MEMORANDUM OPINION AND ORDER
This is a shareholders’ derivative action. Before the Court are two motions to dismiss Plaintiffs’ Second
1
Amended Consolidated Shareholder Derivative Complaint (Doc. No. 23) (the “Complaint”). On April 27, 2007, Defendants Brian Bachman, James Bartlett, Philip Estler, Allan Gaff-ney, James Griswold, Hermann Hamm,
1. Statement of Facts and Procedural Background
Plaintiff Michael C. Miller filed the initial complaint in this matter on August 15, 2006, in the Court of Common Pleas of Cuyahoga County, Ohio. 4 Defendants removed the matter to this court on September 8, 2006, invoking federal question jurisdiction. (Doc. No. 1.) The Court consolidated this matter with three other actions under the caption of the instant case. 5 (Doc. No. 33.)
This consolidated derivative action arises from allegations that directors and officers of KEI manipulated 6 stock option grants. A brief primer on the practices encompassed by the term “manipulated,” courtesy of the Delaware Court of Chancery, is instructive:
Stock options “backdating” is a practice whereby a public company issues options on a particular date while falsely recording that the options were issued on an earlier date when the company’s stock was trading at a lower price. The options are purportedly issued with an exercise price equal to the market price on the date of the option grant. But, in fact, because the grant dates were falsified, the options were “in the money” when granted. The practice of “spring loading” stock options involves making market-value options grants at a time when the company possesses, but has not yet released, favorable, material non-public information that will likely increase the stock price when disclosed. Conversely, “bullet-dodging” options aregranted just after the company releases negative information to the market thereby allowing the recipient the benefit of a lower exercise price that reflects the price decline caused by the negative information.
Desimone v. Barrows,
The Complaint raises federal law claims under Sections 10(b), 14(a), and 20(a) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78 et seq., (the “Exchange Act”), as well as a variety of state law claims. The named Plaintiffs are, and at relevant times have been, shareholders of KEI. (Compl. ¶ 13.) KEI is an Ohio corporation engaged in the design, development, and manufacture of electronic testing and measuring equipment. (Compl. ¶ 14.) The Individual Defendants all are current or former directors and/or officers of KEI. Defendаnts Bachman, Bartlett, Griswold, Hendrix, Keithley, Reddy and White are current members of KEI’s Board. Defendants Estler, Gaffney, Hamm, Hoersten, Hume, Keithley, Patri-cy, Pesec, Plush, Rae, Rebner, Rosica, Sheridan and Willows are, or were, KEI officers, each of whom is alleged to have received options to purchase KEI shares. Specific allegations regarding each of the Individual Defendants are as follows:
A. Directors
Defendant Bachman has served as a director since 1996, as a member of the Board’s Compensation Committee since 1997, and previously served on the Board’s Audit Committee from 2000 to 2001. (Compl. ¶ 16.) Defendant Bartlett has served as a director since 1983, on the Compensation Committee from 1995 to 1997 and from 2005 to the present, and on the Audit Committee since 1998. (Compl. ¶ 17.) Defendant Griswold has served as a director since 1989, on the Compensation Committee from 1996 to 2001, and on the Audit Committee from 1995 to 2001. (Compl. ¶ 18.) Defendant Hendrix has served as a director since 1990, on the Compensation Committee since 1998, and on the Audit Committee from 1995 to 1997. (Compl. ¶ 19.) Defendant Keithley has served as the Board’s Chairman since 1991. He has never served on the Compensation Committee. (Compl. ¶ 15.) Defendant Reddy has served as a director since 2001, and on the Compensation Committee from 2002 to 2004. (Compl. ¶ 20.) Defendant White has served as a director since 1994, on the Compensation Committee from 1995 to 2004, and on the Audit Committee from 1998 to 2004. (Compl. ¶ 21.) With the exception of Keithley, none of the current directors is alleged to have received any options. Defendants Bachman, Bartlett, Griswold, Hendrix, Keithley, Reddy and White are referred to collectively as the “Director Defendants.” The table below illustrates the dates of board and committеe service for each of the relevant directors.
