Defendants in options backdating litigation involving MaximIntegrated Products and Brocade Communications, as well as options“spring loading” in Tyson Foods, had some rather rough sleddingduring the week of Feb. 5, 2007.

The decision that has garnered the most notoriety in the legaland financial media is one by the well-respected and influentialChancellor William B. Chandler III of the Delaware Chancery Courtin the Maxim case related to options issued to Maxim Chairman JohnF. Gifford. On Feb. 6, the chancellor issued an opinion deciding amotion to dismiss in Ryan v. Gifford, et al. (Case No. 2213-N,Court of Chancery, New Castle County, Del.).

This decision is the first major opinion to address several keylegal issues that have arisen in the context of the stock optionsbackdating scandal and ensuing litigation.

Although Maxim did not address any insurance coverage disputes,the decision–which dealt with the pleading stage of the underlyinglitigation–suggests coverage issues already raised by D&Oinsurers in these claims are likely to be continuing sources ofcontention.

For example, strong language from the chancellor, who concludedthat board members acted in bad faith–deliberately violatingshareholder-approved stock options plans–may well support insurers'applications of intentional misconduct exclusion in theirpolicies.

From 1998 through mid-2002, pursuant to shareholder-approvedstock options plans filed with the Securities and ExchangeCommission, the board of directors of Maxim–a technology companyheadquartered in Silicon Valley–granted millions of shares ofcommon stock to Mr. Gifford, who was Maxim's founder, chairman andchief executive officer, and to other officers of the company, aswell.

Under the terms of the plans, Maxim contracted and representedthat the exercise price of the grants would be no less than thefair market value of its common stock on the date of the grant.

As practices surrounding the timing of options grants for publiccompanies began facing increased scrutiny in early 2006, MerrillLynch conducted an analysis of the timing of stock options grantsfrom 1997 to 2002 for Maxim's technology sector.

Merrill Lynch measured the timing of options grants by examiningthe extent to which stock price performance subsequent to optionspricing events diverged from stock price performance over a longerperiod of time. Theoretically, companies should not generatesystematic excess return in comparison with other investors as aresult of the timing of options pricing events.

The investigation revealed that over a five-year period, theannualized return of Maxim's grants was 243 percent–almost 10-timeshigher than the 29 percent annualized market returns for the sameperiod. (Shareholder activists and other critics of executive greedin terms of their compensation might note that 29 percent would bea fairly decent return by any standard without having to go throughthe backdating manipulations!)

Although Merrill Lynch did not render an opinion as to whetherMaxim backdated, it noted that if backdating did not occur, Maxim'smanagement was remarkably effective at timing options.

A flurry of litigation aimed at Maxim's directors and officersfollowed the Merrill Lynch investigation.

Beginning on May 22, 2006, several derivative lawsuits werefiled in the Northern District of California. Three weeks later, onJune 2, 2006, the Maxim litigation was commenced in the DelawareCourt of Chancery. Another derivative complaint was filed inCalifornia state court on June 16, 2006.

The defendants responded with an alternative motion to eitherstay the Delaware litigation in favor of the California federalcase, or to dismiss the Delaware case. (For information on themotion to stay, see related article, page 18.) Dismissal was soughton numerous theories:

o First, defendants contended that the plaintiff failed toadequately plead “demand futility” with particularity because theplaintiff did not show that Maxim's directors were incapable ofmaking an impartial decision regarding litigation.

Before Delaware plaintiffs can file derivatives lawsuits–suitsbrought by shareholders against directors and officers on behalf ofthe company–they are required to make a demand to the board toremedy the situation that gives rise to the suit.

Under Delaware law, however, the failure to make a demand may beexcused under a “demand futility” theory–in other words, if aplaintiff can raise a reason to doubt that a majority of the boardis disinterested or independent, or if it is doubtful that thechallenged acts were the product of the board's valid exercise ofbusiness judgment.

o Second, defendants argued that the plaintiff failed to state aclaim for breach of fiduciary duty because he failed to rebut thebusiness judgment rule.

The business judgment rule is a rule of evidence that presumesthat management has exercised its duty of care, unless grossnegligence or intentional wrongdoing can be shown to overcome thepresumption.

o The defendants also maintained that an unjust enrichment claimwas inadequate because the plaintiff did not allege the manner inwhich Mr. Gifford was unjustly enriched. The basis of thiscontention is the plaintiff never suggested that Mr. Giffordexercised any of his options or sold his stock.

While these were not the only arguments for dismissal, thechancellor's rulings in favor of the plaintiffs regarding breach offiduciary duty and unjust enrichment claims may have importantimplications for insurance coverage litigation going forward.

But whether they fuel protracted and expensive coveragelitigation or they stimulate a quicker pace of settlement activityremains to be seen.

