BACK TO THE FUTURE: The Delaware Court of Chancery's Decisions on Stock Option Backdating

Donald J. Wolfe, Jr.
March 2008

Conventional wisdom attributes to Albert Einstein the cogent quip that the concept of time was created in order to ensure that everything wouldn't happen at once. If so, it is a truly elegant antidote to temporal chaos, but one that is necessarily accompanied by the corollary that events cannot be said to have occurred simultaneously in both the past and in the present. It is this stubborn truism that the Delaware Court of Chancery confronted in a series of recent challenges to the validity of stock options alleged to have been backdated at the time of their issuance in order to maximize retrospectively the value of those options to the recipients.

Those decisions address a variety of practices that have come to be known under the broad rubric of backdating, including not only the simple act of backdating itself, but also the practices of “spring-loading” and “bullet-dodging” in connection with the award of stock option. As will be seen from the discussion below, few if any broad generalizations, black letter rules or bright line tests can be drawn from these decisions with respect to the propriety of such practices. As illustrated by the cases discussed herein, and as observed by Vice Chancellor Strine in Desimone v. Barrows, there is need for “judicial caution” when confronting allegations of stock option manipulation. In each instance, the Court must necessarily consider, among other factors, the terms of the operative option plan and the knowledge possessed by the persons responsible for administering the plan, and the quality of the disclosures to stockholders surrounding the grants. Only then will the court craft an objective judgment about whether allegations of stock option improprieties give rise to director liability. The relevant decisions of the Delaware Court of Chancery on this topic are summarized below.

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

2007 Del. Ch. LEXIS 22 (Del. Ch. Feb. 6, 2007)

In Ryan, a shareholder of Maxim Integrated Products, Inc. advanced a derivative claim on behalf of the company, alleging that the compensation committee of the company’s board of directors had issued to Maxim’s founder, chair and CEO, John Gifford, options to acquire additional stock in the company in violation of the terms of the operative shareholder-approved, stock option plan of the company and in violation of the board’s fiduciary duties. In particular, the plaintiff alleged that the grants in question did not comply with the plan requirement that the strike price for all such options be no less than the market price of the company’s stock as of the date of issuance. The complaint asserted that the options instead had been backdated by the committee so as to coincide with trading days on which the price of the company’s stock was unusually low or that immediately preceded sharp increases in the market price of the stock. Plaintiff claimed that these alleged unfaithful acts had wrongfully deprived Maxim of the higher prices to which it should have been entitled upon exercise of the options and exposed it to adverse tax consequences and the need to restate its financial statements. Defendants responded by moving to stay the action in favor of prior pending litigation and, in the alternative, for dismissal on a variety of grounds.

The Court of Chancery declined to stay the action, in the process emphatically staking claim to Chancery’s traditional turf. Acknowledging the continuing validity of venerable Delaware precedent[1] to the effect that a stay typically is appropriate where a previously filed and similarly crafted action involving substantially the same parties is pending elsewhere, the Chancellor observed that, in the context of derivative litigation as to which potential plaintiffs abound, the speed with which one or another may choose a forum is entitled to less judicial deference than in other settings. More relevant factors, the Court held, include the relative quality of the complaints, as well as factors typically considered in a forum non conveniens analysis, among them the ability of the competing tribunals to render justice. As to the latter factor, the Chancellor was quick to acknowledge that the courts of both federal and sister state jurisdictions were entirely capable of applying Delaware law, but rather pointedly opined that Delaware courts have a particular and substantial interest in resolving controversies that concern the conduct of fiduciaries of Delaware corporations, especially where such issues are presented for the first time. Noting that the issues raised by allegations of backdating are “of great import to the law of corporations.”[2] and that “ Delaware courts have not as yet addressed these fundamental issues,”[3] the Chancellor stated:

An answer regarding the legality of these practices plainly will affect not only the parties to this action, but also parties in other civil and criminal proceedings where Delaware law controls or applies. By directly stating the fiduciary principles applicable in this context, Delaware courts may remove doubt regarding Delaware law and avoid inconsistencies that might arise in the event other state or federal courts, in applying Delaware law, reach differing conclusions.[4]

Turning to the various grounds advanced by defendants to support dismissal of the complaint as a matter of law, the Court made a number of important rulings, among them: 1) that a plaintiff shareholder has no standing to derivatively challenge the validity of stock option grants issued prior to the date that the plaintiff acquired shares in the corporation;[5] 2) that the applicable statute of limitations period for the initiation of such claims is tolled under the doctrine of fraudulent concealment even when the raw information relevant to the claim could have been teased out of public filings, since the concept of reasonable diligence for purposes of determining whether one is on inquiry notice for limitations purposes “does not require a shareholder to conduct complicated statistical analysis in order to uncover alleged malfeasance;”[6] 3) that when the membership of the compensation committee that issued the challenged grants comprises at least one half or more of the entire board, the approval is imputed to the entire board even where the board as a whole took no action on the grants, and the relevant tests for demand futility apply; and 4) that the fact that the recipient was not alleged to have exercised any of the challenged options, while perhaps relevant to the appropriate remedy, constitutes no legal defense to a claim of unjust enrichment.

