Comverse Technology Derivative Shareholder Litigation

The New York Supreme Court, Appellate Division, recently reinstated a shareholder derivative complaint because the plaintiff successfully plead that demand was futile despite the board’s creation of a special committee. In re Comverse Tech., Inc. Derivative Litigation, 56 A.D.3d 49, 866 N.Y.S.2d 10 (N.Y. App. Div. 2008).

Plaintiffs alleged that Kobi Alexander and David Kreinberg, with the assistance of William F. Sorin, awarded themselves backdated options against company policy. Plaintiffs argued that members of the company’s compensation committee, “knowingly or recklessly approved these backdated stock options.” As a result, they contended that a demand on the board of directors would have been futile.  The court applied three tests to determine demand futility: (1) a majority of the directors were interested, (2) the directors did not fully inform themselves, or (3) the directors’ decision was not the use of sound business judgment.

The first test required a majority of the directors to be interested in the transaction. Neither of the parties disputed Alexander and Sorin's self interest and the Court determined Danzinger was interested because he received millions of dollars worth of backdated options. The remaining directors were uninterested because they did not receive any added benefits.

Under the second test, demand is futile when directors do not “fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstance.” The compensation committee approved backdated options without reviewing the assignment date or to whom they were given. Specifically, Plaintiffs alleged the compensation committee approved stock options more than a month after the grant date where the stock price had risen considerably and that the committee orally approved options in violation of the company’s bylaws.

The compensation committee also had a list of individuals who received grants in 2001 that listed more than two-dozen names of individuals who were not Comverse employees, but whom still received grants. Plaintiffs claim these options were placed in Alexander’s “slush fund” and despite possessing this list, the compensation committee did not verify these options nor did they compare the list to Comverse employees. Since the compensation committee did not fully inform themselves of the transactions or make any inquiries into the transactions the demand was excused as futile.

The third test states that demand is futile when “the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment of the directors.” The court relied upon Delaware law where the business judgment rule does not protect directors in cases such as this where backdating options was so egregious. Here, the court determined that passively rubber-stamping the acts of corporate managers was egregious and the directors were not entitled to the protection of the business judgment rule.

Despite the court excusing demand, Comverse argued that its special committee should conduct the investigation. The court determined that the mere creation of a special committee did not justify the stay of a shareholder derivative action for two reasons: (1) one of the two members of the special committee was also a director, debatably creating a conflict, and (2) the minimal steps the compensation committee took failed to establish the committee’s readiness to protect the company.

Because the compensation committee did not fully inform themselves about the transactions and because the directors were not entitled the protection of the business judgment rule, the court held the Plaintiffs’ demand excused as futile.

The primary materials for this post are available on the DU Corporate Governance website.