Legal niceties color backdating cases; There hasn't been a huge wave of class-action suits triggered by the scores of investigations and allegations of improper stock option backdating. One big reason: legal technicalities that make derivative suits more appropriate.

A funny thing has happened on the way to the courthouse in the wake of scores of stock option backdating indictments and investigations: the threat of a tidal wave of class-action lawsuits is breaking apart, even as another type of suit is flourishing.

Much of this hinges on what could be considered a technicality: In order to bring a class-action suit, plaintiffs must not only show that backdating occurred, but that it caused the market to hammer the stock--which does not always happen.

While there were some notable instances in which stock prices plummeted--Computer Sciences experienced a $1.7 billion plunge in market value, Caremark Rx's value sank by $1.5 billion and The Home Depot lost $1.1 billion, according to calculations by Glass Lewis & Co., a Denver-based proxy-voting consultancy--losses were by no means uniform.

And in several cases, moreover, stocks have even gained in value in the wake of backdating announcements--usually on the strength of strong earnings. For example, Glass Lewis reported in April that Apple Computer's market value had increased by more $1.3 billion after its backdating investigation was announced (and its stock reached a 52-week high in early June).

So, while class-action suits have been brought, they're far scarcer than might be expected--about 30 to date. In their place has come a rise in derivative suits, which don't have the stock plunge hurdle, notes Adam Savett, vice president of securities class action services at Institutional Shareholder Services, which counts 158 companies currently being sued in private derivative lawsuits. Such suits are brought by a current shareholder against officers and directors on behalf of the company seeking monetary damages and alleging that company officials are liable for "breach of fiduciary duty."

What happens in a derivative lawsuit, explains Keith Johnson, an attorney at Reinhart Boerner Van Deuren in Madison, Wis., "is that shareholders are suing on behalf of the board, claiming that the board was conflicted or not independent enough to make decisions to pursue those claims."

To date, however, those claims are hardly a slam-dunk for plaintiffs. In a number of cases, courts have dismissed derivative suits brought against companies being investigated for backdating, ruling that plaintiffs failed to show that it would have been "futile and useless" for the board to have done investigations.

Both class-action and derivative suits are now in place against Minneapolis-based UnitedHealth Corp., perhaps the most notorious backdating case. While the healthcare management company has been immensely profitable and a Wall Street darling for years, CEO William McGuire was forced out last year after pocketing an estimated $1.6 billion in options over 12 years, many allegedly at incorrect prices as a result of backdating. The company, the nation's second largest health insurer, faces probes by the U.S. Securities and Exchange Commission (SEC), the Department of Justice and the Internal Revenue Service.

"Dr. McGuire serves as the poster boy for executives that deceptively lavished corporate funds on themselves by engaging in options backdating," says Chris Bebel, a former enforcement attorney at the SEC and now an independent attorney in Houston who serves as an expert witness in securities litigation.

Actually, as ISS's Savett notes, derivatives cases and class-action lawsuits by shareholders include not just backdating--in which executives select stock purchase dates when shares are low, then sell the stock later, when prices have risen--but the "whole genre" of stock options schemes. At issue are also such practices as "spring-loading" and "bullet-dodging."

The California Public Employees Retirement System, or Calpers, which owns more than 6 million shares worth more than $360 million, is the lead plaintiff in a class-action shareholders' suit against UnitedHealth. In "spring-loading," a practice that Calpers is alleging UnitedHealth engaged in, a company's executives and directors time a stock option grant so that its issuance occurs just before the company announces positive news, which is likely to bump up the company's stock price.

"Bullet-dodging," on the other hand, involves issuing stock options after a company releases bad news and the stock price plunges--allowing the recipient to receive a stock-option grant at a rock-bottom price.

Both spring-loading and bullet-dodging are much harder to prove than backdating stock options, which Charles Elson, a law professor and director of the Lerner Center for Corporate Governance at the University of Delaware, likens to "betting on a horse race after the race is over."

To show that spring-loading or bullet-dodging occurred, says Paul Regan, president of Hemming Morse, a San Francisco-based forensic accounting firm, "you try to get an understanding of what information affected the market both prior to, and subsequent to, a sharp change in stock price.

"This is circumstantial evidence," he adds, "but if you're working for an audit committee, you have access to a company's internal records. And if you're working for a plaintiff on a class-action suit, you're talking about depositions."

At least 264 companies have announced internal reviews, have been issued subpoenas by the U.S Department of Justice or are the object of an SEC inquiry, noted Glass Lewis in its April report. Included in the roster are, in addition to companies mentioned elsewhere in this article, such household names as Cheesecake Factory, Cablevision Systems Corp., Clorox Co., Staples Inc. and Barnes & Noble Inc.

Criminal Probes Launched

According to The Wall Street Journal, which broke the stock options backdating scandal last year, the Justice Department has mounted criminal investigations at 54 companies. Indictments and fines have been levied; for example, the SEC has imposed fines of $7 million against Brocade Communications Systems and $40 million against Mercury Interactive (which has since been taken over by Hewlett-Packard Co.).

Yet shareholders and plaintiffs attorneys are having a far harder time seeking redress in civil litigation than the SEC or DoJ, which "have a great deal of power to exert," says K.B. Battaglini, an attorney who specializes in securities litigation at Greenberg Traurig in Houston. "It's shock and awe," he says of the federal forces. "They can freeze all your assets and make it so you can't hire a lawyer, ruin your reputation and turn your world upside down with a complaint and an injunction."