It was in connection with its evaluation of defendants’ argument that the derivative plaintiff had improperly failed to make a pre-suit demand on the board of directors, and defendants’ parallel assertion that the allegations of the complaint had failed to rebut the threshold presumptions of the business judgment rule, however, that the Court offered its most provocative observations with respect to backdating. As to the former, the Chancellor held that the pre-suit demand requirement imposed under Chancery Court Rule 23.1 was excused both under the second prong of the Aronson test,[7] and under the alternatively applicable test enunciated in Rales v. Blasband.[8] As to the existence of reasonable doubt whether the challenged grants constituted a valid business judgment for purposes of Aronson’s second prong, the Court held that “[a] board’s knowing and intentional decision to exceed the shareholders’ 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.”[9] In this regard, the court noted plaintiff’s allegations that each of the nine challenged grants issued over a six year period had been granted at the lowest point in the stock’s market price during the month or year in which it was supposedly granted, that the average annualized return on the grants at issue was nearly ten times higher than the annualized market returns generally during that period, and that the options were granted sporadically, rather than pursuant to a pre-designated schedule. These allegations, together with the assertion that the board had altered the exercise price by falsifying the date of the grant in violation of an express provision of the shareholder-approved option plans and that it had issued intentionally fraudulent public disclosures, were held sufficient to raise doubt whether the option awards were the product of a valid business judgment.

Under the alternatively applicable Rales test, the question presented is whether a majority of the directors confronted a substantial likelihood of liability in connection with the issuance of the challenged options, thus disqualifying them from objectively evaluating the propriety of a shareholder demand seeking to remedy that conduct on the company’s behalf. In this respect, the Court stated:

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 (regarding his violations of a shareholder-approved plan, no less) and yet satisfy his duty of loyalty. 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.”[10]

The Chancellor expanded on this point in the course of rejecting defendants’ claim that plaintiff’s complaint failed to plead facts sufficient to rebut the business judgment presumptions, and thus should be dismissed for failure to state a claim. Noting the recent holding of the Delaware Supreme Court that acts of bad faith – including intentional fiduciary conduct having a purpose other than the advancement of the best interests of the company, or intended to violate applicable positive law, or demonstrating a conscious disregard for the fiduciary’s duties – constitute a breach of the duty of loyalty,[11] the Court stated:

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 option plan, is anything but an act of bad faith. It certainly cannot be said to amount to faithful and devoted conduct of a loyal fiduciary. Well-pleaded allegations of such conduct are sufficient, in my opinion, to rebut the business judgment rule and to survive a motion to dismiss.[12]

The Court of Chancery thus declined to dismiss the action, although just two of the nine option grants challenged could be pursued by plaintiff because of his lack of standing to contest option grants pre-dating his ownership of Maxim stock.

In re Tyson Foods, Inc. Consolidated Shareholder Litigation,

919 A.2d 563 (Del. Ch. 2007), 2007 Del. Ch. LEXIS 19 (Del. Ch. Feb. 6, 2007)

Issued on the same day by the same judge to whom the Ryan case had been assigned, the Tyson decision has much in common with Ryan. It too addressed (at least in significant part) a shareholder challenge to the validity of certain executive stock option grants. It differs from Ryan in one quite material respect, however. While the complaint in Ryan was a challenge to what was characterized as a classic example of intentional backdating in violation of the express terms of the relevant, shareholder-approved option plan, the Tyson complaint[13] mounted an attack on a far more subtle and understated but, in plaintiff’s view, equally invalid practice commonly known as “spring-loading.” This term describes the practice of timing of the award decision to precede immediately the public announcement or disclosure of information by the company that the issuer anticipates will cause an increase in the market price of the company’s stock.[14] Because the exercise price is typically determined by reference to the market price for the shares as of the date of the award under the explicit terms of the shareholder-approved option plan, this can be expected to result in a lower strike price for the options than that which would have obtained had the award followed the disclosure and the attending bump in the market price of the stock. “Spring-loading” thus does not involve an outright misrepresentation of the issuance date of the sort alleged to have taken place in the Ryan complaint, but rather a calculated decision to time the award in such a way as to enhance the value of the options for the benefit of the recipient by virtue of the ensuing release of information and the concomitant increase in the spread between the exercise price and the value of the shares that are the subject of the options. The Tyson complaint thus challenged conduct that was far more nuanced and far less obviously in violation of the express terms of the operative stock option plan than what was alleged to be the case in Ryan.

Before turning to the legal sufficiency of the substantive attack on the practice of spring-loading, the Court took up, as it had in Ryan, the application and effect of the statute of limitations and, predictably, reached the same conclusion. Defendants asserted that the plaintiffs had been placed on inquiry notice with respect to their claims, ultimately instituted well beyond the expiration of the applicable three-year limitations period. They argued that the company’s contemporaneous public disclosures contained all of the raw information necessary to discern the very improprieties now being untimely asserted; the relevant proxy statements had accurately set forth the number of the shares granted, the exercise price, and the date of the grant; and the daily business news made clear at the time that the grants themselves had closely preceded important and favorable company announcements. This argument educed little sympathy from the Chancellor:

… it would be manifest injustice for this Court to conclude, as a matter of law, that “reasonable diligence” includes an obligation to sift through a proxy statement, on the one hand, and a year’s worth of press clippings, on the other, in order to establish a pattern concealed by those whose duty is to guard the interests of the investor.[15]

The statute of limitations was thus deemed to have been tolled,[16] at least for purposes of resolving the motion to dismiss.