Board Member Director_Compensation Committee Audit Committee
Bachman_1996-present_1997-present_2000-2001_
Bartlett_1983-present_1995-1997, 2005-present_1998-present
Griswold_1989-present_1996-2001_1995-2001_
Hendrix_1990-present_1998-present_1995-1997_
Keithley_1991-present_
Reddy_2001-present 2002-2004_
White_1994-present 1995-2004_1998-2004
Defendants Estler, Gaffney, Hamm, Hoersten, Hume, Keithley, Patricy, Pesec, Plush, Rae, Rebner, Rosica, Sheridan and Willows are current or former KEI officers. Each is alleged to have received manipulated options to purchase KEI shares. Of note, Defendant Keithley, KEI’s President and CEO at all times relevant hereto, allegedly received at least 320,000 manipulated stock options. Keith-ley exercised these options, and the shares he acquired as a result were among the 3,400,000 shares he sold during the relevant time period. (Compl. ¶ 15.) These defendants are referred to collectively as the “Option Recipient Defendants.”
C. The Option Grants
The allegedly manipulated stock option grants were approved pursuant to KEI’s two stock option plans, the 1992 Stock Incentive Plan and the 2002 Stock Incentive Plan (the “Plans”). The Plans were approved by shareholders. (Compl. ¶ 49.) Both Plans provided that the price of any options granted was to be not less than 100% of the fair market value on the date of the grant. (Compl. ¶ 50-51.) The Plans also specifically delegated authority for their administration to the Compensation Committee. (Compl. ¶ 53.) KEI provided stock options to certain key executives on an annual basis as part of its compensation plan. In the Complaint, Plaintiffs identified eight of those annual grants (each year from 1995 to 2002) as subjects of alleged manipulation. 7 Those eight grants encompass approximately 2.28 million shares. (Compl. ¶ 2.) According to Plaintiffs, these eight grants were made on dates on which KEI’s stock was trading at or near its lowest price of the relevant fiscal quarter and/or fiscal year. (Id.) Since 1997, KEI has tracked all option grants using computer software known as “Equity Edge.” (Compl. ¶ 60.)
On September 9, 1995, defendants Hamm, Hume, Keithley, Rebner and Sheridan allegedly received option grants at an exercise price 8 of $6.84 per share. According to Plaintiffs, these grants occurred after a significant drop in the share price, and just before a sharp rebound. Plaintiffs allege that these grants initially were approved by the Compensation Committee on July 6, 1995, but were not approved by the full Board until September 9, 1995. (Compl. ¶ 62-63.)
On September 7, 1996, defendants Hamm, Hume, Keithley, Rosica and Reb-ner received option grants at an exercise price of $4.63 per share. Plaintiffs allege that the timing of these grants coincided with one of the lowest closing prices of KEI stock during the 1996 fiscal year. (Compl. ¶ 64.) The Compensation Committee purportedly approved the 1996 grants on August 22, 1996, and the full Board gave its approval on September 7, 1996. (Compl. ¶ 65.)
The 1997 grants to Hoersten, Keithley, Rebner and Rosica are dated September 19, 1997, and were issued at a price of
In 1998, Hoersten, Keithley, Patricy, Plush, Rae and Rosica received option grants at a price of $2.53. These grants passed the Compensation Committee on July 17, 1998, and received Board approval on September 11, 1998. Plaintiffs contend that the strike price of the 1998 grants coincided with one of the lowest closing prices of the year. Plaintiffs characterize this grant as a “bullet dodging” tactic, by which the option recipient defendants allegedly saved a collective $184,475. (Compl. ¶¶ 68-69.)
The 1999 grants to Gaffney, Hoersten, Keithley, Patricy, Plush, Rae, Rosica and Willows were dated July 16, 1999, and carried a strike price of $4.13. According to Plaintiffs, the closing price on July 16, the purported date of the grant, was actually $4.22. The $4.13 price was the closing price on July 19, 1999. This discrepancy was explained as an error by someone identified as Ms. Best in erroneously entering the required information concerning the option grants into the Equity Edge software system. Plaintiffs contend that, following the 1999 grant, KEI stock rose by 72% by the end of the fiscal quarter (approximately two months later). (Compl. ¶¶ 70-72.)
