Corporate governance litigation: 2007 review: report from Delaware: a spotlight on several court rulings that moved the governance needle.

• Author: Reed, John L.
• Position: LIABILITY AND LITIGATION

THE HARSH CONSEQUENCES of being a faithless fiduciary were evident in 2007, when increased efforts by the Securities and Exchange Commission and U.S. Attorneys' Offices resulted in a wave of indictments, convictions, and guilty pleas. In May 2007, the former general counsel of Comverse Technology became the first executive to receive a prison sentence for stock option backdating. In July 2007, Conrad Black, the former chairman and CEO of Hollinger International, was convicted of defrauding shareholders. In August 2007, the former CEO of Brocade Communications was convicted of securities fraud for stock option backdating (the company's HR director was later convicted of conspiring with the CEO to conceal the practice). And, in October 2007, the former general counsel of Amkor Technology was convicted of securities fraud. These are but a few examples, as many executives pleaded guilty to stock option backdating, insider trading, and other offenses in 2007.

Although often inextricably linked to the federal securities laws, poor corporate governance rarely results in criminal prosecution; however, it can result in civil liability for directors and officers, economic losses for shareholders, and delays in the implementation of board decisions. In 2007, the courts of the State of Delaware--America's "Corporate Capital" and the state of incorporation for more than 62% of the Fortune 1000--once again provided lessons for boards and management. Several of those decisions are summarized below.

Stock option pricing manipulation

The impetus for the stock option backdating scandal was a March 2006 report issued by Merrill Lynch, which conducted a statistical analysis of the timing of stock option grants during the period of 1997-2002. In 2007, the Delaware Court of Chancery decided several cases alleging that directors manipulated the pricing of stock options, three of which are discussed here.

The first case to be decided, Ryan v. Gifford, addressed whether backdating violates a director's fiduciary duties. In Ryan, the options at issue were granted by the Compensation Committee of Maxim Integrated Products Inc. to the company's founder, chairman, and CEO, John F. Gifford, pursuant to a stockholder-approved option plan filed with the SEC. The court ruled that backdating is tantamount to a "lie" and cannot be the loyal or faithful act of a fiduciary. The court's opinion was at the early procedural stage and without factual findings; however, the court discussed the portion of the Merrill Lynch report dealing with Maxim: "Merrill Lynch found that the twenty-day return on option grants to management averaged 14% over the five-year period, an annualized return of 243%, or almost ten times higher than the 29% annualized market returns in the same period." The report noted that if backdating did not occur, then company management must have had an uncanny ability to time option pricing events.

Issued the same day as the Ryan decision, In re Tyson Foods, Inc. Consolidated Shareholder Litigation involved "spring loading," not backdating. "Spring loading" is the practice of issuing stock option grants shortly prior to the release of information likely to drive up the price of the issuer's stock. As a result, the optionee receives options that are almost instantly "in the money." Plaintiffs alleged that directors of Tyson Foods "spring loaded" options while representing in public disclosures that such options were granted at market prices. The court accepted these allegations as true, which it was required to do at this early stage of the litigation, and held that plaintiffs stated an actionable claim for breach of fiduciary duty. The court compared "spring loading" to backdating and found that while the latter is essentially a lie, the former "implicates a much more subtle deception"--i.e., the authorization of options with a market-value strike price in accordance with a stockholder-approved option plan at a time when the authorizing directors know that the shares are actually worth more than the exercise price. Once again, the court reiterated that directors who engage in this type of conduct cannot "be said to be acting loyally and in good faith as a fiduciary."

A third option case from 2007 is important for how it differs from both Ryan and Tyson. In Desimone v. Barrows, the court dismissed a stockholder derivative complaint alleging misconduct in the issuance of stock options by the board of directors of Sycamore Networks Inc. The directors had granted three categories of options: (i) options to employees; (ii) options to outside (i.e., nonemployee) directors; and (iii) options to officers. Regarding the employee options, the court found that plaintiff failed to plead facts sufficient to demonstrate that the Sycamore directors were aware that certain grants to employees were backdated. The plaintiff also alleged that the directors failed to exercise proper oversight, but the court dismissed that claim because plaintiff did not allege "any fact...