Not so in civil litigation. "When I teach corporate law, I describe this as 'Bizarro World,'" says Peter Henning, a law professor at Wayne State University in Detroit and a former attorney in the SEC's enforcement division, referring to a planet in Superman comics where everything is backwards from the Earth.

"These cases seldom come close to going to trial," he adds. "Everything is fought out at the motion stage. The fight is over preliminaries, over whether you can move forward to the discovery phase and with the lawsuit.

"If an officer or director is found liable for breach of fiduciary duty," Henning adds, "the real question becomes whether they could get reimbursed for attorneys' fees. So, in a derivative suit, you can't run the risk of going to trial. You try to knock the case out at earlier stages. And if that becomes too hard, you settle."

Adds forensic accountant Regan: "'Discoverability' is the big controversy right now--especially when there's a criminal investigation involving the Justice Department and the SEC. If you produce records, notes and documents to the DoJ, you're under the umbrella of being cooperative and helpful, which may generate lenience. But the plaintiffs' class-action lawyers are going to want those documents. So it's a tightrope."

Deborah Meshulam, a partner at the Washington, D.C., office of law firm DLA Piper and former SEC enforcement attorney, says she is engaged as defense counsel for about a dozen cases in venues that range from the SEC and DoJ to shareholders' class-action lawsuits and everything in between. "Everyone is watching to see how motion-of-dismissal cases are decided," she says.

By all accounts, defense attorneys are expending Herculean efforts to keep the cases from going to the discovery phase, much less a full-blown jury trial. But if there should be discovery, defense attorneys would rather have it occur in a federal court, where, says Stellman Keehnal, a law partner in DLA Piper's Seattle office, "statutes are in play that can prevent discovery from racing off."

So far, however, both sides can claim some measure of success in the derivative suits before the state courts. Defense attorneys have won outright dismissals in state courts in California, New York and elsewhere by claiming that plaintiffs have failed to show "demand futility."

Under this rule, plaintiffs must show that it would have been a "futile and useless act" for a company's own board to perform an internal investigation and prosecution. If plaintiffs are unable to do so, the plaintiffs are seen as attempting to "usurp" the role of the board. This was the reasoning in a ruling at the end of May by a state judge in New York City, who tossed out a derivatives suit against the directors and officers at Bed Bath & Beyond (BBB).

The judge also ruled that plaintiffs had been unable to show that the majority of directors at BBB had benefited from backdating. The company also gained by hiring an independent law firm, Weil Gotshal & Manges, to conduct an internal probe. The law firm's report concluded that, although backdating had occurred, it was "unintentional."

Similarly, a shareholder's derivative suit against the corporate officers and directors of CNET Networks was dismissed by a California judge who ruled that the aggrieved party had failed to show "demand futility." This occurred despite an SEC settlement, resignations by former executives at CNET and an ongoing Justice Department probe.

However, the shareholders' case has been bolstered in the important Delaware courts, where a Chancery Court judge has granted plaintiffs the right to discovery in a derivative lawsuit charging breach of fiduciary duty by the officers and directors at Maxim Integrated Products. There, the judge said that board of the Sunnyvale, Calif.-based high-tech company approved the backdating and would be unable to investigate itself.

The ruling by the Delaware court carries particular clout, attorneys say, because so many major corporations incorporate there and other courts look to Delaware law for guidance. "The Delaware Chancery is respected and has a highly developed body of law," says Keehnal of DLA Piper, who nonetheless adds that he was troubled by the ruling. "It appears that the court relied on newspaper articles that there was egregious behavior," he says.

Attorneys say that the private litigation in the current stock option-backdating scandal remains in its early stages. And, noting that many of the cases arising from the 2001-02 corporate fraud scandals involving Enron et al. took four years or so to wend their way through the courts, attorneys on both sides say that it will be years before the effects of the backdating litigation on companies and shareholders can be evaluated.

Meanwhile, shareholders groups and advocates for good corporate governance say that one salutary aspect of the court cases is that plaintiffs are demanding, as part of their pleadings, a whole raft of corporate governance reforms. "I think that this litigation is emerging as a wake-up call. It's telling companies that independent directors are supposed to be independent and that a lot of the past coziness in the boardroom will just not be tolerated by shareholders and the courts," says Johnson, the Wisconsin plaintiffs' attorney.

That view is echoed by Meshu-lam, the DLA Piper attorney in Washington. She says that much of her work now consists of imparting advice to keep companies out of the courthouse in the future. "We've seen a real trend to change procedures so that top executives and the CEO don't have authority" to issue stockoption grants, Meshulam says.

"There's been a real tightening of the process," she adds. "That function is being brought back to the board level." That won't stop the litigation, of course, but it should keep most financial executives out of the legal cross-hairs.

PAUL SWEENEY ([e-mail]) is a freelance writer in Austin, Texas, and a frequent contributor to Financial Executive.

RELATED ARTICLE: TAKEAWAYS

* The threat of a wave of class-action lawsuits over stock option backdating has receded, in large part because such suits require proof that the stock dropped as a result.

* Another type of suit, the derivative suit, is flourishing. Here, plaintiffs sue on behalf of the board, saying the board was too conflicted or in the dark to pursue the claims the plaintiffs have lodged.

* Attorneys active in these cases say that the threat posed by prosecutors and the SEC are far more potent that civil suits, which often hinge on motion issues and may rarely go to trial.

* Noting that suits over scandals like Enron took four years to wend their way through the courts, lawyers think it will be years before the results of backdating suits will be known.