Desimone v. Barrows: Backdating, Spring Loading and the Imposition of a Scienter Standard

Desimone v. Barrows, 2007 Del. Ch. LEXIS 75 (Del. Ch. June 7, 2007), is the third backdating case to come out of Delaware.  In this instances, however, the opinion was written by Chancellor Strine and, unlike the prior two opinions, upheld the dismissal of the backdating claim brought by shareholders. 

This derivative suit alleged that Sycamore Networks had granted backdated options to six “rank and file” employees in late 2000, with the option exercise price set at the the low for the month, quarter or even the year.  An internal memorandum indicated that documents had been altered (in some cases by changing employee start dates) in order to disguise the backdating.  The plaintiff also alleged that options issued to officers had been manipulated through spring loading and bullet dodging.  

As with the other decisions, Desimone was a demand excusal case.  Applying the test in Rales, the court had to determine "whether the Sycamore board, as constituted at the time Desimone brought suit, could exercise an independent and disinterested business judgment in responding to a demand regarding Desimone's claims."  Two officers (including the CEO and former CEO) sat on the six person board but none of them received any of the options.  The other four directors were independent.  

In noting that Sycamore had an exculpatory provision waiving monetary damages for breach of the duty of care, Chancellor Strine reasoned that a “scienter-based standard for liability applies in determining whether any director faces a threat of personal liability for these Grants.”

Chancellor Strine held that demand was not excused due to the plaintiff’s failure to plead facts sufficient to suggest “an inference that the Sycamore board knowingly granted Sycamore’s officers backdated options.” The facts in the place attributed the backdating for the six employees to the CFO, not the board.  As for the alleged spring loaded grants to officers, the task fell to the Compensation Committee.  Chancellor Strine dismissed the claim on the now familiar ground that Desimone failed "plead particularized facts suggesting that Sycamore's directors knowingly spring loaded any options grants."  It wasn't enough to allege an improper practice or that the Compensation Committee had approved the options.  Shareholders needed to include facts that showed the committee knew of the spring loading and awarded the options anyway.  All of this had to be done at the pleading stage, without any discovery. 

Far more complex than the actual ruling in this case was the Court’s discussion of stock option grant manipulation. The court placed great weight on the absence of a requirement in the shareholder approved plans that the options be at fair market value.  It appears that where the shareholder-approved options compensation plan does not dictate that the exercise price of the grants be at the fair market price on the day of the grant, a plaintiff will have a much more difficult time surviving a motion to dismiss. In any event, it is clear from the Court’s holding in this case that plaintiffs will certainly be held to the traditionally rigorous pleading standards of Delaware Courts in shareholder derivative suits.

The Court’s opinion can be found at the DU Corporate Governance website.