Corporate Governance

Failure to Meet Demand Execusal Requirements Proves Fatal to Backdating Case

By Vaughn Marshall

Delaware’s demand requirement can be an insurmountable obstacle facing a plaintiff in a shareholder derivative suit even when there is evidence of wrongdoing by board members. This was the case in Risberg v. McArdle, 2008 WL 54815 (D. Mass., Jan. 4, 2008).

The compensation committee of Aspen Technology was accused of backdating numerous stock option grants to employees, leading to restatements of earnings for a ten year period. The committee was granted complete authority in the administration of the stock option compensation plan. While granting the defendant director’s motion to dismiss for failure to make demand on the board, the court rejected multiple arguments for demand excusal by the plaintiff.

In response to the motion, the plaintiff argued that demand was excused because a majority of the seven member board was not disinterested or independent for various reasons.  Once again, despite evidence of backdating, the case turns not upon the inappropriate behavior by officers and directors but the largely unrelated issue of whether a majority of the board is "independent."  As we have noted often on this Blog, meeting the definition of independent under state law does not at all mean that directors are in fact independent. 

The first of these reasons, according to the plaintiff, was that a majority of the directors had in fact served on the compensation committee when the backdated options were granted. However, two of the four directors whose disinterested status was challenged did not join the compensation committee until approximately nine months after the last allegedly backdated option was granted. While the plaintiff argued that this grant was backdated, and was thus awarded at a later date, possibly after the two directors joined the compensation committee, she could not point to the date on which this allegedly occurred. The court determined that this was insufficient to meet the particularized pleading standards of Delaware law.

The next argument raised by the plaintiff claimed that demand was futile because a majority of the board faced a serious risk of liability. The same four directors accused of granting the backdated options, along with one other, made up Aspen’s audit committee. According to the plaintiff’s argument, the committee failed to properly oversee Aspen’s financial statements and disclosures, as evidenced by the company’s restated earnings. The court noted that in cases like this one, where the corporate charter contains an indemnity provision for breaches of fiduciary duty by board members, “a serious threat of liability may only be found to exist if plaintiff pleads a non-exculpated claim against the director based upon particularized facts.”

The standard required to show this “serious threat of liability” is one of gross negligence, or “conscious disregard” of the director’s responsibility to monitor the company’s financial disclosures, as laid out in Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). Two of the directors in question only served on the audit committee for one year, which the court found as insufficient to raise a substantial likelihood of liability, even if they were remiss in their duties for that period.

While the plaintiff also asserted that a claim under section 14(a) of the Exchange Act does away with the demand requirement, the court quickly dismissed this argument as the plaintiff relied on a case from the Southern District of New York that has never been followed.

The complaint and the trial court's opinion can be found at the DU corporate governance website.

Full post as published by The Race to the Bottom on February 01, 2008 (boomark / email).