Desimone and the Struggle to Validate Backdating

We have been discussing the three Delaware cases addressing backdating, Ryan, Tyson and Desimone, with Vaugn Marshall, one of the students on the blog, having written the posts.  Two of them -- Ryan and Tyson -- let the backdating case go forward as a derivative action.  Desimone did not.  We will continue with our discussion of Desimone.

In Ryan and Tyson, Chancellor Chandler had nothing positive to say about the practice of backdating.  "At their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made."   

InDesimone v. Barrows, Chancellor Strine had a very different view and struggled to make backdating seem like a positive development.  As he described:     

• "By contrast, in a situation where directors are expressly permitted under the terms of a stockholder-approved option plan to issue below-market options, it would be well within the realm of business judgment to choose to issue all options to a set of similarly-situated employees at a uniform strike price reflecting the stock's low point for the quarter. But even in that situation, a director could not, with impunity, secretly backdate the option grants while falsely representing that they were made at fair market value on the dates of the grants or account for them as such."

Chancellor Strine is trying to remove the element of deception from backdating.  He therefore suggest that "secret backdating" is fine as long as it is not accompanied by false disclosure.  Somehow it is the false disclosure that makes backdating a deception.  Said another way, as long as the plan allows for below market pricing, the company can backdate without affirmative disclosure about the practice (retaining secrecy) and only get into trouble if it affirmatively lies by representing that the options are priced at market value. 

But in fact it's the secrecy that is the deception, the lie is an additional violation.  As Chancellor Chandler noted, backdating is inherently deceptive.  Indeed, there is no reason to backdate except to obtain a secret benefit.  Backdating shortens vesting schedules and creates the appearance that options were priced on the date issued at market value, obscuring that the options were really issued in the money at an earlier date.  This is a deception.

The same economic result could be achieved without deception and without backdating.  To the extent backdating is bout pricing options at a time when a company's share prices were lower, options could be issued on the date disclosed but priced at a discount.  The discount could be the lowest price of the quarter or any other discount determined by the board (assuming consistency with the terms of the plan).  The practice would be apparent, not secret, and the board would have to justify the issuance of "in the money" options and the arbitrary exercise price under its fiduciary obligations.  

Improper backdating, therefore, is not limited to a violation of a plan followed by a lie that the options were at fair market value.  Backdating is the practice of hiding from shareholders that option recipients received in the money options on the date issued.  In other words, it is not enough to avoid affirmative lies.  Backdating will be a deception unless management makes full disclosure of the practice and, with full disclosure, the reasons for backdating disappear.  

Comments

[Steve H]

Two points. First, if the plan permits backdating, then there is hardly reason to be upset---unless, as VC Strine noted, there is a false disclosure. Thus, if your plan permits backdating and you tell the stockholders that you didn't backdate, there's a problem.

Second, you wrote: "Indeed, there is no reason to backdate except to obtain a secret benefit." But the whole reason to backdate is to be in-the-money. It doesn't have to be a secret because the optionholder already has the benefit, regardless of whether people know. If a stockholder knows that the CEO backdated, the CEO still has the benefit.

I think Chandler overstated it when he said, essentially in absolute terms, that backdating is inherently deceptive. In practice, that appears to have been what's happened in most cases. But VC Strine put a finer touch on it---that it is possible that one could backdate without being deceptive. Now whether that's actually happened outside of the classroom is a different story....

[J. Robert Brown]

Two responses.

First, the Delaware courts have apparently concluded that plans permit backdating if they allow the option exercise price to set at below fair market value. In my opinion, that is not sufficient to allow a practice of giving out options at an earlier date. For the plan to permit backdating, it would have to explicitly authorize options issued on an earlier date.

Second, Chancellor Strine's position would allow companies to backdate, then disclose the option exercise date and the option exercise price, creating the appearance that the options were issued at fair market value. What the company cannot do, according to his opininon, is affirmatively lie and say that they were issued at fair market value. In other words, they can give that impression but just can't say it. If companies must disclose the option exercise price, the option date and affirmatively admit that they backdated (not hide behind the contention that the plan permits it), I submit that backdating would stop. Without secrecy, it has no purpose. You can accomplish the same thing by issuing options on the relevant date (the employment start date, for example), and simply price at the backdated price.