In 2000, defendants Gaffney, Hoersten, Keithley, Patricy, Plush, Rae and Rosica received options dated August 1, 2000, at a strike price of $45.13. According to the complaint, the grant date and price coincide with the lowest price of KEI stock during the fourth quarter of its 2000 fiscal year. The stock price proceeded to rise 56.22% by the end of the quarter, less than two months later. (Compl. ¶ 72.) The Board met on July 21, 2000. At that meeting, the Board discussed the handling of the 2000 option grants in light of considerable recent volatility in KEI’s stock price. (Compl. ¶ 73.) On August 1, 2000, a team of unidentified KEI executives met to discuss the option grants. (Compl. ¶ 74.) At some point during the process of considering the 2000 option grants, a printout of historical KEI stock prices showing prices from July 21, 2000 through August 3, 2000 was created. Some unidentified person circled the August 1, 2000 date as the lowest price during that period. (Compl. ¶ 75.) Unlike prior years, the members of the Compensation Committee are now unable to recall whether, in fact, thе option grants were approved at the August 1, 2000 meeting. (Compl. ¶ 74.) Contrary to established policies and procedures, the August 1, 2000 grants were not entered into the Equity Edge software system until August 7, 2000, by which time the stock had risen to $57.00, 26.3% higher than on the purported date of the grant. (Compl. ¶ 76.) Defendants Keithley and Plush, neither of whom was on the Compensation Committee, allegedly participated in the decision process regarding the 2000 options. (Compl. ¶ 77.)
The 2001 stock options recipients were Estler, Gaffney, Hoersten, Keithley, Plush, Rae and Rosica. The grant date was July 24, 2001 and the exercise price was $18.41. According to Plaintiffs, the grant date and price coincide with one of the lowest closing prices of the fiscal year. (Compl. ¶ 79.) The Compensation Committee and the full Board met on July 20, 2001 and approved the grants. As in 2000, a historical printout of stock price information was produced. The printout listed prices from July 20, 2001 through August 8, 2001. The lowest closing price during that period occurred on July 24, 2001. That date and
Options were granted to Estler, Gaffney, Hoersten, Keithley, Pesec, Plush, Rae and Rosica in 2002. The grant date was July 23, 2002, and the exercise price was $13.76. According to Plaintiffs, the grant came after a significant price drop, and just before a sharp rise. (Compl. ¶ 81.) The Compensation Committee and the full Board met and approved thе grants on July 19, 2002. Again a printout of historical stock prices was produced showing prices from July 19, 2002 to July 24, 2002. The lowest closing price in this range occurred on July 23, 2002. This date was circled on the printout, and was selected for the grant date and price. The information was not entered into the system until July 27, 2002. Despite having no role in the Compensation Committee, Keithley and Plush allegedly participated in the decision making. (Compl. ¶ 82.)
D. SEC Filings
KEI filed 10-K annual reports with the SEC for every fiscal year from 1995 to 2006 in December of each year. (Compl. ¶ 92.) Defendants Keithley and Plush, as CEO and CFO, respectively, filed certifications of KEI’s financial reports on each Form 10-Q and 10-K filed after August 2002, pursuant to the requirements of Section 906 of the Sarbanes-Oxley Act of 2002. (Compl. ¶ 93.) These certifications state that each 10-Q and 10-K “fully complies with the requirements of section 13(a) or 15(d) of the [Exchange Act],” and that the “information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.” (Compl. ¶ 93.)
Plaintiffs allege that proxy statements filed with the SEC and disseminated to shareholders annually from 1995 to 2002 falsely reported the grant date of options. (Compl. ¶ 95.) Plaintiffs further allege that a total of thirty-three (33) Form 4 9 filings between November 6, 2003 and January 6, 2006 reported false grant dates. (Compl. ¶ 96.)
