Options Backdating: One year later

November 4, 2007

A year ago, the emerging stock options backdating scandal was a hot topic, dominating the headlines of the financial pages and commanding the attention of the professional liability industry. The options backdating story may now seem like old news but the mass of options backdating-related litigation that flooded in a year ago has not gone away; rather, it is slowly working its way through the system.

With the passage of time, a number of the options backdating-related cases have now been resolved, and so it may now be appropriate to consider how the cases are ending up and what it may mean for the directors’ and officers’ industry.

The options backdating scandal generated considerable litigation. Thirty-four companies were sued in options backdating-related securities class action lawsuits, and 164 companies were sued in options backdating-related shareholders derivative lawsuits. Some companies were sued in both types of lawsuits. In addition, five companies were sued in options backdating-related Employee Retirement Income Security Act (ERISA) lawsuits. Many of those cases remain pending, but quite a few cases have been resolved.

In many instances, the cases required significant defense expense, much of which has been borne by D&O insurers. In addition, as some of the cases have settled, D&O insurance contributed significantly to the settlements.

While a comprehensive overview of the options backdating case outcomes is beyond the scope of this article, it is possible to get a sense of the general direction of case outcomes.

In one of the few options backdating securities lawsuits that have been resolved on the merits — the lawsuit pending against Amkor Technology — the court dismissed the case. Other securities class action lawsuits have settled.

The most significant options backdating-related securities class action settlement to date is the $117.5 million settlement reached in the Mercury Interactive case. The Mercury Interactive case not only involved options backdating, but, at least according to the Securities Exchange Commission, also included filing false and misleading financial statements as part of a “fraudulent and deceptive scheme.”

Other significant class action settlements include the Rambus settlement ($18 million), Vitesse Semiconductor ($10.2 million) and Newpark Resources ($9.5 million). It should be noted that the Vitesse settlement resolved both securities litigation and a shareholders’ derivative lawsuit, so the settlement amount reflected more than just the settlement of the securities class action claims.

The Newpark settlement involved significant allegations other than options backdating.

The record is mixed as far as the outcome of motions to dismiss filed in options backdating shareholders’ derivative lawsuits. On the one hand, Chancellor William Chandler of the Delaware Chancery Court has written strongly worded denials of dismissal motions in Ryan v. Gifford (Maxim Integrated Products) and Tyson Foods cases. But dismissals were granted in other options backdating cases pending in the Delaware Chancery Court, such as in the Sycamore Networks case.

Outside of Delaware, a number of courts have granted the defendants’ motions to dismiss the shareholders’ derivative lawsuits, on the grounds of “demand futility” — that is, that the plaintiffs’ had failed to establish that the various companies’ boards lacked the ability to consider whether or not to bring the lawsuit on the companies’ behalf. Significant dismissals include the shareholders’ derivative cases pending against CNET Networks, DiTech Networks, Bed Bath and Beyond, and Computer Sciences Corp.

In addition to the rulings on the motions to dismiss, there have been a number of settlements of the options backdating-related shareholders’ derivative lawsuits. Typically, the settlements have involved some combination of the company’s agreement to adopt certain corporate therapeutics, such as improved internal controls. The settlements also typically include paying the plaintiffs’ attorneys fees, but no more than about $1 million to $2 million.

There have been a few shareholders’ derivative settlements where the dollar amounts were more significant, such as in the Rambus derivative settlement. In that case, two former officers agreed to pay cash and cash equivalents of $6.5 million.

When the options backdating scandal was emerging one year ago, the D&O industry consensus was that the scandal would not become a significant event for the industry. Based on the bulk of the outcomes, that early assessment appears to remain valid.

The one wild card is the $117.5 million Mercury Interactive settlement. That large settlement may or may not prove to be predictive of any future settlements. Among other things, that case was somewhat unique in that it involved one of the few instances where a significant stock price drop followed the company’s announcement of options related concerns. The D&O insurance contribution, if any, to the Mercury Interactive settlement has not been publicly disclosed. However, if there were to be a significant number of additional settlements the same magnitude as the Mercury Interactive settlement that were substantially funded by D&O insurance, options backdating could become more of an event than perhaps the industry has been assuming.

Yet at this point, the Mercury Interactive settlement looks like an outlier, and other case resolutions to date are consistent with the early assessment that options backdating will not prove to be a disruptive event for the D&O industry.

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