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

The decision that has garnered the most notoriety in the legal and financial media is one by the well-respected and influential Chancellor William B. Chandler III of the Delaware Chancery Court in the Maxim case related to options issued to Maxim Chairman John F. Gifford. On Feb. 6, the chancellor issued an opinion deciding a motion 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 key legal issues that have arisen in the context of the stock options backdating scandal and ensuing litigation.

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

For example, strong language from the chancellor, who concluded that board members acted in bad faith–deliberately violating shareholder-approved stock options plans–may well support insurers' applications of intentional misconduct exclusion in their policies.

From 1998 through mid-2002, pursuant to shareholder-approved stock options plans filed with the Securities and Exchange Commission, the board of directors of Maxim–a technology company headquartered in Silicon Valley–granted millions of shares of common stock to Mr. Gifford, who was Maxim's founder, chairman and chief executive officer, and to other officers of the company, as well.

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

As practices surrounding the timing of options grants for public companies began facing increased scrutiny in early 2006, Merrill Lynch conducted an analysis of the timing of stock options grants from 1997 to 2002 for Maxim's technology sector.

Merrill Lynch measured the timing of options grants by examining the extent to which stock price performance subsequent to options pricing events diverged from stock price performance over a longer period of time. Theoretically, companies should not generate systematic excess return in comparison with other investors as a result of the timing of options pricing events.

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

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

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

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

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

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

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

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

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

The business judgment rule is a rule of evidence that presumes that management has exercised its duty of care, unless gross negligence or intentional wrongdoing can be shown to overcome the presumption.

o The defendants also maintained that an unjust enrichment claim was inadequate because the plaintiff did not allege the manner in which Mr. Gifford was unjustly enriched. The basis of this contention is the plaintiff never suggested that Mr. Gifford exercised any of his options or sold his stock.

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

But whether they fuel protracted and expensive coverage litigation or they stimulate a quicker pace of settlement activity remains to be seen.

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

The chancellor stated that the timing of the grants, in his judgment and by the support of empirical data, seems too fortuitous to be mere coincidence. He also seized on the fact that the board did not grant options at set or designated times, but rather sporadically.

Further, the chancellor ruled that the alleged facts suggest the director defendants violated an express provision of the options plans and exceeded the grant of authority given to them by Maxim's shareholders.

The chancellor concluded his analysis of this issue by reiterating that since the plaintiff pointed to specific grants, specific language in option plans, specific public disclosures and supporting empirical analysis to allege knowing and purposeful violations of shareholder plans and intentionally fraudulent public disclosures, the plaintiff had pleaded with particularity sufficient to survive a motion to dismiss.

The chancellor also briefly addressed the issue of whether or not the board was disinterested, noting that since three of six board members approved the backdated options and another board member received them, doubt existed as to the disinterestedness of the board and a pre-suit demand was therefore excused for that reason, as well.

The chancellor held that to survive a motion to dismiss on a breach of fiduciary duty claim, the complaint must rebut the business judgment rule. To rebut the business judgment rule, the plaintiff must show that the directors breached either their fiduciary duty of due care or duty of loyalty in connection with a challenged transaction. Such a breach may be shown where the directors act intentionally, in bad faith, or for personal gain.

Regarding whether the plaintiff's allegations constituted bad faith, the chancellor stated in what is likely to be an oft-quoted section of the opinion:

“I am unable to fathom a situation where the deliberate violation of a shareholder-approved stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith. It certainly cannot be said to amount to faithful and devoted conduct of a loyal fiduciary. Well-pleaded allegations of such conduct are sufficient, in my opinion, to rebut the business judgment rule and to survive a motion to dismiss.”

Defendants contended that the plaintiff's claim for unjust enrichment failed because there was no allegation that Mr. Gifford exercised any of the alleged backdated options and, therefore, did not obtain any benefit to which he was not entitled to the detriment of another.

The chancellor tersely held that “this defense is contrary both to the normal concept of remuneration and to common sense.” He further stated that he could not conclude that there is no reasonably conceivable set of circumstances under which Mr. Gifford might be unjustly enriched, particularly since Mr. Gifford does retain something of value at the expense of the corporation and its shareholders–the allegedly backdated options.

The Maxim decision is likely to be extremely influential–and not a harbinger of good news for backdating defendants down the road. The facts in Maxim are quite similar to those in many of the other backdating litigations now pending across the country. Given the factual similarities and the influence and respect of the Delaware Chancery Court, we are likely to see the Maxim reasoning applied in future cases, defeating defense motions to dismiss.

Without addressing any insurance coverage disputes directly, the decision highlights sources of contention between insurers and policyholders that are already being raised, including the potential applicability of conduct exclusions and the question as to whether any monetary settlements or judgments in these cases may be 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 are clearly implicated.

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

Not only would the establishment of such conduct preclude a successful business judgment rule defense in the underlying litigation, it could also support the application of the intentional misconduct exclusion. Key, of course, would be whether the exclusionary language requires a final adjudication or some lesser standard.

In sustaining the plaintiff's claim of unjust enrichment despite the fact that none of the options at issue were exercised, the decision also highlights the potential applicability of the personal profit exclusion. Similar issues as would arise with the intentional misconduct exclusion would also determine its ultimate applicability.

At least with respect to any executive who is the recipient of a backdated option, there is an issue of insurability of any settlement or judgment amount, apart from the applicability of the conduct exclusions, based upon a long line of case law and well-developed public policy that ill-gotten gain should not be insurable under any liability insurance policy.

Thus, although Maxim does not suggest that the derivative litigation involving backdating necessarily poses any more severity in terms of D&O insurer exposure than most observers originally concluded, it does suggest these cases may not easily be disposed upon motion practice. It will be interesting to see whether the decision engenders any significant wave of settlement activity.

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