E. Special Committee
On August 11, 2006, two days after this action commenced, the Board appointed a special committee (the “Special Committee”) to review the company’s stock option practices from 1995 to the present. (Compl. ¶ 7.) KEI has not disclosed the composition of the Special Committee or the basis for the alleged independence of its membership. (Compl. ¶ 9.) The Special Committee retained the law firm of Jones Day to conduct the internal corporate investigation. (Compl. ¶ 7.) On September 14, 2006, the United States Securities and Exchange Commission (“SEC”) began its own investigation into option practices at KEI. (Compl. ¶ 100.)
In addition to the press release, Jones Day authored an outline (the “Outline”) of the Special Committee’s findings. (Compl. ¶ 9.) According to Plaintiffs, the Outline acknowledged that (1) certain option grants carried exercise prices that were lower than the stock price on the date those grants were approved by the Board; (2) the Board did not possess documentation to support the grant date and price regarding certain other grants; and (3) management exceeded its authority under the stock option plans (specifically, that Keithley and Plush, without any formal delegation of authority, were involved in selecting grant dates and exercise prices regarding the 2000, 2001 and 2002 options that were beneficial to themselves, despite the fact that the plans require the Compensation Committee (of which they were not members) to select and approve grants). (Compl. ¶ 9.) The Outline specifically stated that, “[o]n a few occasions between April 2000 and January 2003, discretionary stock option grant dates were selected based in part upon the price of the Company’s stock on the grant date.” (Compl. ¶ 59.)
At the time this action was commenced, the Board consisted of ten members: defendants Bachman, Bartlett, Griswold, Hendrix, Keithley, Reddy and White, and non-parties Brian Jackman, Thomas Sapo-nas, and Barbara Scherer (the “Demand Board”). (Compl. ¶ 136.) Plaintiffs did not ask the Demand Board to initiate action against the company based on the alleged options manipulation. (Compl. ¶ 135.)
II. Law and Analysis
A. Legal Standard
In deciding a motion to dismiss, the allegations in the complaint are taken as true and viewed in the light most favorable to the non-moving party. A claim will not be dismissed “unless it appears beyond a reasonable doubt that the plaintiff can prove no set of facts to support his claim which would entitle him to relief.”
Hiser v. City of Bowling Green,
On a motion to dismiss under Rule 12(b)(6), the court must accept all factual allegations in the complaint as true.
Tellabs, Inc. v. Makor Issues & Rights, Ltd.,
In the context of a motion to dismiss a securities fraud claim, a court “may consider the full text of the SEC filings, prospectus, analyst’s reports and statements ‘integral to the complaint,’ even if not attached, without converting the motion into one for summary judgment under Fed.R.Civ.P. 56.”
Bovee v. Coopers & Lybrand C.P.A.,
B. Demand Futility
Defendants move to dismiss this action based upon Plaintiffs’ failure to make a pre-litigation demand to the Board. Federal Rule of Civil Procedure 23.1 provides that in a shareholder derivative action, the complaint must “allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiffs failure to obtain the action or for not making the effort.” Motions to dismiss for failure to allege demand futility are considered under Fed. R.Civ.P. 12(b)(6).
McCall,
Under Ohio law, it is presumed that any action taken by a director on behalf of the corporation is taken in good faith and for the benefit of the corporation. Ohio Rev.Code § 1701.59(C)(1);
Drage,
An exception to the general demand rule permits a shareholder to proceed with an independent suit without making a demand when the shareholder can demonstrate that the demand would have been futile. Ohio Civ. R. 23.1. “Futility means that the directors’ minds are closed to argument and that they cannot properly exercise their business judgment in determining whether the suit should be filed. It is not enough to show that the directors simply disagree with a shareholder about filing a suit.”
Drage,
Establishing demand futility under Ohio law “is not an easy task.”
In re Ferro Corp. Derivative Litig.,
No. 1:04CV1626,
Demand futility is assessed with respect to the board as it existed at the time the complaint was filed.