At an earlier point in the opinion, the Court had concluded that the pre-suit demand requirement with respect to all of the derivative claims asserted in the action was excused in this instance under Aronson’s first prong by reason of the combined effects of self-interest and lack of independence on the part of a majority of the relevant board. The Court then turned to defendants’ substantive argument that the complaint failed to state a legally cognizable claim with respect to the issuance of spring-loaded options because it failed to plead facts sufficient to rebut the threshold presumptions of the business judgment rule. Plaintiffs’ complaint in this regard was held to be properly directed only to the specific directors who had served as members of the compensation committee, which had acted on its own pursuant to a grant of exclusive authority from the board. The individual directors in question were not recipients of any of the options in question and they were not deemed to have lacked independence from the recipients of those options. Nor were they accused of having acted in a grossly negligent fashion (quite to the contrary, in fact). The question posed on the motion to dismiss for failure to state a claim against them therefore was whether the complaint was sufficient to permit a reasonable inference that their decision fell outside the bounds of business judgment because it constituted an act of bad faith and therefore a violation of the duty of loyalty.

As to this, the Court acknowledged that the question whether directors of a Delaware corporation may in good faith approve spring-loaded options was thornier than that presented by an act of premeditated backdating. Reiterating his holding in Ryan, the Chancellor observed that classic backdating always involves a “fundamental and incontrovertible lie” to shareholders with respect to the date on which the grant was actually made, which “against the background of a shareholder-approved stock-incentive program, amounts to a disloyal act taken in bad faith.”[17] While challenges to the practice of spring-loading “implicate a much more subtle deception,”[18] the conduct nonetheless is rooted in deception.

The Court was careful to point out that the problem with spring-loading does not lie in the fact that the options awarded are immediately in the money. To the contrary:

A board of directors might, in an exercise of good faith business judgment, determine that in the money options are appropriate forms of executive compensation. Recipients of options are generally unable to benefit financially from them until a vesting period has elapsed, and thus an option’s value to an executive or employee is of less immediate value than an equivalent grant of cash. A company with a volatile share price, or one that expects that its most explosive growth is behind it, might wish to issue options with an exercise price below current market value in order to encourage a manager to work hard in the future while at the same time providing compensation with a greater present market value. One can imagine circumstances in which such a decision, were it made honestly and disclosed in good faith, would be within the rational exercise of business judgment.[19]

Rather, the Court declared that the root problem with spring-loading is the fact that it is grounded in an implicit deception that conflicts with a director’s fiduciary responsibility to deal fairly and honestly with shareholders, even when there is no outright violation of the literal terms of the shareholder-approved option plan.

The relevant issue is whether a director acts in bad faith by authorizing options with a market-value strike price, as he is required to do by a shareholder-approved incentive option plan, at a time when he knows those shares are 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.[20]

The Court concluded its discussion with a summary of the elements that are necessary to plead a legally cognizable claim that the issuance of spring-loaded (or, presumably, bullet-dodging) options by an admittedly disinterested and independent board or committee constitutes a disloyal act of bad faith that falls beyond the inviolate bounds of business judgment:

1) the approving directors possessed material non-public information, soon to be released, that would affect the price of the company’s stock; and

2) that the approving directors issued the options with the intent to circumvent otherwise valid, shareholder-approved restrictions on the exercise price of the options.[21]

“[I]t is conceivable’” the Court observed, “that a director might show that shareholders have expressly empowered the board of directors (or relevant committee) to use backdating, spring-loading or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law.”[22] Barring such a showing however, the Tyson decision seems clearly to hold that a complaint that contains the allegations set forth above will survive a motion to dismiss for failure to state a claim upon which relief will be granted, and that a plaintiff that so establishes at trial will succeed in his challenge to invalidate so-called “spring-loaded” stock options.

Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007),

2007 Del. Ch. LEXIS 75 (Del. Ch. June 7, 2007)

Like Ryan and Tyson, the Court of Chancery’s decision in Desimone involved allegations of stock option “backdating” and “spring-loading,” but dealt as well with another practice identified in the emerging stock option lexicon, “bullet-dodging.” This practice is said to occur when options are granted shortly following the release of negative information about the company with the expectation that the recipient will benefit from the lower exercise price reflected in the depressed market price for the stock. Unlike Ryan and Tyson, however, the Court in Desimone granted defendants’ motion to dismiss the claims, demonstrating once again the Court of Chancery will consider each case based on its own unique facts and circumstances.

