Delaware Court Slaps Staples on Backdating

In another ruling tough on management for disclosing too little on probe findings, Chancery sets scene for stock-option abuse trial.

A judge in Delaware’s Court of Chancery, extending a string of rulings that have been tough on managements and corporate boards,
said that Staples Inc. must stand trial in a shareholder lawsuit targeting past stock-option-granting practices.

The office-supply retailer had asked Vice Chancellor Stephen P. Lamb to dismiss a derivative suit accusing company officials of wrongly backdating more than 7.5 million stock-option grants from 1993 to 2003. The company argued that there was insufficient evidence of officials intentionally doing anything wrong, and that the plaintiffs failed to use the normal process of “demanding” board action before filing suit.

Lamb, though, became the latest Chancery judge to criticize a poor level of communication between the company and its shareholders in letting a case proceed. He noted that Staples and its audit committee “ended their ‘review’ without explanation and apparently without seeking redress of any kind.” That put the plaintiffs in an “odd” position of not being able to count on the board to rule on shareholder objections before filing suit.

“In fact, the ‘findings’ of the review conducted by the company and the audit committee, other than the grossest generalities, have been carefully hidden from both the stockholders and the court,” the judge wrote in refusing to dismiss the case. “There also can be no suggestion that either the company or the members of the audit committee were unaware that the company had potential claims for relief, such as those asserted in this complaint,” he wrote. After all, Lamb continued, the complaint came “in the middle of a naitonal scandal involving backdated options….”

In November 2006 Staples disclosed in a 10Q filing that an internal review conducted by the company and its audit committee had uncovered “accounting errors due to the use of incorrect measurement dates,” causing the company to record a $10.8 million expense in that period. The internal review found that the use of incorrect dates did not result from intentional wrongdoing.

In addition to questioning the level of explanation to investors about that finding, the judge raised questions about the company being “represented by the same lawyers who represent the officers and directors who received those backdated options and the three directors who approved them.” Wrote Lamb: “Given the finding of erroneous dating practices (by inference, backdating), the court questions how it is that the interests of the corporation are not, or at least do not appear to be, adverse to the interests of the individual defendants.” Listed as defendants are 21 directors or executives, including Staples CFO John J. Mahoney.

At the company’s headquarters in Framingham, Mass., spokesman Paul Capelli told CFO.com: “We were disappointed the motion to dismiss was denied. We’re confident that when the facts of the case are presented the conclusion will be that there was no wrongdoing.”

The complaint, Donna Conrad v. Arthur M. Blank, et al., and Staples Inc., was filed on behalf of a Massachusetts woman who has owned Staples shares since 1998. It alleges breaches of fiduciary duty on the part of the defendants for having expressly authorized the practice of backdating options, or for having permitted the practice over the years. The suit seeks compensatory damages. It also seeks to recover from the management defendants on grounds that “they were unjustly enriched by millions of dollars as a result of the decade-long scheme.”

In one case early this year, involving Maxim Integrated Products, Delaware Chancellor William B. Chandler III wrote harshly of the illegality of backdating, and suggested penalties for those who allow it. “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 an earlier case of abuse in another legal area, Chandler 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.’” Delaware’s business judgment rule grants wide latitude to executives and directors in making decisions, as long as they act with loyalty to the shareholders, and not in their own self-interest.

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