McCall,
A director is considered interested when, for example, he will receive a personal financial benefit from a transaction that is not equally shared by the stockholders, or when a corporate decision will have a “materially detrimental impact” on a director but not the corporation or its stockholders.
Rales v. Blasband,
1. Creation of Special Committee
Plaintiffs first contend that demand would have been futile, and no inquiry into the disinterestedness of individual directors is needed, because the Board responded to this lawsuit by creating the Special Committee, which the Board tasked with investigating Plaintiffs’ claims. Plaintiffs argue that the creation of the Special Committee by the Board may be viewed by the Court as a concession of demand futility. In support of this proposition, Plaintiffs cite
In re FirstEnergy S’holder Derivative Litig.,
FirstEnergy
does not, however, stand for so expansive a proposition as Plaintiffs suggest, and in any event, is distinguishable on its facts. As Defendants point out, Plaintiffs’ argument ignores the critical distinction between a special litigation committee and an investigatory committee. The distinction lies in the authority vested in the committee by the Board. Creation of a special litigation committee vested by the board with the power to determine whether to pursue certain litigation can imply that the board is not disinterested.
See FirstEnergy,
2. Receipt of Personal Financial Benefit
Plaintiffs assert that Defendant Keithley is interested by virtue of his receipt of 320,000 allegedly manipulated stock options. It is well established that ordinary director compensation alone is insufficient to show demand futility.
Loveman v. Lauder,
None of the other nine directors on the Demand Board received any options at all, and therefore did not receive a personal financial benefit from the allegedly manipulated options. Accordingly, the Court concludes that this argument serves to establish only that Keithley possessed a disabling interest. In order to excuse demand as futile, Plaintiffs must show that at least four other members of the Demand Board were not disinterested.
3. Control
Plaintiffs allege in the Complaint (though not at all in the response to the motion to dismiss) that the entire Board is controlled by Keithley, based on two facts: (1) Keithley is the son of the company founder and (2) Keithley controls 60.2% of the voting power of KEI shares. (Complaint at ¶ 139.) 12
A controlled director is one who is dominated by another party, whether through close personal or familial relationship or through force of will. A director may also be deemed “controlled” if he or she is beholden to the allegedly controlling entity, as when the entity has the direct or indirect unilateral power to decide whether the director continues to receive a benefit upon which the director is so dependent or is оf such subjective material importance that its threatened loss might create a reason to question whether the director is able to consider the corporate merits of the challenged transaction objectively.
Telxon Corp. v. Meyerson,
4. Personal/Business Relationships
Plaintiffs also contend that defendant Reddy lacks independence because of his longstanding personal and professional relationship with Keithley. (Complaint at ¶ 136f.) Again, Plaintiffs make no mention of this contention in opposing the motion to dismiss. Directorial independence “may be compromised by financial, familial or social ties to other persons who are interested in the board’s decision, but only if the plaintiffs plead facts that would support the inference that the director would be more willing to risk his or her reputation than to risk the relationship with the interested person.”
In re Sonus Networks, Inc. S’holder Derivative Litig.,
5. Failure to Void Stock Options
Plaintiffs contend in the Complaint (though, as appears to be their wont, not in the opposition) that demand should be excused because the Board failed to void the stock option grants at issue after discovering, via the Special Committee investigation, that those grants were not made in compliance with the Plans. Plaintiffs argue that the Board’s failure to take action to recover the gains of those defendants who received the allegedly manipulated options is not protected by the business judgment rule, and therefore saddles its members with a disqualifying interest. (Compl. ¶ 140.) This argument ignores that, as a matter of Ohio law, demand futility is assessed as of the filing of the initial complaint.
Drage,
The Complaint also includes an allegation that demand would be futile because KEI’s directors and officers liability insurance policy contains an “insured versus insured” exclusion that disclaims coverage for lawsuits between directors. (Compl. ¶ 141). Plaintiffs do not advance this contention in their response to suppоrt the demand futility argument. Courts examining Delaware law reject this argument routinely.
