Taking the wrong option
Directors and officers most often solve problems and settle crises for others. Now they are in their own heap of trouble. America’s top business court sent notice early this year that board members may face personal liability if they played any games in granting employee stock options.
In two rulings handed down on the same day in February, Chancellor William Chandler III of Delaware’s Court of Chancery denounced options backdating and its less famous relative ‘springloading,’ which involves the timing of options just ahead of favorable company news.
Chandler was ruling only on preliminary motions allowing the cases to proceed, but his language about the nature of options manipulation was so strong that it is resounding across boardrooms. It seems every major law firm put out a lengthy bulletin on the cases. They have also prompted urgent discussion between directors, corporate secretaries, insurers and other counsellors, lawyers say.
‘These decisions are interesting because they really are the first ones [on options] and they’re from quite an influential court,’ says Mark Collins, a partner in the Washington office of McDermott, Will & Emery. ‘On the other hand, given the preliminary stage in the litigation in which they decided on a motion to dismiss, I don’t think ultimately the rulings are that significant. But everyone is watching to see how they play out.’
A significant concern is that Chandler’s wording seems to rule out any possibility that options manipulation might be protected under Delaware’s business judgment rule, which gives directors lots of space for maneuvering. Loss of this shield could mean board members would lose protection provided by their D&O insurance policies. The rulings also suggest that it is not a certainty that directors can rely on the statute of limitations to stop such suits even though much of the activity took place well in the past.
Chandler’s negative take on backdating and springloading is expected to have wide effect. ‘I think the relevance of these cases is the precedential impact they’ll have,’ says Kevin LaCroix, an attorney and director for Oakbridge Insurance Services, who specializes in executive liability coverage. ‘The Delaware courts are so highly respected, they will be influential in other jurisdictions. For companies and individuals sued in other jurisdictions, many defenses they hoped to rely on may be weaker.’
Not so rare
Backdating in particular appears to have been widespread, at least until the passage of the Sarbanes-Oxley Act in 2002, which began requiring companies to report options grants within 48 hours of making them. In the research that helped blow open the scandal, University of Iowa finance professor Erik Lie found that 18.9 percent of supposed at-the-money options issued between 1996 and 2005 were backdated or otherwise manipulated. (At-the-money options means the exercise price cannot be lower than the closing price on the grant date.)
Anomalies occurred with higher frequency at tech companies, small companies and firms with high stock price volatility; in many cases, they provided a potential windfall for recipients since the falsely dated options often coincided with market lows.
Some 170 companies are involved in options timing investigations or litigation. Scores of executives have lost their jobs and a few face criminal investigations. The web has stretched to include directors, thanks to the Delaware civil suits. Potentially, backdating could give rise to traditional securities class actions. But the practice hasn’t caused much of the type of damage to stocks that is required to support a securities action. What’s more common in options-timing cases are shareholder derivative suits.
In the Delaware cases, Ryan v. Gifford and In re Tyson Foods, shareholders allege that the directors at the underlying companies breached their duties of loyalty and/or care by deliberately or negligently allowing these backdating practices. This sort of claim is brought by shareholders, but it is based on a wrong to the corporation, so the shareholder’s right to sue and recover is only derivative. ‘It’s a positive development for a company itself,’ Croix says. ‘It’s potentially money back in the treasury.’
The Ryan suit seems the more clear-cut of the two. The case is against the board of directors and the compensation committee members of Maxim Integrated Products over millions of allegedly backdated stock options from 1998 to 2002 to John Gifford, Maxim’s founder, chairman of the board and CEO. The company’s stock plan required that options be granted at-the-money, and that the board not only appeared to contravene those terms, it failed to disclose its actions.
Interestingly, Chandler had the opportunity to stay the Ryan case since the same issues are being litigated in a separate suit in the Northern District of California. But he found Delaware had an overwhelming interest in coming to its own conclusions on an issue of such ‘great import to the law of corporations.’
Going against the plan
Many people watching the options debacle have observed that backdating isn’t necessarily unlawful, though problems do occur when disclosure isn’t made, either on tax returns or earnings reports. The Ryan case is more difficult because the board went against the company’s own shareholder-approved stock option plan.
Chandler, though, seems to take a view that backdating can never be right. In the Ryan opinion, he writes: ‘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.’
He goes on to say that he is ‘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.’
Another big surprise is that companies won’t be able to invoke the statute of limitations. ‘The chancellor said the statute would be tolled,’ says LaCroix. ‘It just didn’t run because of the concealment.’