Defendant Sycamore Networks, Inc. was among the many technology companies ensnared in the web of suspicion surrounding alleged stock option backdating. Plaintiff John Desimone filed a derivative action against the members of Sycamore’s board of directors and certain of its officers claiming that the board members breached their fiduciary duty by allowing certain stock option grants to occur. Plaintiff challenged several categories of option awards; specifically, grants made to rank and file employees (the “Employee Grants”) and grants made to Sycamore’s officers (the “Officer Grants”). Also in issue were certain grants made to Sycamore’s outside directors (the “Outside Director Grants”). Defendants moved to dismiss all the claims for lack of standing, for failure to adequately plead demand futility under Court of Chancery Rule 23.1, and for failure to state a claim under Rule 12(b)(6).

Vice Chancellor Strine first took up defendant’s challenge to plaintiff’s standing to challenge the option grants. As in Ryan, all but two of the option grants in issue occurred before plaintiff acquired stock in Sycamore. Under Section 327 of the Delaware General Corporation Law, a plaintiff must be a shareholder at the time of the transaction of which he complains. The Court was unpersuaded by plaintiff’s argument that the option grants constituted a pattern of “continuing wrongs,” which under applicable law would allow Desimone standing to contest such grants despite the fact that he did not own shares at the very outset. Relying upon Elster v. American Airline,[23] the Court observed that “ the granting of a stock option is an individual transaction that is completed the moment the options are granted.”[24] Accordingly, and consistent with the Court’s holding in Ryan, Desimone was held to lack standing to challenge the option grants made prior to the time he became a shareholder of Sycamore.

Although plaintiff’s lack of standing disposed of most of his claims, the Court of Chancery nevertheless examined the sufficiency of the entire complaint under Rules 12(b)(6) and 23.1 as well. Before doing so, the Vice Chancellor took the opportunity to observe that not all stock option backdating or spring-loading cases necessarily implicate a director’s duty of loyalty. The Court explained that, depending upon the terms of the company’s option plan and the degree of knowledge of a director responsible for option grants, it may or may not be appropriate to impose liability upon any particular director. In the Vice Chancellor’s view, “[l]umping context-specific behavior involving varying motivations into generic categories such as backdating, spring-loading and bullet-dodging, and driving results by such labeling, seems unlikely to do justice.”[25]

To illustrate, the Court posited a scenario in which a company’s option plan did not require grants at market price, and a board of directors made below-market awards with full disclosure of the rationale for the pricing decision. The Court reasoned:

In this context, there would be no deception on the corporation’s stockholders, as the directors would have fully disclosed why they made the award, and the compensation committee would seemingly be entitled to strong protection from both the § 102(b)(7) clause and § 141(e) of the Delaware General Corporation Law. All of these factors – the candor of the directors about the reason for the grant, their compliance with the terms of the relevant plan, and their good faith reliance on experts – would be of great relevance to a court considering whether a challenge to the grants stated a claim under Tyson, because they present a more traditional context in which the fundamental issue is whether the directors have made a rational compensation decision.[26]

Applying Rales,[27] the Court then analyzed the Employee and Officer Grants under Rule 23.1 for demand futility. Because the complaint did not allege that any member of Sycamore’s board of directors was involved in the backdating of Employee Grants, the Court found that demand was not excused. The Officer Grants also involved allegations of backdating, spring-loading and bullet-dodging, the Court found that it could not infer from the complaint that the Sycamore board knowingly granted Sycamore’s officers backdated options. As for the allegations of spring-loading and bullet-dodging relating to the Officer Grants, the Court observed that, unlike Tyson, the Sycamore incentive plan did not impose exercise price restrictions. Moreover, plaintiff’s complaint failed to plead particularized facts evidencing a conscious decision to spring-load grants, as no director was alleged to have been aware of positive information at the time of the grant. Accordingly, no director faced a substantial threat of liability with respect to the Officer Grants. As a result, the board was held capable of objectively considering a demand to institute suit with respect to such a claim. Demand therefore was held to have been required.

The Court turned finally to the Outside Director Grants. Because a majority of the board were recipients of such grants, demand was excused under Rales with respect as to plaintiff’s challenge to the Outside Director Grants. The Court was thus called upon to determine whether the claim also survived dismissal under Rule 12(b)(6). Holding that it did not, the Vice Chancellor recognized that the Outside Director Grants were made automatically each year on the date of Sycamore’s annual shareholders meeting. The Complaint did not allege that the timing of such meetings had been manipulated to produce a superior option exercise price. Although the Outside Director Grants were alleged to have been profitable for the recipients in 2001 and 2003, the Court surmised that the grant price had not been beneficial in 1999, 2000, 2002 and 2004. Thus, because the “complaint simply allege[d] that the directors took the good and the bad that came with a non-discretionary plan,” plaintiff’s challenges to the Outside Director Grants failed to state a claim. Accordingly, plaintiff’s complaint was dismissed.