See Coca-Cola Enters.,
Certainly, a provision prohibiting directors from bringing suits against each other would deprive the directors of the ability to exercise independent judgment as to the advisability of instituting action against any officer or director for mismanagement, and thereby [divest them] of the power to govern this aspect of the corporation’s affairs.
Drage,
7. Potential Liability of Compensation Committee Members
Finally, the Court addresses Plaintiffs’ contention that demand must be excused because a majority of the Board lacked the requisite disinterestedness because those who served on the Compensation Committee and approved the allegedly backdated options face a substantial likelihood of liability. Specifically, Plaintiffs argue that individual defendants Bachman, .Bartlett, Griswold, Hendrix, Reddy and White (a majority of the Demand Board’s ten members), each of whom serves or served on the Compensation Committee, must be
The demand futility issue thus turns entirely on whether the allеgations in the Complaint sufficiently establish a substantial likelihood of liability as to any four of the following group of directors: Bachman, Bartlett, Griswold, Hendrix, Reddy and White. The allegations against these directors are, for the most part, not individualized, but rather are generic statements regarding the group based on their status as members of the Compensation Committee and the Board. Plaintiffs do not make any specific statements regarding actions taken, or knowledge possessed, by particular directors. Assuming for purposes of this analysis that the option grants identified by Plaintiffs were indeed backdated, the allegations against these individual directors effectively consist of the following: (a) that each of the individuals was a member of both the Compensation Committee and the Board at large at times when the allegedly manipulated grants were issued; (b) that the individuals, in their capacity as Board and Compensation Committee members, approved the option grants; (c) that the individuals knew, or are chargeable with knowledge, that the shareholder approved stock option Plans required option grants to reflect the fair market price on the date of the grant; (d) that backdated option grants violated the terms of the Plans; and (e) that the Board’s directors and officers (“D & 0”) insurance policy contained an “insured versus insured” exclusion. The relevant question for purposes of demand excusal is whether these allegations support a reasonable inference that a majority of the individual directors on the Demand Board bear a substantial likelihood of personal liability.
Generally, to show that the potential for liability rises to a “substantial likelihood,” the plaintiff must plead particularized facts “detailing the precise roles that these directors played at the company, the information that would have come to their attention in these roles, and any indication as to why they would have perceived the [wrongdoing].”
Guttman v. Huang,
a. Options Backdating Cases
Plaintiffs rely heavily on the Delaware Court of Chancery opinion in
Ryan v. Gifford,
The plaintiff identified nine option grants over a six-year period, each of which was granted “during the lowest market price of the month or year in which it was granted.” 16 Id. The plaintiff supported the backdating allegations with an empirical analysis performed by Merrill Lynch comparing the stock price performance following option grants to the firm’s general stock price performance over longer time periods. The comparison measured the aggressiveness of the timing of the option grants, and revealed that the average annualized return on option grants to management was 243%, nearly ten times higher than the general 29% market returns on the stock during the same period. Id. In a footnote, the court addressed the defendants’ argument that the plaintiffs allegations regarding the directors’ knowledge were not particularized sufficiently because they did not directly allege knowledge on behalf of the directors:
[I]t is difficult to understand how a plaintiff can allege that directors backdated options without simultaneously alleging that such directors knew that the options were being backdated. After all, any grant of options had to have been approved by the committee, and that committee can be reasonably expеcted to know the date of the options as well as the date on which they actually approve a grant. Nor is it a defense to say that directors might not have had knowledge that backdating violated their duty of loyalty. Directors of Delaware corporations should not be surprised to find that lying to shareholders is inconsistent with loyalty, which necessarily required good faith.
Id. at 355, n. 35.
