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United States Commercial Law Seminar
Masaryk University
April 11-21, 2011
Lecture Three:
 Duties and liability of officers and
directors; shareholder derivative actions
Joseph D. Lee
Munger, Tolles & Olson LLP

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Readings
1.Ryan v. Gifford, 918 A.2d 341 (2007)
2.In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996)
3.Shareholder Derivative Complaint, White v. Jung (Avon Products)

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“The Perfect Payday”
wall-street-journal_1 copy
aaaa-0001

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What is a STOCK OPTION?
pA stock option gives an employee the right to
pbuy shares in the future at the market price on
pthe date a grant is approved. If the stock rises,
pexercise, sell and make a profit.
p
p
pGrant date – June 30 >> $10.00/share market price
p1,000 options granted, vesting over 4 years
pAll exercised at the end of Year 4 >> employee pays $10,000.
pSold on the same day, $25.00/share >> employee receives $25,000
pGain >> $15,000
p
p

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Who was doing it?
p140 Companies under Federal investigation; 70 executives lost jobs and 10 face federal or state
criminal charges. Numerous SEC investigations.
pKLA-Tencor –  Settled with 3 city/state pension plans for $65 million
pBrocade – Settled with the SEC for $7M and CEO Greg Reyes convicted and sentenced to 21 months in
prison
pMonster Worldwide – Deferred prosecution for terminally ill former CEO

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Backdating of Executive Stock Options (ESO) Grants
[http://www.biz.uiowa.edu/faculty/elie/backdating.htm]

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Stock Option Backdating:
Ethical and Accounting Challenges
Rick Fezell, Ernst & Young
Kirk Hanson, Markkula Center for Applied Ethics, SCU

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V-Charts – “The pictures were telling us a story” - WSJ
ALL GRANTS
DAILY CLOSING PRICE 1/3/00 THRU 12/29/00
$0.00
$5.00
$10.00
$15.00
$20.00
$25.00
$30.00
$35.00
$40.00
$45.00
$0
$2,000,000
$4,000,000
$6,000,000
$8,000,000
$10,000,000
$12,000,000
$14,000,000
$16,000,000
$18,000,000
$20,000,000
$22,000,000
MARKET CAP OF GRANTS
INTEGRATED SILICON SOLUTION, INC. DAILY CLOSING PRICE
REVIEWED GRANTS
PRIVILEGED AND CONFIDENTIAL
PREPARED AT THE REQUEST OF COUNSEL
* MARKET CAPITALIZATION OF GRANTS WAS CALCULATED BY MULTIPLYING THE CLOSING MARKET PRICE ON THE
RESPECTIVE GRANT DATE BY THE NUMBER OF SHARES ISSUED.

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What is BACKDATING?
pBackdating is selecting a date prior to the
pactual grant when the stock price was lower,
pthus increasing the award's value.
p
pGrant date – June 30 >> $10.00/share market price
p“Backdated” grant date – May 19 >> $6.00/share
p1,000 options granted, vesting over 4 years
pAll exercised at the end of Year 4 >> employee pays $6,000.
pSold on the same day, $25.00/share >> employee receives $25,000
pGain >> $19,000
p

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How Was Backdating Detected?
pAcademics, analysts and news organizations. The WSJ won a Pulitzer Prize for its investigative
reporting, which began in March 2006 – The Perfect Payday
p
pAffiliated Computer Services CEO - all six of his stock-option grants from 1995 to 2002 were dated
just before a rise in the stock price, often at the bottom of a steep drop. Just lucky? A Wall
Street Journal analysis suggested the odds of this happening by chance are extraordinarily remote
-- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket
are one in 146 million.
p
pMaybe insider trading? No, the SEC eventually came to "an increasing realization that the
companies were in fact lying about the timing of the grants."

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Why Was it Done?
pIntense competition for employee talent
p
pNon-cash – nobody cares and nobody gets hurt
p
pEveryone else does it

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Duty of Care (Lack of Oversight)
pLeading case:  In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
p
p“Possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a
judgment.”
p
p“Absent grounds to suspect deception, neither corporate boards nor senior officers can be charged
with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on
the company’s behalf.”  Id. at 969.
p
p “Only a sustained or systematic failure of the board to exercise oversight – such as an utter
failure to attempt to assure a reasonable information and reporting system exists – will establish
the lack of good faith that is a necessary condition to liability.”

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Shareholder Derivative Suits
pBrought by shareholder of a corporation on its behalf
pTypically brought against company’s most senior officers and directors
pSuits are authorized by state statutes
p“Demand futility” hurdle
p

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Duty of Loyalty
p“Acts taken in bad faith breach the duty of loyalty.”  Ryan v. Gifford, 918 A.2d at 357.
pBad faith may be shown where
n“the fiduciary intentionally acts with a purpose other than that of advancing the best interests
of the corporation”
n“where the fiduciary acts with the intent to violate applicable positive law,” or
n“where the fiduciary intentionally fails to act in the face of known duty to act, demonstrating a
conscious disregard for his duties.”
pStone v. Ritter, 911 A.2d 362, 369 (Del. 2006)
pUnder many state statutes, directors are immunized from liability for a breach of the duty of
loyalty, so long as it does not involve:
nintentional misconduct
nknowing violation of the law, or
pa transaction from which they would receive undue personal benefit.

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Business Judgment Rule
pRyan v. Gifford:
n“The business affairs of a corporation are to be managed by or under the direction of its board of
directors.”
n“In an effort to encourage the full exercise of managerial powers, Delaware law protects the
managers of a corporation through the business judgment rule.”
n“This rule ‘is a presumption that in making a business decision the directors of a corporation
acted on an informed basis, in good faith and in the honest belief that the action taken was in the
best interest of the company.’”
pPresumption can be rebutted by evidence of:
nBad faith
nIntentional wrongdoing
pAction for personal gain