In re Tyson Foods, Inc. Consolidated Shareholder Litigation,

Consolidated C.A. No. 1106-CC, 2007 Del. Ch. , LEXIS (August 15, 2007)

Six months following the denial of their motion to dismiss that aspect of the complaint challenging the board’s authorization of spring-loaded stock options, a decision described above, defendants tried again to dispose summarily of that claim, this time by way of a motion for judgment on the pleadings. The crux of that motion was the fact that the Court had grounded its earlier refusal to dismiss the claim in large part on the fact that the options in question were alleged to have been granted at a price other than the fair market price of the underlying shares on the date of the grant, in violation of the explicit pricing requirement of the shareholder approved option plan. Though neither party had pressed the point in connection with the motion to dismiss, the Court was made aware at that time that the company’s proxy statements had indicated that the board’s Compensation Committee was also empowered under the applicable stock incentive plan approved by Tyson stockholders to issue nonqualified stock options, rather than the incentive options also authorized by the plan, and that the Committee was authorized under the plan to issue nonqualified stock options at any price, without regard to the fair market value on the date of issuance. At the dismissal stage, however, the Court had concluded that the allegation was sufficient to survive dismissal because, even if the challenged stock options were of the nonqualified variety, there was reason to infer that they might nonetheless have been issued “with the intent to circumvent otherwise valid shareholder restrictions upon the exercise price of the options.”[28]

On the ensuing application for judgment on the pleadings, the defendants sought to establish as beyond any factual dispute on the face of the pleadings that the challenged stock options had been nonqualified options, as to which no exercise price restrictions were applicable, and thus that judgment in their favor was warranted with respect to this aspect of the complaint. In addressing defendants’ application, the Court referenced the text of the Plan itself, as well as various proxy statements and other of the Company’s publicly-filed documents reporting issuance of the options at hand; it explicitly found the Plan itself to be integral to the allegations of plaintiffs’ complaint, and the company’s public documents to be subject to judicial notice, concluding that they therefore could be considered on a motion such as this.[29]

In reviewing the relevant proxy statements, the Court noted that, while the challenged options hand not been explicitly identified as nonqualified options, they were described as failing to qualify as incentive options under the Internal Revenue Code, thus falling outside the definition of incentive options as defined in the plan. This contradicted the allegation in the complaint that the plan required that the options in question carry an exercise no lower than the value on the day of the grant. It also changed the nature of the appropriate judicial analysis in the Chancellors view. In considering the motion to dismiss, the question newly confronted by the Court was whether the issuance of spring-loaded options could be deemed to fall within the business judgment of the board when the shareholder authorized plan required a market value exercise price. The Court held that, while the absence of any such restriction in the Plan significantly changed the crux of the plaintiffs claim, it did not change its validity. What had been a claim importantly based on an alleged intent to circumvent shareholder approved restriction on the pricing of the options, identified by the Court in the dismissal opinion as among the allegations critical to asserting a viable claim for spring loading, had now become one more directly focused on fiduciary candor in connection with the issuance of the options and the intention, in practical effect, to place them immediately in the money pursuant to the spring-loading scheme. From such intentional deception, the Court found, an inference arises that the challenged grants were inherently unfair to shareholders and fell outside the bounds of business judgment.

This approach prompted the Court to reexamine the list of necessary elements that its earlier decision in the case had set out as critical to the statement of a legally viable claim for spring-loading. The first Tyson decision, summarized above, had indicated that a plaintiff must allege that the options were issued pursuant to a plan approved by shareholders, that the directors who had approved the options had material non-public information, to be released imminently, that would affect the price of the company’s shares, and that they did so with the intent to circumvent the restrictions of the applicable option plan. The Court on this record indicated its inclination to revisit the need to allege an implicit violation of a shareholder approved plan. Instead, where there exists a basis for reasonable inference that the board later concealed the nature of the grant from stockholders, the Court held it appropriate to conclude, even in the absence of a Plan violation, that the options were granted in abrogation of the directors’ duty of loyalty, not in connection with the nondisclosure itself, but in connection with the nondisclosed act itself, the issuance of spring-loaded options.

The Court took notice of Vic Chancellor Strine’s analysis in Desimone, discussed above, and explicitly distinguished the facts at hand from the hypotheticals there described. Conceding that directors might well act appropriately in awarding managers spring-loaded options as a method of compensation, the Chancellor observed that the posited fact patterns importantly assumed that the board had candidly revealed its intention to do so, an assumption that was glaringly absent from the alleged facts at hand. In this regard, the Chancellor stated:

As Vice Chancellor Strine thus made clear, if a board of directors candidly discloses why and when it awarded options, and accounted for them in a lawful manner consistent with the actual facts, the board has, absent unusual circumstances, insulated itself from fiduciary liability for misleading investors or regulatory authorities. What the directors would remain subject to was a well-pled claim that the compensation awarded was actionably excessive because, for example it involved self-dealing and was not fair to the corporation… What the defendants here fail to confront is that their disclosures regarding the options under attack do nothing to rebut the pleading stage inference that the defendants intended to conceal a pattern of unfairly stocking up insiders’ larders with option grants shortly before the announcement of events likely to increase the Company’s stock price. In fact, the magnitude and timing of the grants, when accompanied with no disclosure of the reasons motivating the grants, is suggestive, at the pleading stage.[30]

