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.