The court in Ryan concluded, in the alternative, that demand also was futile under the Rales test, which applies when the entire board does not approve the challenged transaction and requires pleading of particularized facts creating a reasonable doubt that a majority of the directors would have considered the demand independently and disinterestedly. Id. The court in Ryan stated, in broad language seized upon here by Plaintiffs, that
[a] director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders (regarding his violations of a shareholders-approved plan, no less) and yet satisfy his duty of loyalty. Backdating optionsqualifies as one of those “rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment and a substantial likelihood of director liability therefore exists.”
Id.
at 355-56, (quoting, in part,
Aronson,
Several subsequent courts, confronting similar allegations of options backdating and the
Ryan
decision, found
Ryan
distinguishable.
See In re Computer Sciences Corp. Derivative Litig.,
No. CV 06-5288 MRP,
In
Computer Sciences,
the complaint alleged that the compensation committee of the board bore responsibility for review and approval of stock option awards to the company’s insiders.
Computer Sciences,
The Court acknowledges the view advanced in [Ryan ], that a director faces a “substantial likelihood” of liability for options backdating, but notes that this “rule” only applies to directors who directly approved or received the backdated options, or who are dependent on those who did, and only when plaintiffs allege with particularity that the options backdating occurred. To apply this view as a rule ascribing liability and interest to all directors when the core allegations of backdating are comparatively weak and lack particularity would circumvent the demand requirement in every case where backdating and spring-loading of options is claimed.
Id. Computer Sciences thus appears to agree with Ryan’s conclusion that directors who, as members of a compensation committee charged with administering a company’s stock option plan, approve backdated options, are subject to a disqualifying interest because they face a substantial likelihood of liability.
Other courts, however, confronted with very similar facts, found them insufficient to raise a reasonable doubt regarding the disinterestedness of any director. As in the instant case, in
CNET,
the plaintiffs alleged that all the director-defendants “ratified” the backdated option grants.
In
Verisign,
another case distinguishing
Ryan,
the court agreed with both of
Ryan’s
statements (a) that directors who approve backdated options face at least a substantial likelihood of liability, and (b) that options backdating qualifies as one of those “rare cases” where a transaction may be sufficiently egregious on its face that it loses the protection of the business judgment rule.
Verisign,
Faced with the plaintiffs’ contention that Ryan stands for the proposition that demand is excused upon a mere allegation that a company granted backdated options, the Verisign court did not disagree, but distinguished Ryan on grounds that the complaint failed to particularly allege “which director or directors approved which grant, or when such grant was approved and how it was backdated — and [included] no allegations showing how or why a particular director would know that the options were backdated.” Id. 19 Moreover, in contrast to Ryan, a majority of the VeriSign directors at the time of the complaint were not on the board at the time of the alleged backdating. Id. Regarding the plaintiffs’ allegations that certain board members served on various committees (including the compensation committee), and thus “the Board ‘should have been aware’ that VeriSign used different measurement dates when computing compensation costs for certain stock option grants; and claim that under the charters and policies of these three Committees, the directors had an obligation to investigate the differences in measurement dates and recorded dates of option grants,” the court found such allegations “wholly insufficient” to excuse demand. Id. at 1194. To support this conclusion, the court in Verisign repeated its determination that the complaint failed to allege facts describing the part each director played, by virtue of committee service or otherwise, in the alleged wrongdoing. Id.
Here, Plaintiffs’ allegations regarding the actual involvement of the individual directors in the alleged wrongdoing are similarly vague. Upon close examination, however, the facts alleged in
Ryan,
which that court found sufficient to excuse demand, were not so highly particularized. The cases distinguishing
Ryan
on the basis of its highly particularized allegations do not address in detail the exact allegations present in
Ryan
and absent from the distinguishing cases that make the difference. One that several courts cite as a distinguishing factor — the Merrill Lynch statistical analysis — is a rather compelling factor not presented here or in any other case where demand was not excused. It is clear, however, that such a detailed statistical analysis is not required to survive a motion to dismiss.