Ryan v. Gifford , C.A. No. 2133-CC,

2007 Del. Ch. LEXIS 168 (Del. Ch. Nov. 30, 2007)

In Ryan v. Gifford,[31] a subsequent discovery ruling in the seminal litigation discussed above, the Court of Chancery of the State of Delaware examined an issue that has fundamental importance not only to matters involving backdating, but to all derivative claims that form the subject of an investigation by a special litigation committees; the extent to which a plaintiff stockholder may gain access by way of discovery to purportedly privileged communications by and among the company, a special committee of the company’s board of directors, and the committee’s independent counsel in connection with the committee’s investigation of alleged misconduct of certain directors that forms the basis of the plaintiff’s claim. In its analysis of this issue, the Court considered in important part the limits of the “joint” or “common interest” privilege as applied to such communications, the concept of waiver of the privilege in such a context, and the nature of the showing that a plaintiff must make in order to establish “good cause” for gaining access to information falling within the privilege of the company, whose interests plaintiff seeks to advance in connection with his derivative claim.

As noted above, the Ryan litigation commenced when shareholders of Maxim Integrated Products, Inc. (“Maxim”) advanced derivative claims on behalf of the company alleging that the compensation committee of the company’s board of directors had issued to Maxim’s founder, chair, and CEO, John Gifford, back-dated options to acquire additional stock in the company in violation of the terms of the operative shareholder-approved stock option plan of the company and therefore in violation of the board’s fiduciary duties. In particular, the plaintiffs alleged that the grants in question did not comply with the plan requirement that the strike price for all such options be no less than the market price of the company’s stock as of the date of issuance, but rather had been backdated so as to coincide with trading days on which the price of the company’s stock was unusually low or that immediately preceded sharp increases in the market price of the stock. Plaintiffs claimed that those alleged unfaithful acts had wrongfully deprived Maxim of the higher prices to which it should have been entitled upon exercise of the options and exposed it to adverse tax consequences and to the difficult consequences that necessarily attend the resulting obligation to restate its financials.

Following the failure of defendant’ motion to dismiss the complaint, a Special Committee was established by Maxim’s board of directors to investigate the challenged conduct. The Special Committee retained Orrick, Herrington & Sutcliffe LLP (“Orrick”) as its legal advisor and LECG Corporation to provide forensic accounting services. The ensuing investigation by the Special Committee concluded in early 2007.

In the course of the discovery that followed in the underlying litigation, plaintiffs’ filed a motion to compel the production of numerous categories of documents that defendants had withheld on various grounds. One such motion sought the production of responsive documents in native file format with metadata from Maxim. Rejecting Maxim’s argument that the metadata was not relevant, the Court granted the motion, noting that because “the integrity of the dates entered facially on documents authorizing the award of stock options is at the heart of the dispute,” the metadata was relevant.[32] The Court found the metadata’s relevance was further illustrated, and defendants’ arguments of undue burden was correspondingly undercut, by the fact that the Special Committee and the Company’s auditors had been provided with the metadata in connection with their investigations into Maxim’s backdating problems.[33]

Of broader interest perhaps is the Court of Chancery’s holding in connection with the plaintiffs’ motion to compel production from Maxim, the Special Committee, Orrick (counsel to the Special Committee), and LECG Corporation relating to the Special Committee’s investigation. In that aspect of the motion, plaintiffs sought an order compelling production of (1) all communications between Orrick and the Special Committee occurring during the course of the Special Committee investigation, (2) all communications between Orrick and Maxim relating to Orrick’s presentation of the final report of its findings to the Special Committee and the full Maxim board, and (3) all documents withheld by Orrick on work-product grounds, including interview notes and Orrick’s forensic analysis of Maxim’s computer system.

In connection with communications between Orrick and the Special Committee relating to the Special Committee investigation, the Special Committee argued that the attorney-client privilege clearly applied and protected such communications from disclosure to the plaintiff. Maxim argued in turn that its communications with Orrick were privileged for the same reasons as advanced by the Special Committee in that Maxim’s interests were aligned with those of the Special Committee and its counsel and were thus equally entitled to protection from disclosure of pursuant to the “common interest” or “joint privilege” doctrine.

Taking up the latter claim first, the Court posited that a privileged relationship existed as between the Special Committee and Orrick, and further assumed (without deciding) the existence of a joint or common interest between the Special Committee and Maxim for privilege purposes. It concluded nonetheless that, even assuming the existence of such a joint privilege, the plaintiffs, as shareholders of Maxim, the direct beneficiary of the privilege, had demonstrated “good cause” for gaining access to such the company’s privileged information and thus were entitled under Garner v. Wolfinbarger,[34] to inspect Maxim’s presumably privileged communications with the committee and its counsel.[35] In specifically reviewing the relevant factors identified in Garner, the Court found that the plaintiff shareholders had demonstrated: (1) the existence of a colorable claim against the directors; (2) the unavailability of the information sought from other sources due to the lack of a written report from the Special Committee, the inability to depose certain witnesses due to privilege , and the unavailability of other witnesses who had invoked the 5^th Amendment; and (3) the information sought was identified with sufficient specificity.[36] The Court deemed it particularly significant that the information at issue, information that was at the heart of the plaintiffs’ claim, was unavailable elsewhere.[37] It therefore Court ordered the communications between Maxim and Orrick to be produced.[38]

