Delaware and Backdating: Ryan v. Gifford

Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007) is the first of the three Delaware backdating cases. The case arose in the context of demand excusal.

The suit arose following a study released by Merrill Lynch in May of 2006 examining the timing of stock options grants to executives in the semiconductor industry. The study found that executives at Maxim Integrated Products Inc. realized extraordinary returns of 249% annually, compared with the market average of 29%.

Plaintiff brought suit, focussing mainly on options issued to defendant, John F. Gifford, founder, chairman of the board, and chief executive officer pursuant to shareholder approved stock option plans. The complaint sought to show backdating mostly by emphasizing the coincidence that the exercise price was usually determined at lows for the months or year. As the Complaint noted:

• "The Merrill Lynch report . . . shows that most of the option grants in question were purportedly granted at the low market price of the month, or year, in which the stock was traded.

• "Many of the other grants occurred from one day to one week before a major rise in the market price of Maxim common stock. As the charts in the Merrill Lynch SOX report show . . . each trade was made in a 'valley' on the chart. The timing is too favorable on a repeated basis to be mere coincidence."

The options were issued pursuant to plans approved by shareholders. Under the plan, options were to be issued at fair market value on the date granted by the board. The board had the authority to delegate responsibility to a committee. The responsibility was, therefore, vested in the compensation committee consisting of three independent directors. Plaintiff alleged that the compensation committee "approved the option grants to Defendant Gifford."

Chancellor Chandler concluded that Aronson, rather than Rales, provided the applicable standard, although he ended up applying both. In determining whether the backdating allegations transgressed the business judgment rule, the court concluded that they did.

• "Plaintiff alleges that the challenged transactions raise a reason to doubt whether the option grants were a valid exercise of business judgment. Specifically, plaintiff states that the terms of the stock option plans required that '[t]he exercise price of each option shall be not less than one hundred percent (100%) of the fair market value of the stock subject to the option on the date the option is granted.' The board had no discretion to contravene the terms of the stock option plans. Altering the actual date of the grant so as to affect the exercise price contravenes the plan. Thus, knowing and intentional violations of the stock option plans, according to the plaintiff, cannot be an exercises of business judgment. I conclude that the unusual facts alleged raise a reason to doubt that the challenged transactions resulted from a valid exercise of business judgment." (footnote omitted).
  

As for whether plaintiff had pled reasonable doubt about the independence and disinterest of the board, the court again agreed that he had.

• "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 (regarding his violations of a shareholder-approved plan, no less) and yet satisfy his duty of loyalty. Backdating options qualifies as one of those 'rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.' Plaintiff alleges that three members of a board approved backdated options, and another board member accepted them. These are sufficient allegations to raise a reason to doubt the disinterestedness of the current board and to suggest that they are incapable of impartially considering demand." (footnote omitted).

In addition to the demand excusal issue, defendants contended that plaintiff has failed to state a claim for breach of fiduciary duty. Plaintiff had not sufficiently alleged that a majority of the board had "personal interests potentially adverse to the interests of the company and its shareholders" or that directors had acted "intentionally, in bad faith, or for personal gain." Chancellor Chandler had no patience with the contention. "I am unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholder into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith. . . Well pleaded allegations of such conduct are sufficient, in my opinion, to rebut the business judgment rule and to survive a motion to dismiss."

Footnote 31 of the opinion did take the time to remind the plaintiff of the "procedural posture of the case." As a motion to dismiss, plaintiff had received certain "presumptions of the truth." As a result, the complaint could rely upon empirical evidence to raise the possibility of backdating. At trial, however, plaintiffs would have to establish "1) specific instances of backdating; 2) violations of shareholder-approved plans or some other legal obligation; and 3) fraudulent disclosures regarding compliance with that plan."

Primary materials (including the complaint and relevant motions) and the Chancery Court opinion can be found on the DU Corporate Governance website.