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On February 6, 2007, the Delaware Court of Chancery issued two decisions in derivative securities lawsuits that could significantly impact future options backdating and spring-loading litigation. That includes not just private suits, but SEC and criminal enforcement actions as well.

The first case, Ryan v. Gifford, No. 2213-N, 2007 WL 416162 (Del. Ch. February 6, 2007), involved allegations in a derivative suit that the board of directors of Maxim Integrated Products, Inc., a California computer chip manufacturer, breached, among other things, their fiduciary duty of loyalty by approving backdated option grants to former Chairman and CEO John Gifford. The complaint alleged that the backdated options were approved in contravention to the Maxim shareholder-approved stock option plan, which prohibited the granting of options at exercise prices below the closing price on the date of the grant, and that the directors made false representations regarding the option dates in public filings.

The director defendants moved the court to dismiss the case on its merits. Chancellor William Chandler denied the motion and held “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 and is therefore an act in bad faith.” Id. at 11. The court noted that the directors’ alleged misconduct “certainly cannot be said to amount to faithful and devoted conduct of a loyal fiduciary.” Id. at 12. Moreover, addressing the defendants’ contention that the plaintiffs failed to comply with the Delaware demand requirement before bringing suit, the Chancellor stated:

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. 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.”

Id. at 10 (quoting Aronson v. Lewis, 473 A.2d 805, 815 (Del. 1984)).

The Chancery Court’s assessment of backdating practices in Ryan v. Gifford – a clear pronouncement that backdating practices involve deep-seated deception – is further expressed in a spring-loading case issued on the same day.

In the second case, In re Tyson Foods, Inc., No. 1106-N, 2007 WL 416132 (Del. Ch. February 6, 2007), Chancellor Chandler held that spring-loading – intentionally timing stock option grants so they are awarded just prior to the release of positive news regarding the company – can also give rise to a breach of fiduciary duty claim. As in Ryan v. Gifford, the Tyson shareholders alleged that the directors approved the spring-loaded options in violation of the shareholder-approved stock option plan.

As the Chancellor observed, “[w]hether a board of directors may in good faith grant spring-loaded options is a somewhat more difficult question than that posed by options backdating….” Id. at 18. “At their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made. Allegations of spring-loading implicate a much more subtle deception.” Id. This is so because spring-loaded options are set at the market price on the date of the grant, which, as was the case in Tyson, does not explicitly violate stock option plans.

Nonetheless, although acknowledging that an honest and fully disclosed decision to grant spring-loaded options may be an appropriate form of executive compensation, Chancellor Chandler concluded that “[g]ranting spring-loaded options, without explicit authorization from shareholders, clearly involves an indirect deception.” Id. He further noted, “It is inconsistent with [a director’s duty of loyalty] for a board of directors to ask for shareholder approval of an incentive stock option plan and then later to distribute shares to managers in such a way as to undermine the very objectives approved by shareholders. This remains true even if the board complies with the strict letter of a shareholder-approved plan as it relates to strike prices or issue dates.” Id.

According to the court, the relevant issue in spring-loading cases is whether a director acts in bad faith if he authorizes options with a market-value strike price “when he knows those shares are actually worth more than the exercise price.” Id. at 18. In the court’s opinion, such a situation results in a breach of loyalty. Therefore, the court held that spring-loading will give rise to a breach of fiduciary duty claim if: (1) the options were issued according to a shareholder-approved plan, (2) the directors possess material non-public information soon to be released that would impact the company’s share price, and (3) the options are issued with the intent to circumvent shareholder-approved restrictions on the exercise price of the options.

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These two cases, both denying motions to dismiss, evidence a sharp judicial hostility to options dating practices commonly followed by many public companies. The impact of these twin decisions by such an influential court should embolden plaintiffs’ counsel while at the same time make it difficult for defendants to dismiss such claims at the pleading stage. Corporate defendants will face an uphill battle if cases like Ryan v. Gifford and Tyson are allowed to stand.

The decisions should also make it substantially more difficult for counsel for the 100-plus companies and their employees embroiled in SEC backdating cases to negotiate favorable settlements with the SEC and Department of Justice. While a few enforcement cases have come down in recent weeks, the overwhelming majority of cases are still waiting to be resolved and the language and reasoning of the Delaware Chancery Court bodes poorly for such targets.