Moreover, the Court stated that, even assuming the existence of a privileged relationship as between the Special Litigation Committee and its counsel, the existence of a joint or common interest between the company and the Special Committee, and the absence of a showing of good cause under Garner, all communications by and among Maxim, the Special Committee, and the committee’s counsel were nonetheless discoverable by plaintiffs because any such privilege had been waived. That waiver was held not to be limited merely to the presentation of the report at the meeting of the full board, but as to all such communications between the Special Committee and its counsel regarding the subject matter of the committee’s investigation, its final report, and its presentation.[39] The Court based its finding of waiver on the fact the Special Committee and Orrick had presented the Special Committee’s final report to the full board of Maxim in a meeting attended by the director defendants who were the subject of the investigation and the law firm that was representing them in the underlying derivative action.[40] The Court specifically noted that the presentation was not “a mere acknowledgement of the existence of the report” but a detailed explanation of the Committee’s investigation and its findings sufficiently specific as to warrant the direction to those in attendance that they turn in any notes they may have made during the course of the presentation.[41] Concluding that the director defendants and their personal counsel who were in attendance were in a necessarily adversarial relationship with the company and the Special Committee, the Court found that the purportedly privileged communications had been made in the presence of third parties who fell outside the privileged relationship and thus constituted a waiver of any existing privilege.[42] The Court declined to accept the assertion that no waiver had occurred because the defendant directors had attended the meeting in question in their fiduciary roles rather than in their personal capacities, given that they had subsequently relied expressly on the findings of the Special Committee report to try to exculpate themselves as individual defendants in an action instituted against them for the benefit of the corporation.[43] As stated by the Chancellor, “[t]he individual defendants, though directors of the board of [the company], cannot be said to have interests that are so parallel and non-adverse to those of the Special Committee that they could reasonably be characterized ‘joint venturers.’”[44] Rather, the Court observed that such interests were more accurately characterized as “adversarial in nature” because “[t]he Special Committee was formed to investigate wrongdoing in response to litigation in which certain directors were named as individual defendants.”[45]

With respect to the documents withheld by the Special Committee’s counsel pursuant to the work-product doctrine, the Court noted that Orrick characterized these documents as notes taken during interviews relating to the Special Committee investigation containing attorney “thoughts, impressions, opinions, and conclusions.”[46] The Court held that because Orrick represented that these notes were not “a verbatim account of witness testimony” or “fact” work-product, but were, rather, more akin to “opinion” work-product, which is “the paradigmatic type of work product that Rule 26(b)(3) operates to protect,” the Court would not order production of the documents.[47] Instead, it directed Orrick to produce those documents for in camera inspection, upon review of which the Court would determine whether the documents were properly withheld or whether they should be produced, either in their entirety or in redacted form.[48]

In an ensuing decision denying defendants’ motion to certify an interlocutory appeal of the Court of Chancery’s privilege ruling in Ryan, the Court offered some helpful comment on the analysis that had lead to its earlier ruling.[49] The Court specifically noted in its ensuing opinion that the holding in Ryan “would not apply to a situation (unlike that presented in this case) in which the board members are found to be acting in their fiduciary capacity, where their personal lawyers are not present, and where the board members do not use the privileged information to exculpate themselves. Similarly, the decision would not affect the privileges of a Special Committee formed under Zapata, or any other kind of committee that (unlike the committee here) has the power to take actions without approval of other board members.”[50] The Court further explained that the decision should not be considered controversial because “the only thing directors cannot do under the decision is receive purportedly privileged material while acting in their personal (as opposed to fiduciary) capacity and still maintain the privilege.”[51]

The Court of Chancery’s privilege decision in Ryan v. Gifford, highlights the need for board committees and their counsel to consider carefully to whom and under what circumstances privileged committee communications are disclosed so as to limit, where appropriate, the possibility that privilege will be deemed waived. At the same time, the Court’s decision and its subsequent opinion denying the application for interlocutory appeal confirm that a committee’s communications with its separate counsel for the purpose of facilitating the rendition of legal advice generally will be protected by the attorney-client privilege and that the privilege likely will not be lost merely by the committee’s communicating with the full board about otherwise privileged matters, so long as the other directors are acting in their fiduciary capacity and other third parties (such as the directors’ personal counsel) are not present. Committee members, other directors, and their counsel should always bear in mind, however, that stockholders are the ultimate beneficiaries of a corporation’s privilege, and there is always a possibility that otherwise privileged communications will be deemed not to be privileged vis a vis plaintiff stockholders if those stockholders can make the requisite showing of “good cause” under Garner.

The author is a partner in the Wilmington Delaware law firm of Potter Anderson & Corroon LLP. He wishes to acknowledge the important contributions of several of his colleagues in the preparation of the summaries contained in this article, in particular his partners Peter J. Walsh, Jr., John F. Grossbauer, Michael A. Pittenger, as well as Kirsten A. Zeberkewicz, an associate at the firm.