The plaintiff argued that knowing and intentional violations ofthe stock option plans cannot be an exercise of valid businessjudgment, and based on what he characterized as the “unusual factsalleged,” the chancellor agreed.

The chancellor stated that the timing of the grants, in hisjudgment and by the support of empirical data, seems too fortuitousto be mere coincidence. He also seized on the fact that the boarddid not grant options at set or designated times, but rathersporadically.

Further, the chancellor ruled that the alleged facts suggest thedirector defendants violated an express provision of the optionsplans and exceeded the grant of authority given to them by Maxim'sshareholders.

The chancellor concluded his analysis of this issue byreiterating that since the plaintiff pointed to specific grants,specific language in option plans, specific public disclosures andsupporting empirical analysis to allege knowing and purposefulviolations of shareholder plans and intentionally fraudulent publicdisclosures, the plaintiff had pleaded with particularitysufficient to survive a motion to dismiss.

The chancellor also briefly addressed the issue of whether ornot the board was disinterested, noting that since three of sixboard members approved the backdated options and another boardmember received them, doubt existed as to the disinterestedness ofthe board and a pre-suit demand was therefore excused for thatreason, as well.

The chancellor held that to survive a motion to dismiss on abreach of fiduciary duty claim, the complaint must rebut thebusiness judgment rule. To rebut the business judgment rule, theplaintiff must show that the directors breached either theirfiduciary duty of due care or duty of loyalty in connection with achallenged transaction. Such a breach may be shown where thedirectors act intentionally, in bad faith, or for personalgain.

Regarding whether the plaintiff's allegations constituted badfaith, the chancellor stated in what is likely to be an oft-quotedsection of the opinion:

“I am unable to fathom a situation where the deliberateviolation of a shareholder-approved stock option plan and falsedisclosures, obviously intended to mislead shareholders intothinking that the directors complied honestly with theshareholder-approved option plan, is anything but an act of badfaith. It certainly cannot be said to amount to faithful anddevoted conduct of a loyal fiduciary. Well-pleaded allegations ofsuch conduct are sufficient, in my opinion, to rebut the businessjudgment rule and to survive a motion to dismiss.”

Defendants contended that the plaintiff's claim for unjustenrichment failed because there was no allegation that Mr. Giffordexercised any of the alleged backdated options and, therefore, didnot obtain any benefit to which he was not entitled to thedetriment of another.

The chancellor tersely held that “this defense is contrary bothto the normal concept of remuneration and to common sense.” Hefurther stated that he could not conclude that there is noreasonably conceivable set of circumstances under which Mr. Giffordmight be unjustly enriched, particularly since Mr. Gifford doesretain something of value at the expense of the corporation and itsshareholders–the allegedly backdated options.

The Maxim decision is likely to be extremely influential–and nota harbinger of good news for backdating defendants down the road.The facts in Maxim are quite similar to those in many of the otherbackdating litigations now pending across the country. Given thefactual similarities and the influence and respect of the DelawareChancery Court, we are likely to see the Maxim reasoning applied infuture cases, defeating defense motions to dismiss.

Without addressing any insurance coverage disputes directly, thedecision highlights sources of contention between insurers andpolicyholders that are already being raised, including thepotential applicability of conduct exclusions and the question asto whether any monetary settlements or judgments in these cases maybe uninsurable as a matter of law.

With respect to the conduct exclusions in the D&O policy,both the intentional misconduct and personal profit exclusions areclearly implicated.

Although almost all policies employ language that will precludethe insurer from denying coverage based upon the bare allegationsin the pleadings, the chancellor's ruling with respect to breach offiduciary duty sets forth at least his view in these cases thatthere is likely a “deliberate violation” of an approved stock planand conduct that “is anything but an act of bad faith.”

Not only would the establishment of such conduct preclude asuccessful business judgment rule defense in the underlyinglitigation, it could also support the application of theintentional misconduct exclusion. Key, of course, would be whetherthe exclusionary language requires a final adjudication or somelesser standard.

In sustaining the plaintiff's claim of unjust enrichment despitethe fact that none of the options at issue were exercised, thedecision also highlights the potential applicability of thepersonal profit exclusion. Similar issues as would arise with theintentional misconduct exclusion would also determine its ultimateapplicability.

At least with respect to any executive who is the recipient of abackdated option, there is an issue of insurability of anysettlement or judgment amount, apart from the applicability of theconduct exclusions, based upon a long line of case law andwell-developed public policy that ill-gotten gain should not beinsurable under any liability insurance policy.

Thus, although Maxim does not suggest that the derivativelitigation involving backdating necessarily poses any more severityin terms of D&O insurer exposure than most observers originallyconcluded, it does suggest these cases may not easily be disposedupon motion practice. It will be interesting to see whether thedecision engenders any significant wave of settlement activity.