The Tyson case may be tougher for plaintiffs to prove. The springloading allegation is one of several complaints against the food producer for millions in payments from the company to the Tyson founders and board members. Tyson allegedly granted several groups of options ahead of positive company news, including the sale of a major division. If the case moves to trial, plaintiffs will have to show that directors were authorizing options at a ‘market’ value at a time when they knew those shares would actually be worth more, and did this in a way that went against shareholder-approved restrictions on exercise prices.
Chandler wrote that he found the practice troubling. ‘At their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made,’ the Tyson opinion says. ‘Allegations of springloading implicate a much more subtle deception.’
While the tone of both Delaware decisions is severe, it is important to note the rulings were on motions to dismiss. ‘The chancellor has to accept all of the factual allegations as being true solely for the purpose of ruling on the motion to dismiss,’ says Collins. ‘If it goes forward to trial or on a motion for summary judgment, at that point he weighs the evidence.’
Disclosure is the key
The Ryan and Tyson defendants would have strong inclinations to settle. ‘There would likely be some sort of negotiated resolution,’ says LaCroix. ‘It is possible that it would go to trial. But the possible loss on breach of fiduciary duty is probably a reason directors would not want to risk a finding, as strongly worded as the opinions in those cases were.’
Both cases raise a host of D&O insurance coverage issues. Gilbert Randolph, a partner at Jonathan Cohen, who often represents individuals in coverage disputes, argues that insurance policies generally cover breach of fiduciary duty. ‘It depends on the policy language, but policies are designed to cover all kinds of wrongful acts directors and officers are sometimes accused of doing,’ he says.
Collins contends that certain findings may trigger policy exclusions, such as breach of fiduciary duty or non-compliance with the business judgment rule. Giving out remuneration without the approval of shareholders, as apparently happened in the Ryan case, and deliberate criminal or fraudulent acts, also create risk. There can be an exclusion for profit or advantage to which the insured is not legally entitled.
Collins assures that ‘it will be very fact specific.’
Some boards may just rubber-stamp options decisions. ‘It is possible some directors may have only acted negligently and had no intent to do anything wrong, and an exclusion like this would not apply,’ Collins says. ‘But failure to disclose provides an inference of criminality.’
Even if the policy stands to protect directors, there are still worries. ‘A lot of insurance policies provide coverage to a lot of people out of one pool of assets. So there’s a single limit that applies to all those covered,’ reminds Cohen. ‘It’s a limited pool of assets, and you don’t want to be the last in line.’
Not every company that has backdating issues is in the same hot water as Tyson and Maxim. Nonetheless, they may be looking to avoid that trouble all together. One path could involve canceling any suspect options. Perhaps hoping to blunt criticism, ousted UnitedHealth CEO William McGuire has so far given back a significant portion of his options. ‘That’s a very sober and straight up approach to it,’ LaCroix says.
Another way out
But it could be a lot easier than all that.
Another way out for companies in the future may be to write stock option plans with less specificity, giving directors more room to maneuver. Most stock plans, like Maxim’s, are currently structured with options distributed at-the-money. ‘It seems logical that a plan could be written that wouldn’t have a bright-line prohibition,’ Collins says.
There is a potential problem. ‘At disclosure, you might have someone suing over the plan,’ LaCroix says, adding ‘but that’s a very different kind of lawsuit. It’s not nearly as dangerous.’
Broc Romanek, counsel for the National Association of Stock Plan Professionals (NASPP) and editor of corporatecounsel.net, says it’s probably too early to tell the extent to which plans will be amended because the cases are so new and companies haven’t had time to react. NASPP will also likely do a member survey on the topic. ‘Anecdotal evidence clearly suggests that quite a few companies will be making changes, perhaps even building window periods into their plans specifying time periods when grants can be made under the plan,’ Romanek says.
Insurers may seek their own protections. There has been speculation that they may attempt to exclude options claims in new policies. ‘In my experience and in talking to in-house lawyers, no broad exclusions have been invoked as far as I know,’ Collins says. ‘But insurers are asking more questions about options practices and whether companies have gotten any investigation notices from the SEC, no matter how preliminary.’
‘In the early days of backdating, insurers were very concerned and thought it could be a mini crisis. Later, insurers started to take the view that it was probably going to be less of an issue for them,’ Cohen says. ‘Insurers have been pretty quiet about what they think is likely to happen,’ he adds.
While nothing is set in stone, all eyes will be on the Ryan and Tyson cases and the opinion of Delaware courts for a window into the future and the courts’ appetite for litigation. With directors on the line, and insurance providers possibly looking for a way out it is unlikely this issue will be far from the minds of corporate leaders and those who administer options programs.