Conrad v. Blank: Backdating and Pre-Suit Demand Requirements

We continue discussing the recently released decision in Conrad v. Blank, 2007 WL 2593540 (Del. Ch. 2007).

The case was brought against past and present executives and directors of Staples, Inc., and alleges up to 12 incidents of option backdating between 1994 and 2003. In our last post, we discussed the defendants’ assertion that the plaintiff lacked standing to pursue the claim. We now turn to an examination of the court’s decision on the defendants’ assertion that the plaintiff failed to make a pre-suit demand as required by Delaware law.

Delaware requires a shareholder wishing to bring a derivative claim to first demand that the board take action. However, Delaware allows for the requirement of demand to be excused if the allegations of the complaint create a “reasonable doubt that a majority of the board can exercise, ‘its independent and disinterested business judgment in responding to a demand.’” See Rales v. Blasband, 634 A.2 d 927, 933 (Del. 1993). As a practical matter, the independence issue in backdating cases turns upon whether the directors directly benefited from the backdated options or whether they knowingly approved the backdated options. With shareholders usually unable to prove actual knowledge, the cases in turn depend upon the degree of circumstantial evidence the courts will accept. On this topic, Delaware courts are divided.

The Conrad court agreed that the two directors who had allegedly received backdated options were not disinterested. As the court noted: " Most obviously, both have a strong financial incentive to maintain the status quo by not authorizing any corrective action that would devalue their current holdings or cause them to disgorge improperly obtained profits. This creates an unacceptable conflict that restricts them from evaluating the litigation independently."

Demand excusal, therefore, turned on the independence of the three directors on the compensation committee. Relying on VC Strine's opinion in Desimone, defendants argued that plaintiffs failed to show the directors on the compensation committee knowingly approved backdated options. In both Conrad and Desimone, the outcome depended mostly on the treatment of statistical evidence suggesting that the options were backdated. In Desimone, the court largely rejected statistical evidence designed to show knowledge. The court in Conrad, however, disagreed. As the opinion noted:

• The Staples stockholder-approved option plans, by contrast, gave no discretion to the compensation committee in setting exercise prices--the grant date controlled in all cases. Thus, it is less likely than was true in Desimone that the compensation committee could innocently or unknowingly authorize backdated options. The complaint also identifies 12 option grants by specific grant dates and alleges that these options were directly authorized by the compensation committee. In addition, the plaintiff has provided the court with a statistical analysis to bolster the inference that grants were deliberately backdated to more favorable dates in violation of the company's stated procedures. Perhaps most importantly, Staples's public disclosures support the plaintiff's argument. The company announced a 65 cent correction to option grants made on July 1, 2003, changing the strike price nearly 5%. While Staples's barren disclosures did not reveal the correct grant dates, the complaint alleges that the company backdated these options by ten days. Given the more thorough and convincing pleadings in this case, the analysis in the Desimone decision is of little help to the defendants.

VC Lamb, in Conrad, cited favorably the use of statistical data, relying on the court's reasoning in Ryan v. Gifford, 918 A.2 d 341 (Del. Ch. 2007).

• The plaintiff in Ryan included a statistical analysis comparing the annualized returns of the option grants versus the common stock over the same period to demonstrate the unlikelihood that the defendants randomly selected the grant dates. Here, the complaint also challenges a series of option grants at the low price for the month or the quarter, and additionally includes allegations drawn from Staples's public filings admitting the use of incorrect measurement dates.

The opinion suggests that Chancellor Chandler (in Ryan) and VC Lamb (in Conrad) have a different and more realistic approach to backdating cases and VC Strine (in Desimone). They will allow them to go forward where the circumstantial evidence in the complaint suggests that the board was involved in the practice. This allows shareholders to undertake discovery and resolve the board's involvement. As VC Lamb noted, discovery may reveal a different set of facts than what was pleaded.

The materials for Conrad, Desimone, and Ryan can all be found on the DU Corporate Governance website.