March 12, 2008
Assessing Risk From Options Grants Under Delaware Law
Coauthored by Stephen B. Brauerman
In 2007 the Delaware Court of Chancery issued a series of decisions addressing the practice of options granting, specifically backdating and “spring loading” options. These decisions have begun to shape the battlefield on which these claims will be decided, not only in Delaware, but throughout the nation, for years to come.
By linking executive compensation with company performance, properly issued options grants can help maximize corporate efficiencies by incentivizing management to increase profitability and the corresponding shareholder return. Recently, however, an alarming number of companies have faced public scrutiny from equity holders, the press, and the investment community for allegedly backdating and spring-loading options awarded to directors. Companies caught in the crossfire, and those wishing to avoid it, must understand the problems options manipulation presents and the mechanics by which such actions are challenged.
The case law has identified two primary methods of manipulating stock options: backdating and spring loading.1 Backdating occurs when a company issues stock options along with falsified documentation that reflects an earlier issuance date. The falsified date often corresponds with an unusually low stock price, which provides corporate executives - often the same executives who approve the stock grants - a windfall because the timing of the issuance inflates the value of the stock options. Not surprisingly, Delaware courts have expressed a strong interest in resolving “all of the intricacies potentially associated with stock options backdating claims” and emphasized Delaware’s “sizable interest in resolving such novel issues to promote uniformity and clarity in the law.”2
Although the deception associated with spring loading is more subtle than with backdating, the practice has nonetheless drawn the watchful eye of the court. With spring loading, a company issues options grants in accordance with a shareholder-approved compensation plan at then-current market values while possessing “favorable, material non-public information that will likely increase the stock price when disclosed.”3 Spring-loading options violates a director’s duty to deal fairly and honestly with shareholders because the options are issued at a time when management “knows those shares are actually worth more than the exercise price.”4 As the Court of Chancery explained, “[a] director who intentionally uses inside knowledge not available to shareholders in order to enrich [insiders] while avoiding shareholder-imposed requirements cannot, in my opinion, be said to be acting loyally and in good faith as a fiduciary.”5
Companies with spring-loading concerns should take care to investigate the potential for backdating as well, which could adversely color the lens through which the Court reviews the challenged action. Consistent with Delaware’s oft-stated deference to the independence of corporate executives to manage their companies free from Court interference, those companies that undertake active investigations and take steps to remedy any wrongdoing discovered will inevitably fare better in the eyes of the Court, even if the remedy falls short of what the Court itself might have awarded.
When assessing potential liability from manipulated options grants, companies should consider several important procedural requirements that may bar shareholder challenges. Companies should consider whether the shareholder bringing the action has standing to do so, whether the jurisdiction in which he brought the action is appropriate, and whether the action can proceed in
In 2007 the Delaware Court of Chancery issued a series of decisions addressing the practice of options granting, specifically backdating and “spring loading” options. These decisions have begun to shape the battlefield on which these claims will be decided, not only in Delaware, but throughout the nation, for years to come.
THE PROBLEM WITH MANIPULATING STOCK OPTIONS
By linking executive compensation with company performance, properly issued options grants can help maximize corporate efficiencies by incentivizing management to increase profitability and the corresponding shareholder return. Recently, however, an alarming number of companies have faced public scrutiny from equity holders, the press, and the investment community for allegedly backdating and spring-loading options awarded to directors. Companies caught in the crossfire, and those wishing to avoid it, must understand the problems options manipulation presents and the mechanics by which such actions are challenged.
The case law has identified two primary methods of manipulating stock options: backdating and spring loading.1 Backdating occurs when a company issues stock options along with falsified documentation that reflects an earlier issuance date. The falsified date often corresponds with an unusually low stock price, which provides corporate executives - often the same executives who approve the stock grants - a windfall because the timing of the issuance inflates the value of the stock options. Not surprisingly, Delaware courts have expressed a strong interest in resolving “all of the intricacies potentially associated with stock options backdating claims” and emphasized Delaware’s “sizable interest in resolving such novel issues to promote uniformity and clarity in the law.”2
Although the deception associated with spring loading is more subtle than with backdating, the practice has nonetheless drawn the watchful eye of the court. With spring loading, a company issues options grants in accordance with a shareholder-approved compensation plan at then-current market values while possessing “favorable, material non-public information that will likely increase the stock price when disclosed.”3 Spring-loading options violates a director’s duty to deal fairly and honestly with shareholders because the options are issued at a time when management “knows those shares are actually worth more than the exercise price.”4 As the Court of Chancery explained, “[a] director who intentionally uses inside knowledge not available to shareholders in order to enrich [insiders] while avoiding shareholder-imposed requirements cannot, in my opinion, be said to be acting loyally and in good faith as a fiduciary.”5
Companies with spring-loading concerns should take care to investigate the potential for backdating as well, which could adversely color the lens through which the Court reviews the challenged action. Consistent with Delaware’s oft-stated deference to the independence of corporate executives to manage their companies free from Court interference, those companies that undertake active investigations and take steps to remedy any wrongdoing discovered will inevitably fare better in the eyes of the Court, even if the remedy falls short of what the Court itself might have awarded.
PROCEDURAL CONCERNS
When assessing potential liability from manipulated options grants, companies should consider several important procedural requirements that may bar shareholder challenges. Companies should consider whether the shareholder bringing the action has standing to do so, whether the jurisdiction in which he brought the action is appropriate, and whether the action can proceed in