[1] See McWane Cast Iron Pipe Corp. v. McDowell-Wellman Engineering Co., 263 A.2d 281 (Del. 1970).

[2] Ryan v. Gifford , C.A. No. 2213-N, 2007 Del. Ch. LEXIS 22, at *16 ( Del. Ch. Feb. 6, 2007).

[3] Id.

[4] Id. at *16.

[5] Id. at *41-43. This holding resulted in the dismissal of seven of the nine stock option grants challenged in the complaint.

[6] Id. at *46.

[7] Aronson v. Lewis, 473 A.2d 805 ( Del. 1984) (failure to make demand may be excused if a plaintiff can raise a reason to doubt that: 1) a majority of the board is disinterested or independent or 2) the challenged acts were the product of a valid exercise of business judgment). Here, a majority of the board, and the entirety of the compensation committee, did not receive any of the options in question, thus eliminating the application of Aronson’s first prong.

[8] Rales v. Blasband, 634 A.2d 927, 933 (Del. 1993) (where the challenged transaction was not a decision of the board, question is whether complaint creates reasonable doubt that the board in place at the time the complaint is filed could have properly exercised its independent and disinterested business judgment in responding to a demand).

[9] Ryan, 2007 Del. Ch. LEXIS 22, at *29 (referencing the holding in Sanders v. Wang, 1999 Del. Ch. LEXIS 203 (Del. Ch. Nov. 10, 1999)).

[10] Id. at *33-34 (quoting Aronson, 473 A.2d at 815) (emphasis in original).

[11] See Stone v. Ritter, 911 A.2d 362 (Del. 2006).

[12] Ryan, 2007 Del. Ch. LEXIS 22, at *40.

[13] The Tyson opinion in fact addresses a wide array of allegedly self-interested compensation awards and related party transactions. For the limited purposes of this article, we focus solely on plaintiff’s challenge to the validity of the executive stock option grants.

[14] This is to be contrasted with the obverse practice known as “bullet-dodging,” in which options are awarded in the wake of the release of material information that has resulted in a decline of the market price of the stock and, therefore, the applicable strike price as determined on the date of the grant.

[15] In re Tyson Foods, Inc. Consol. S’holders Litig., C.A. No. 1106-N, 2007 Del. Ch. LEXIS 19, at *63 ( Del. Ch. Feb. 6, 2007).

[16] Id. at *63-64. This holding was based both upon the theory of fraudulent concealment (defendant by “actual artifice” has fraudulently concealed the facts necessary to put plaintiff on notice of the truth) and the doctrine of equitable tolling (plaintiff reasonably relied on the competence and good faith of a fiduciary). As to the latter, the Chancellor stated that “It is difficult to conceive of an instance, consistent with 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.” Id. at *62 (emphasis in original).

[17] Id. at *66-67 & n. 74.

[18] Id. at *67.

[19] Id. at *67-68 n. 75; see also Steiner v. Meyerson, 1995 Del. Ch. LEXIS 95, at *24 (Del. Ch. July 18, 1995) (“…it is not the case that the grant of a stock option that is immediately exercisable at a profit to the holder necessarily constitutes corporate waste…. Options obviously can be granted as a preferred form of compensation to corporate directors, officers or employees. Compensation can come in a wide range of forms: cash, notes, stock or options are only the most obvious. So long as there is some rational basis for directors to conclude that the amount and form of compensation is appropriate and likely to be beneficial to the corporation, the grant will not constitute waste even if it were immediately exercisable at a profit”).

[20] Tyson, 2007 Del. Ch. LEXIS 19, at *70 (emphasis in original)

[21] Id. at *71.

[22] Id. at *71-72.

[23] 100 A.2d 219 (Del. Ch. 1953).

[24] Desimone v. Barrows, 2007 Del. Ch. LEXIS 75, * 42 (Del. Ch) (citation omitted)

[25] Id. at *81

[26] Id. at 76-77

[27] 634 A.2d 927 (Del. 1993).

[28] In re Tyson, 919 A.2d at 575, n. 15.

[29] The Court expressly excluded the minutes of the Compensation Committee at which the options were approved, however, declining to consider documents that were not referenced in the complaint, and thus had been “cherry-picked” by defendants’ before plaintiffs had been given the benefit of discovery.

[30] 2007 WL 2351071 at *6.

[31] C.A. No. 2133-CC, 2007 Del. Ch. LEXIS 168 (Nov. 30, 2007).

[32] Ryan v. Gifford , C.A. No. 2133-CC, 2007 Del. Ch. LEXIS 168, at *3 (Nov. 30, 2007).

[33] Id.

[34] 430 F.2d 1093, 1103-4 (5^th Cir. 1970).

[35] 2007 Del. Ch. LEXIS 168, at *9-10.

[36] Id. at *9.

[37] Id. at *9-10.

[38] Id. at *10.

[39] Id. at *12-13.

[40] Id.

[41] Id.