Backdating and the View from Outside Delaware

The Delaware Chancery Court has been wrestling with backdating cases.  The cases arrive at the Chancery Court on the issue of demand excusal.  That issue in turn depends not on the underlying behavior but on the independence of the board of directors.  In general, this requires some type of evidence that the directors responsible for awarding options were somehow aware of or involved in the backdating process.  But since the courts deny any discovery on the issue, plaintiffs cannot explore what the board (or compensation committee) actually did or knew. 

As a result, the cases turn on whether allegations of statistical evidence of backdating, coupled with board responsibility for issuing options, is enough to show a lack of independence.  VC Lamb in Conrad and Chancellor Chandler in Ryan tended to say it was; VC Strine, in an extraordinary opinion, saw things otherwise.  InDesimone, he not only refused to allow a case on those facts to go forward, he also more or less wrote an opinion that attempted to justify both backdating and spring loading as routine compensation practices.   

So it is with some interest that we read the opinion in Edmonds v. Getty, 2007 US Dit. Lexis 90249 (WD Wash Dec. 5, 2007), a backdating case relying on Delaware law as interpreted by a non-Delaware judge. 

The opinion examined allegations of backdating by certain officers and directors of Getty Images.  Following notice of an investigation by the SEC, Getty Images announced an internal investigation into stock option grant practices.  The committee found evidence that dates had been selected retroactively, but no evidence of "intentional wrongdoing."  The company ultimately undertook a restatement.   

As usual, the case turned on demand excusal and as usual resolution turned upon board independence.  In this case, plaintiff needed to produce evidence that four of the seven directors were not independent.  Plaintiff did not challenge the independence of the two independent directors who chaired the special committee.  Of the remaining five directors, three received backdated options and three sat on the compensation committee.  With respect to those receiving the options, the court described the issue as whether "it may be reasonably inferred that backdating, as opposed to an innocent bookkeeping error occurred." 

Plaintiff presented statistical evidence indicating that options had been backdated.  The company vigorously challenged the data, including the methodology used by plaintiff.  Noting that "at the pleading stage, the plaintiff need not prove that backdating occurred, but rather must only allege circumstances from which it may be reasonably inferred," and citing Ryan, the court concluded that the allegations were "sufficient to reasonably infer that backdating rather than innocent bookkeeping errors occurred." 

The conclusion, however, only disqualified three directors.  Plaintiff needed four.  Two additional directors also served on the compensation committee (there were three, one of whom allegedly received the backdated options).  Directors on the committee could lose their independence because of the potential for liability to the extent the evidence showed they approved the backdated options.  This required some evidence of the committee's involvement in the backdating scheme. 

Without the benefit of discovery, plaintiff alleged that the compensation committee had the authority to award options and ensure that they were at fair market value, the backdated options violated the stock option plan, and that the committee falsely represented that they complied with the plan.  The company cited Desimone and argued that plaintiff failed to plead facts creating a rational inference that the directors had approved the backdating.  The court, however, disagreed.  "The court is not persuaded by Getty Images' arguments.  The court finds that the allegations in the complaint, if true, demonstrate that the members of the compensation committee face a substantial likelihood of liability."

In short, it was enough to show statistical data indicating that backdating had occurred and evidence that the board (or the compensation committee) was responsible for the options.  This finding means nothing more than the case can go to discovery.  Once discovery occurs, it may well turn out that the statistical evidence was incorrect or that the compensation committee had nothing to do with the backdating.  But, contrary to VC Strine's opinion in Desimone, this is an inappropriate issue to be resolved at the demand futility stage, where the precise role of the board cannot be determined. 

Said another way:  Game and match to Chancellor Chandler's opinion in Ryan.