Corporate Governance

Backdating and Derivative Litigaiton: In re Finisar Corp

By Christopher Erskine

On January 11, 2008, the District Court for the Northern District of California dismissed a derivative suit on behalf of Finisar Corporation. In re Finisar Corp., 2008 U.S. Dist. LEXIS 4590 (N.D. Cal. Jan. 11, 2008). The plaintiffs filed the case without first making demand upon the board, alleging that current and former directors and officers engaged in a backdating scheme that spanned five years. The court dismissed the shareholders suit, finding that the plaintiffs failed to provide sufficient facts for demand excusal.

The plaintiffs allege Finisar backdated stock options given to officers and directors on twelve separate occasions between August 15, 2000 and August 31, 2005, all of which were approved by Finisar’s Compensation Committee. In support of their claim, the plaintiffs noted that the options “were granted at or near the lowest closing price for the month and/or fiscal quarter or preceding a significant increase in the price of stock,” and that the cumulative return from the 20 days following each of the grants was substantial. Thus, the only likely explanation was that the stock options in question were backdated, as the random occurrence was implausible.

The court first considered which test is applicable in determining whether or not demand should be excused. The plaintiffs argued in favor of the test laid out in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), arguing that the board was not independent at the time the options were granted.  The court, however, disagreed, instead applying the test from Rales v. Blasband, 634 A.2d 927 (Del. 1993). The Rales test resulted because “the challenged transaction was not a decision of the board,” as only a minority of board members sat on the Compensation Committee for the remaining transactions.

The plaintiffs attempted to prove partiality by showing that Finisar’s directors had received backdated stock options, or in the alternative, the directors were partial because they faced a substantial likelihood of personal liability by knowingly approving such options. As is the case in many derivative suits, the problem that the plaintiff’s faced was one of proving their case with particularity. The plaintiffs averred that this case was analogous to Ryan v. Gifford, 918 A.2d 341 (Del. Ch. Feb. 6, 2007), where the court excused demand because the timing of option grants evidenced backdating.

The court, however, disagreed. First, this case’s option grants were less suspicious on their face than those in Ryan. Second, the plaintiffs did not explain the methodology they used in choosing the questioned options, and thus did not adequately respond to the defendant’s argument that they merely “cherry-picked” the dates to support their theory of backdating. Third, there was no empirical data presented that compared the option grant returns with general stock market returns. Lastly, the plaintiffs provided no specific facts suggesting that the directors knew the options were backdated. With these deficiencies the court held that the plaintiffs failed to prove that the directors were incapable of considering the demand with impartiality.

The case shows that even in the presence of evidence suggesting backdating, shareholders must show at the motion to dismiss stage an absence of an independent board, something the courts do not make easy, particularly those relying on Delaware law. 

The primary materials on this case can be found at the DU Corporate Governance website.

Full post as published by The Race to the Bottom on February 24, 2008 (boomark / email).