FindLaw | Find a Lawyer. Find Answers.

Delaware Ruling Lights Way for Stock-Option Backdating Suits

A key ruling by an influential Delaware state court judge allows a shareholder plaintiff to proceed with stock-option-backdating charges against officers and directors of chip maker Maxim Integrated Products and it may clear the way for similar suits nationwide.

Chancellor William Chandler, the highly regarded chief judge of the prestigious Delaware Chancery Court, refused to dismiss most of the suit after finding sufficiently specific allegations that a majority of the defendant directors knowingly violated company policy by manipulating stock-option award dates.

The ruling marks the first time the nation's foremost business court has squarely addressed the requirements to pass a key threshold test all for derivative backdating suits.

Those are shareholder suits brought on behalf of the company that allege executives got undeserved windfalls when they cashed in stock options improperly pegged to low points in the company's stock price history.

Since most of the country's Fortune 500 companies are chartered in Delaware or states that model their business law after Delaware's, the decision could provide a roadmap for plaintiffs in more than 150 backdating cases that face the same "pre-suit demand" hurdle.

Under the pre-suit demand provision of Delaware law, a shareholder who sues his officers and directors derivatively must give the board of directors a chance to review the charges and take corrective action.

If the shareholder skips this step and immediately files suit, he must be able to show that the board members lack the objectivity and independence to give the suit a fair hearing.

There are estimated to be more than 150 backdating cases nationwide but there have been mixed results in the few decisions so far on the pre-suit demand test.

However, Chancellor Chandler said that, that, assuming the truth of the allegations in this case, pre-suit demand clearly would have been futile on directors who knowingly violated the company's backdating policy and then issued false disclosures to shareholders and the Securities and Exchange Commission that concealed it.

The suit filed by Maxim shareholder Walter Ryan Jr. is one of many backdating actions that followed the March 2006 publication of a study indicating that hundreds of companies had issued millions of stock options with false award dates, resulting in billions of dollars of undisclosed cost to the companies when the recipients cashed in their overly discounted share options.

Backdating caused Maxim's earnings to be less and its operating costs more than reported, Ryan alleges.

The suit asserts that officers and directors of the Sunnyvale, Calif., integrated circuit maker are guilty of breach of duty, gross mismanagement, constructive fraud and corporate waste because they accepted or approved the options.

The defendants asked the Chancery Court to stay the action in favor of several parallel suits filed earlier in California federal court that allege the same charges plus violations of the federal securities laws.

If the court rejected that option, the defendants said, it should dismiss the Delaware action entirely because it fails the pre-suit demand test and fails to show why the directors' decisions are not protected by the deference given to directors under Delaware's business-judgment rule.

In his decision Chancellor Chandler said that, although the California cases were filed first and include federal charges not in the Chancery Court case, Delaware law directly controls many options backdating cases and this case presents issues that the Delaware court should address.

Next he found that pre-suit demand was excused because a majority of the six-member board had served on the compensation committee that was actively involved in awarding the stock options and setting the dates of the awards.

For the same reasons, the business-judgment rule does not protect the directors' decisions, he said.

"The board had no discretion to contravene the terms of the stock-option plans," the chancellor wrote. "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."

The judge allowed Ryan to go forward with all claims except those involving stock-option grants pre-dating 2001 when Ryan became a Maxim stockholder via its acquisition of another company in which he held stock.

Ryan's attorney, Norman Monhait of Rosenthal Monhait & Goddess in Wilmington, Del., said he had no comment on the decision.

Maxim said in a statement that an internal investigation determined that although some stock options may have been given incorrect dates, no wrongdoing was involved.

The company's CFO, Carl Jasper, resigned shortly after the internal investigation report was released.

CEO John Gifford, who had received the bulk of the stock options in question, resigned Dec. 21, citing health concerns.