Shareholder options actions proceed against directors.

The intentional backdating or "spring-loading" of stock options by corporate directors, if proven, would be a breach of the good-faith element of the duty of loyalty sufficient to rebut the business judgment rule, the Delaware Court of Chancery has held in two shareholder derivative lawsuits. (Ryan v. Gifford, 2007 WL 416162 (Del. Ch. Feb. 6, 2007); In re Tyson Foods, Inc., Consol. Shareholder Litig., 2007 WL 416132 (Del. Ch. Feb. 6, 2007).)

In options backdating, a company issues stock options on one date but provides fraudulent documentation indicating that the options were issued earlier. In spring-loading, a company grants options shortly before releasing good news that directors know will increase the stock's price.

"I believe that the chancery court wanted to make two things absolutely clear: that the Delaware courts will make these decisions under Delaware law, and that backdating, lying to shareholders, is utterly and clearly a breach of the directors' duty," said Clint Krislov of Chicago, who represented the plaintiffs in Ryan.

"The decision leaves no spin room," he added.

In Ryan, the plaintiff sued members of the compensation committee and other directors of Maxim Integrated Products, a California-based electronic engineering company, alleging that they had granted backdated options for the purchase of millions of shares of common stock to the company's CEO and chairman. In Tyson Foods, the plaintiffs alleged that members of the company's compensation committee had conspired to enrich one another to the detriment of shareholders through the approval of consulting contracts and a variety of other related-party transactions, including the granting of spring-loaded options.

The plaintiffs in both cases claimed that the option grants violated the companies' shareholder-approved stock option and stock incentive plans.

Chancellor William Chandler III found that such transactions, if proven, would constitute violations of the directors' duty of loyalty.

"The intentional violation of a shareholder-approved stock option plan, coupled with fraudulent disclosures regarding the directors' purported compliance with that plan, constitute conduct that is disloyal to the corporation and is therefore an act in bad faith," Chandler wrote.

In both cases, the court excused the plaintiffs' failure to make demand on the boards of directors before filing the derivative suits, as required under the chancery court's rules, and denied the defendants' motions to dismiss, allowing the litigation to proceed. The court held that a board's "knowing and intentional decision to exceed the shareholders' grant of express (but limited) authority raises doubt regarding whether such decision is a valid exercise of business judgment and is sufficient to excuse a failure to make demand."

In Tyson Foods, the court noted that the practice of granting spring-loaded options presented a more difficult question than backdating. "At their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made," the court said. "Allegations of spring-loading implicate a much more subtle deception."

The court clearly disapproved of both practices, holding that it is inconsistent with a director's fiduciary duty to deal fairly and honestly with shareholders "for a board of directors to ask for shareholder approval of an incentive stock option plan and then later to distribute shares to managers in such a way as to undermine the very objectives approved by shareholders."

Megan McIntyre of Wilmington, Delaware, one of the attorneys representing the plaintiffs in Tyson Foods, said the court made it very clear that "even though the grant of options may follow the letter of a company's stock option plan," directors may have violated their duty of loyalty "if it violates the spirit" of the plan, an issue not previously addressed by the chancery court. She also noted that the court opened up an additional avenue of recovery for shareholders by determining that the plaintiffs' unjust-enrichment claims could proceed against the recipients of the spring-loaded options, including recipients who were not actually involved in granting the options.

Two other recent rulings have followed the chancery court's decisions. In one--a consolidated shareholder suit against semiconductor manufacturer Broadcom Corp. involving allegations that backdated options were given to the company's executives--a California federal district court refused to dismiss the suit, noting that the plaintiffs had pleaded sufficient facts to show that any presuit demand on the company's directors would have been futile. (In re Broadcom Corp. Derivative Litig., No. 2:06-cv-03252 (C.D. Cal. Mar. 8, 2007).)

Similarly, in a backdating case brought by shareholders against officers and directors of UnitedHealth Group, a Minnesota federal district court denied the defendants' motion to dismiss and stayed the action until a special litigation committee concluded its independent investigation of the allegations. (In re UnitedHealth Group, Inc., Shareholder Derivative Litig., 2007 WL 803048 (D. Minn. Mar. 14, 2007).)