Backdating: Not a ”Judgment Call”

The stock-option practice qualifies as one of those "rare cases," according to the Delaware Court of Chancery, in which "a transaction may be so egregious on its face that board approval cannot meet the test of business judgment."

The stock-options scandal has snarled CEOs, CFOs, and other corporate executives in internal and government investigations, not to mention bad press. For the most part, independent directors have managed to keep clear.

Now the net seems to be widening, thanks to a pair of rulings by the influential Delaware Court of Chancery earlier this month. The decisions by Chancellor William Chandler III to allow shareholder derivative lawsuits to proceed — against directors of Tyson Foods and Maxim Integrated Products — is “extraordinary” for the traditionally business-friendly court, says law professor Charles Elson.

The allegations that directors breached their fiduciary duty “are pretty serious,” adds Elson, also the chairman of the Center for Corporate Governance at the University of Delaware’s school of business. “And the court’s patience with management is beginning to wear thin.”

Just how thin might be measured against Chandler’s criticism in 2005 of the Walt Disney board and former CEO Michael Eisner, who together granted a $130 million severance package to ousted president Michael Ovitz. Chandler ruled that even though that decision fell “significantly short of the best practices of ideal corporate governance,” it was made in good faith, and the board members were exonerated.

Directors at Maxim and Tyson might be less fortunate if shareholders can prove they backdated option grants to take advantage of historically favorable share prices or “spring-loaded” the grants by awarding them just before announcing favorable news. “A director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders…and yet satisfy his duty of loyalty,” Chandler wrote in his opinion on the Maxim case, Ryan v. Gifford.

Citing a 1980s Delaware decision, Chandler also wrote that “backdating options qualifies as one of those ‘rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.’ ”

Maxim’s stock-option plan allows only at-the-money options; that is, the exercise price must be no lower than the closing price on the grant date. That’s true for most companies caught up in the current scandal, according to Paul Hodgson, a senior research associate at The Corporate Library. The Maxim lawsuit alleges that six directors who served various terms between 1998 and 2002 backdated nine stock option grants awarded to former chief executive officer John Gifford, to take advantage of an earlier (and lower) exercise price.

Attorneys for Gifford did not immediately respond to a request for comment.

Earlier this year, Maxim announced that according to a special committee, all option grants to officers of the company had been properly awarded, and no evidence had been found that outside directors engaged in wrongdoing or malfeasance regarding any stock-option awards. Nonetheless, the company restated financial results for nearly seven years, acknowledged deficiencies in its process of granting stock options, and severed ties with Gifford and chief financial officer Carl Jasper. Maxim also faces inquiries by the Securities and Exchange Commission and the U.S. Attorney for the Northern District of California.

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