Options Backdating Lawsuit Dismissed for Insufficient Demand Futility Allegations

On April 11, 2007, Judge William Alsup of the San Francisco federal court granted the defendants’ motion to dismiss the consolidated shareholders’ derivative complaint filed in the connection with alleged options backdating at CNET Networks, based on plaintiffs’ failure “to plead with particularity that demand on the board was excused as futile.”

The plaintiffs’ complaint, as amended, asserted four derivative claims based on federal securities laws, against thirteen individuals and against CNET itself as nominal defendants. Six of the thirteen individuals were board members at the time that the plaintiffs’ filed the initial complaint. In order for plaintiffs to pursue their claim, the plaintiffs are required under Rule 23.1 of the Federal Rules of Civil Procedure to plead the steps they have taken to “obtain the action the plaintiff desires from the directors or comparable authority” or alternatively to show the reasons for not making this effort. The CNET plaintiffs alleged they did not make any demand on CNET’s board because they contend demand would have been futile. In assessing the plaintiffs’ demand futility allegations, Judge Alsop relied on Delaware law because CNET is a Delaware corporation.

In order to support their allegation that demand was futile, the plaintiffs allege that the six individual defendants who were directors when the complaint was filed received backdated options and that they had “ratified” the backdated options grants.

Judge Alsup had “failed to plead with particularity that a majority of the board was not disinterested or independent or did not exercise business judgment in making decisions.” Judge Alsup examined the plaintiffs' options grant allegations, and found with respect to board recipients of the few options grants the plaintiffs successfully allged to have been backdated, only one board member recipient was still on the board when the complaint was initially filed. So the plaintiffs' allegtions that the board members had received the backdated options failed to establish demand futility. Judge Alsup also found that the plaintiffs' allegations that the board members "ratified" the allegedly backdated options grants was conclusory and insufficiently particularized to support demand futility allegations.

In reaching the conclusion that the plaintiffs had not adequately plead demand futility, Judge Alsup expressly distinguished Chancellor Chandler’s recent finding of demand futility in the Maxim Integrated Products case (here), where, Judge Alsop noted, the plaintiffs “had pleaded particularized facts” supporting demand futility, including allegations of knowing approval of backdated option grants, along with alleged intentional failure to disclose the backdated options. (My prior post regarding the Maxim Integrated Products case can be found here.)

The amended complaint on which Judge Alsup granted the dismissal motion was the CNET plaintiffs' fourth iteration, due to which Judge Alsup said that he was “inclined to deny further leave to amend.” However, he withheld his final determination on whether or not to grant leave to amend. He asked the parties to provide additional submissions on the question whether he had authority to allow the plaintiffs limited discovery about the possible “taint” to two of the directors defendants’ service on the CNET board’s compensation committee.

As noted in the April 16, 2007 Law.com article entitled “Federal Judge Axes CNET Stock Option Claims” (here), the CNET decision shows “how difficult it may be for plaintiffs to succeed in numerous similar claims related to stock-options backdating.” It does show that plaintiffs will have to allege more than merely that options grant dates differed from the measurement date, or even that the members of the board received allegedly backdated options.

Judge Alsup’s opinion also show that the Delaware Chancery Court decision in the Maxim Integrated Products case is not necessarily determinative of the demand futility question in other backdating cases, even other cases to which Delaware law applies. Judge Alsup’s particularized inquiry based on the plaintiffs’ specific allegations suggests that these issues will be determined on a case by case basis. Judge Alsup’s insistence on particularized allegations and his unwillingness to accept unsupported inferences as a basis for demand futility suggests that it could prove challenging for demand futility allegations in other options backdating lawsuits to survive dismissal motions.

UPDATE: According to the CorporateCounselNet.com blog (here), Judge Alsup has ruled to allow the plaintiffs to amend, and is considering whether to stay the case while permitting limited discovery.

An interesting and helpful memo on the CNET case by the Fenwick & West law firm can be found here.
Options Backdating Litigation Update: With the addition of the new derivative complaint filed against Lehman Brothers Holdings (here), The D & O Diary’s current tally (here) of the number of companies sued as nominal defendants in shareholders’ derivative complaints based on options backdating allegations stands at 157. The number of securities class action lawsuits stands at 29. In addition, as a result of the ERISA suit filed against KB Homes (here), the number of ERISA or 401(k) options backdating lawsuits now totals 5.