Backdating and the Result Oriented Reasoning of Desimone v. Barrows

Chancellor Strine is nothing but colorful, as he demonstrated at one of the recent SEC roundtables on proxy reform. This comes across in his opinion writing, as Desimone illustrates, and his use of hypotheticals and other reasoning that seek to validate backdating and insider trading. We will talk about this today and tomorrow. Let us start with an examination of his analysis in greater detail.

We examined Ryan v. Gifford, the first of the Delaware backdating cases, a few days ago. There, the plaintiff alleged that backdating had occurred, relying on statistical evidence. Plaintiff also included one sentence stating that the options had been approved by the compensation committee but provided no more information about the role of the board of directors. For Chancellor Chandler, this was enough to let the case go forward. He reminded the plaintiff that this did not obviate the duty to prove that backdating actually occurred and that the board was aware of the practice but that for the time being the case could continue through discovery.

No matter how much Chancellor Strine tries to spin it, the facts in Desimone are stronger than those in Ryan. Plaintiff in Desimone alleged that backdating occurred and, rather than rely only on statistical evidence, produced an internal memorandum that more or less proved the practice occurred. The memorandum discussed promises made to various employees about their option exercise price and the method of backdating to make good on the promises.

For example, the first person mentioned in the unsigned memo was Ed Zaval, the VP of Customer Service. The memorandum states that he "was promised his tock option grant would be issued at the low of the quarter price" The memorandum identified that date as 12/1 and provided instructions to "[c]hange Ed's date of hire to reflect 12/21/00" The memorandum went on assess the risk, presumably of detection, noting "Low risk. Senior level employee and the risk of exposure to this agreement is low. No audit risk." The memo is, by the way, on the DU Corporate Governance web site as an attachment to the complaint.

The memorandum also had a curious reference. Under risk assessment for one employee, the memorandum noted that "she does have a relationship with Hassan Ahmed that could work to our advantage should the risk of exposure of this agreement surface." According to at least one published article, there was a Hassan Ahmed who had worked with Gururaj Deshpande, the Chairman and one time President of Sycamore. See The 100 Highest Rollers, Forbes, April 2, 2001.

Like Ryan, therefore, the complaint provided statistical evidence suggesting backdating. Unlike Ryan, the complaint provided allegations of actual backdating (that is, misrepresenting the date of option grants), that it was apparently an ordinary part of the hiring process, and that it was apparently widely known.

What about the board's involvement? First, a former director of human resources at Sycamore alleged that the backdated options were approved by the CFO and/or the President (and director), Daniel Smith. In other words, there were allegations that a board member participated in the backdating. With respect to the options issued to officers by the Compensation Committee (which included 500,000 to the CFO who the complaint described at the "enforcer" of the backdating grants), the complaint alleged that the committee administered the plans and the court conceded that "it is reasonable, at this stage, to infer that Sycamore's Compensation Committee retained direct authority over the Officer Grants."

Despite potential involvement of the President, despite allegations that the Compensation Committee "retained direct authority" over the options (and acknowledgement by the court that some were actually issued by the committee), despite the attachment of a memorandum that suggested the backdating practice was widespread and common knowledge, the court managed to find that the plaintiffs failed to plead sufficient facts showing that the board knew about the practice. Compare this to the views of Chancellor Chandler in Ryan: "After all, any grant of options had to have been approved by the committee, and that committee can be reasonably expected to know the date of the options as well as the date on which they actually approve a grant."

The result? A case with a smoking gun memo, with behavior under apparently investigation by the SEC and Justice Department, that resulted in a restatement and more than $215 million in additional expenses, has been dismissed without any opportunity for discovery to determine what actually happened with respect to the options. Hopefully the Delaware Supreme Court will see this differently.