loading, he added, entail “much more subtle deception.”

Tyson did not immediately respond to a request for comment.

Despite the judge’s strongly worded opinions, says Hodgson of The Corporate Library, Chandler is not necessarily signaling a new management-shareholder balance of power. Hodgson suggests, rather, that the Maxim and Tyson rulings recognize that “boards and management have not done the best jobs they could to represent stockholders, who are their ultimate employers.”

Indeed, it’s not a matter of “business versus shareholder or shareholder versus business,” says Stuart Grant of Grant & Eisenhofer, who represents the plaintiffs in the Tyson case; the very strong message is simply that “backdating can never be right.”

A shift in the judicial winds would be putting it too strongly, says Stephen Radin, a partner with Weil, Gotshal & Manges, which represents companies involved in backdating issues, but he acknowledges that many observers are concerned with the Delaware court’s actions. Chandler did make a “forceful condemnation” of intentional backdating in plans requiring at-the-money options, adds Radin, but he maintains that plaintiffs will find it difficult to prove that the dates in question were indeed purposefully and improperly chosen.

Even so, the Maxim defendants’ reliance on “improbable good fortune” may not serve them well in court, Chandler’s ruling suggests. Option grants that coincide with the lowest market price during the month or year in which they were granted, wrote the judge, are “by my judgment and by support of empirical data, too fortuitous to be mere coincidence.”

Chandler’s opinion raises the possibility that officers and directors involved in similar backdating or spring-loading schemes might face personal liability, though the amount of any penalty is far from clear, say legal observers. In the case of spring-loading, employees who received improperly granted options might be required, under the theory of unjust enrichment, to forfeit their gains even if they received them “honestly in the first instance,” Chandler wrote.