Spring-Loading and Bullet-Dodging of Stock Options Should Have Been Disclosed

Company directors who approved spring loaded and bullet dodged stock option grants may have breached their fiduciary duty and forfeited the protection of the business judgment rule, held the Delaware Chancery Court, since the spring-loading and bullet-dodging practices constituted material information that should have been disclosed. Vice Chancellor Lamb also ruled that the alleged stock manipulation supported a claim of corporate waste. While recognizing that a claim of waste must satisfy a difficult test, the court noted that the allegations were not so much that the grants were excessive, but that the directors and officers should not have received any of the timed options at all, and that the grants were approved without any valid corporate purpose. (Weiss v. Swanson, Del Chan Ct, Mar 7, 2008, No. 2828-VCL).

In its earlier Tyson ruling, the Chancery Court ruled only that the practice of spring-loading options was material. This appears to be the first ruling that bullet dodging is also material information that should have been disclosed.

The challenged options were granted pursuant to stockholder-approved option plans. But the shareholder alleged that the directors bullet-dodged the options by delaying their grant until after the release of adverse information and, conversely, when the quarterly earnings release contained positive information expected to drive up the market price of shares, they spring-loaded the options by granting them just prior to the earnings release, without ever disclosing to stockholders that they timed option grants in this manner.

It was reasonable to infer that stockholders would consider the practice of timing options to be important in deciding whether to approve the option plans or to reelect board members. Under Tyson, because the allegations support an inference that the directors never disclosed this practice in the plans themselves, subsequent proxy statements, or SEC filings describing the option grants, the allegations also give rise to an inference that the directors violated their fiduciary duties. Echoing Tyson, the Vice Chancellor said that shareholders have a right to the full, unvarnished truth in the area of executive compensation, and therefore directors, as fiduciaries, have a duty to disclose all material information when seeking stockholder approval of an option plan, or when disclosing an option grant.

The court noted that, unlike the disclosures in Tyson, the company’s disclosures did not
affirmatively state that all options were granted with a fair market value strike price. Rather, the disclosures appear to be much more ambiguous about the options’ strike prices. For example, the compensation committee reports accompanying annual proxy statements stated that the corporation retained the right to grant options that did not qualify for treatment under IRC section 162(m), indicating grants may have been issued in the money, i.e., with a below fair market value strike price. These grants would not be considered performance based under 162(m) and thus not outside the $1 million cap on executive pay.

Therefore, the inference of impropriety is somewhat weaker in this case than it was in Tyson. Nonetheless, the shareholder alleged facts creating a reasonable doubt that the option grants resulted from a valid exercise of business judgment.

The court rejected the directors’ argument that this case is distinguishable from Tyson because the SEC had ceased its investigation of the company. The allegations in this case involve whether the directors violated their fiduciary duties, not federal securities law, noted the court. Therefore, it is immaterial to this case that the SEC ceased its investigation.