Delaware Chancery Court Dismisses Options Backdating Derivative Case

In the options backdating related derivative case pending in Delaware Chancery Court involving Sycamore Networks as nominal defendant, Vice Chancellor Leo E. Strine, Jr. granted the defendants’ motion to dismiss, in an opinion (here) that carefully distinguished the earlier Delaware Chancery Court dismissal denials in the Ryan v Gifford (Maxim Integrated Products) case and the Tyson Foods case. (Refer here for my post regarding the prior cases.) In addition to holding that the Sycamore Networks plaintiff lacked standing to challenge option grants that occurred before the plaintiff acquired his shares, Vice Chancellor Strine also held that the plaintiff had not established demand futility.

The Sycamore Networks plaintiff’s allegations involved three categories of grants, Employee Grants, Officer Grants and Outside Director Grants. With respect to the Employee Grants, the Vice Chancellor held that "because the complaint is devoid of any facts suggesting a rational inference that any members of Sycamore’s board, much less a majority, knew about the backdated Employee Grants, [the plaintiff] has failed to create a reasonable doubt about the Sycamore board’s ability to impartially consider a demand as to this category of claim."

The Officer Grant allegation involved not only options backdating allegations but "the more subtle issues raised by "springloading and bullet-dodging as well. The Court held with respect to these allegations that the plaintiff had failed to show that there was not a disinterested majority of the board available to consider the allegations. In making this finding, Vice Chancellor Strine specifically distinguished the earlier decision in the Tyson case, which contained detailed allegations of multi-year concealments, by contrast to the Sycamore Networks complaint, which alleged only "weak allegations about a single alleged instance of spring loading involving information that did not even clearly affect the company’s stock trading price."

Vice Chancellor Strine found in connection with the third category of backdated grants, the Outside Director Grants, that because the directors in fact received the disputed grants, it would be "difficult to find them independent." However, the Vice Chancellor found that the disputed options were made pursuant to a shareholder approved plan that expressly permitted below-market grants, and no adverse inferences could be drawn from the fact that the awards followed adverse news disclosures. Chancellor Strine specifically noted that by contrast to the plaintiff in the Ryan v. Gifford (Maxim Integrated Products) case, the Sycamore Network plaintiff "has pled no facts to suggest even the hint of a culpable state of mind of any director."

The Vice Chancellor also drew a contrast between the detailed allegations in the Tyson case, which built upon the fruits of a prior books and records request, and the Sycamore Networks plaintiff, who "rushed in to court, making generalized charges unaccompanied by fact pleading about the involvement of the directors in the improprieties he contends occurred."

The 77-page Sycamore Networks opinion not only reflects a detailed analysis of the case before the Court, but also contains a painstaking comparison between the Sycamore Networks allegations and the allegations in the Maxim Integrated Products case and the Tyson Foods case. The Sycamore Networks case on the one hand and the two prior cases on the other hand now present opposite outcomes under Delaware law on options backdating derivative case dismissal motions, and represent contrasting precedents from which parties in future cases will attempt to argue. Certainly, Vice Chancellor Strine’s distinction between the Sycamore Networks complaint and the allegations in the prior two cases will present a road map from which defendants can attempt to argue their dismissal motions.

The Sycamore Networks opinion also contains a lengthy discussion of the important differences between backdating, on the one hand, and sprinloading and bullet dodging on the other hand, as well as a broad discussion of boards’ duties and potential liabilities generally.

The Sycamore Networks plaintiff relied heavily on the allegations contained in the separate complaint of a former Sycamore Networks employee who claimed that his employment contract was terminated because he complained about the company's stock option practices. A July 12, 2006 Wall Street Journal article describing the complaint and the backdating allegations can be found here, subscription required.

Professor Larry Ribstein has an interesting discussion of the Sycamore Networks case on his Ideoblog (here). Hat tip to the Delaware Corporate and Commercial Litigation Blog (here) for the link to the opinion.

Zoran Backdating Case Survives Motion to Dismiss: The Sycamore Networks case and several other options backdating related derivative cases (refer here) have been dismissed due to the plaintiffs’ failure to establish that a demand on the board to address the alleged misconduct would be futile. However, on June 5, 2007, Judge William Alsup denied the defendants’ motion to dismiss in the Zoran backdating derivative litigation, specifically holding that the plaintiffs had established demand futility. A copy of the Zoran opinion can be found here.

The basis of the Court’s finding of demand futility is the plaintiffs’ allegation that each board member (including even two who were not named as defendants) had received backdated stock options. Based on this allegation, Judge Alsup concluded that that the directors are "interested" in the dispute, stating:

a decision now to correct the grant dates would have a detrimental impact on the directors by removing the financial benefit of the backdating. The director may be required to pay back the difference in price between the true grant date and the purported grant date. The directors may even face legal exposure. Accordingly, if plaintiffs can plead with particularity that the directors received backdated grants, those directors will be considered interested.

Judge Alsup specifically cited the Ryan v Gifford (Maxim Integrated Products) case. The Zoran opinion preceded the Sycamore Networks case, and so Judge Alsop’s analysis does not consider the distinguishing factors to which Vice Chancellor Strine referred in concluding that the Sycamore Network directors were not "interested" despite having received challenged options.

A press release discussing the Zoran decision can be found here. My prior post discussing the Zoran lawsuit can be found here.

Alleged Sharp Practices: If you have not read Judge James M. Rosenbaum’s denial of the defendants’ motion to dismiss in the United Health Group options backdating related securities class action lawsuit, you will definitely want to take a moment and read the brief opinion here.

The fate of the dismissal motions was definitely tipped when the court characterized the defendants’ motions as "expending forests of trees and millions of electrons." Of the plaintiffs’ allegations, the court said, "if plaintiffs are correct, this case is incredibly simple. Plaintiffs claim defendants were playing with a stacked deck. When awarded options, with deliberately selected grant dates which were already in the money, defendants were playing a game they knew they could not lose; and unsurprisingly, defendants won."

Having started with the "stacked deck" card playing analogy, Judge Rosenbaum switches his comparison to horse racing, and compares the defendants’ alleged scheme to the plot of the 1973 Academy Award-winning movie The Sting, in which the lead characters revenge themselves by a "scheme involving ‘past-posting,’ or betting on horse races after the results are known." The Court’s conclusion? Motion denied, with a note that "the Court commends The Sting to all parties."

While the Court settled on the horse racing analogy, I have myself preferred the card-playing comparison, as I noted in my comment (here) early in the unfolding of the backdating scandal, where I quoted Talleyrand’s remarks about the baleful effects of cheating at cards.

Hat tip to Adam Savett of the Securities Litigation Watch (here) for the link to the United Health Group opinion.

Anyone who was around when The Sting first came out will undoubtedly recall the film's score, inspired by the music of Scott Joplin, including the movie theme based on Joplin's song , The Entertainer, a sound file for which can be found here.

An inspired updated video mash up based on The Sting can be found here: