By James Hamilton, J.D., LL.M.
In the context of a shareholder derivative action, the Delaware Chancellor has ruled that allegations that stock options were backdated in intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the directors’ purported compliance with that plan, constituted conduct that was disloyal to the company and therefore an act in bad faith. In addition, Chancellor Chandler said that the compensation committee’s alleged knowing and intentional decision to exceed the shareholders’ grant of express limited authority raised doubts regarding whether such decision was a valid exercise of business judgment and was sufficient to excuse a failure to make demand. Ryan v. Gifford, Civ. Action No. 2213-N, Feb. 6, 2007.
It was difficult for the court to conceive of a context in which directors may simultaneously lie to their shareholders regarding their violations of a shareholder-approved plan and yet satisfy their 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. Indeed, the shareholder alleged bad faith and, therefore, a breach of the duty of loyalty sufficient to rebut the business judgment rule and survive a motion to dismiss.
Allegations that the three members of the compensation committee of a six member board approved backdated options, and another board member accepted them, were sufficient to raise a reason to doubt the disinterestedness of the current board and suggest that they are incapable of impartially considering demand.
Later, the shareholder may have to rely on evidence presented at trial to demonstrate by a preponderance of the evidence that the directors in fact backdated options, and thus are not afforded the protections of the business judgment rule. Even at that point, the directors may still prevail by meeting the hefty burden of proving that the challenged transactions were entirely fair to the corporation and its shareholders.