CNET,
The narrow question at issue then is whether such allegations, plus the rather generalized allegation that a majority of the current directors served on the Compensation Committee that approved the allegedly manipulated options were granted, is, without more, sufficient to excuse demand as futile because those directors bear a substantial likelihood of liability. Under
Ryan,
this would appear to be enough. The Complaint in this case contains virtually no factual allegations about the knowledge of the individual directors regarding the terms of the option grants at the time they approved them. Similarly little is said about what the directors actually did to approve the option grants. Nor, apparently, did the complaint in
Ryan
contain such specifics. The factual
Ryan
thus appears to stand for the proposition that members of a compensation committee vested with authority to approve stock option grants, who in fact approve option grants that contravene the terms of stock option plans, face a substantial likelihood of liability for that conduct. This is so, under
Ryan,
without specific factual allegations regarding knowing wrongdoing on the part of the individual directors. Rather than requiring such allegations, the court in
Ryan
assumed, based on the facts, that such individuals could not have approved backdated stock options without acting at least recklessly. The court charged the directors on the compensation committee who approved the option grants with knowledge of the date of the options as well as the date of the actual grant.
Ryan,
The courts that distinguished
Ryan
may have had valid bases for doing so. For instance, in
Verisign,
a majority of the demand board clearly had no involvement in the approval of the allegedly backdated options — six of the eleven members did not join the board until after the last backdated option was issued.
Verisign,
b. Timeliness of Claims
One vital aspect of assessing the likelihood of liability faced by a directоr that approved manipulated stock options, not squarely addressed by any existing authority in the demand futility context, is whether the potential causes of action against an individual director are barred by applicable statutes of limitation. Plaintiffs argue that this is not appropriately considered in assessing demand futility, but the Court rejects this argument. None of the cases cited by Plaintiffs squarely addressed this point. The Court agrees with the statement by the court in
Verisign
that claims that were time-barred could not be used as a basis for alleging demand futility.
The Court must, therefore, address the potential liability of individual directors relative to when they served on the Compensation Committee. Specifically, of the members of the Demand Board who served at various intervals on the Compensation Committee, only Bachman, Hendrix, and White served during 2002. (Compl. ¶ 138.) Defendant Griswold, a member of the Demand Board, served on the Compensation Committee with Bachman, Hendrix, and White from 1998 to 2001.
(Id.)
In additiоn, Defendant and Demand Board member Bartlett served on the Compensation Committee in 1995 and 1996.
21
(Id.)
Thus, for instance, if potentially viable claims (i.e., claims not barred by statutes of limitation) date back only to 2002, then only Bachman, Hendrix, and White face a substantial likelihood of liability. With Keithley (rendered interested by his receipt of allegedly backdated options), this represents less than the requisite half of
i. Timeliness — Federal Claims
Defendants argue that Plaintiffs may not maintain claims under Section 10(b) and Rule 10b-5 that are based on events that occurred outside the statute of repose relevant to such claims. The statute of repose for securities fraud claims under § 10(b) and Rule 10b-5 is the earlier of two years following discovery of the facts constituting the violation or five years following the violation. 28 U.S.C. § 1658(b). Plaintiffs stated clearly that their claims under § 10(b) are brought under Rule 10b-5, subsections (a) and (c). Rule 10b-5 provides, in pertinent part, as follows:
It shall be unlawful for any person, directly or indirectly by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud [...]
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
17 C.F.R. § 240.10b-5. By contrast to a claim under Rule 10b-5(b), which seeks to impose liability based on material misrepresentations or omissions, claims under 10b-5(a) and (c) are based on the allegedly fraudulent scheme itself. In this case, the “scheme” alleged by Plaintiffs is the alleged backdating of stock options. “A claim under § 10(b) that is based upon the backdating itself accrues on the date the option grant was made.”
In re Affiliated Computer Servs. Derivative Litig.,
Applying the five-year statute of repose to Plaintiffs’ 10b-5 claim, the Court concludes that only the options granted on July 23, 2002 are actionable. Accepting for purposes of this motion that Plaintiffs have adequately pleaded the backdating of the July 23, 2002 stock options, the Court concludes that, consistent with Ryan, the members of the Compensation Committee that approved those options (Bachman, Hendrix, and White) are subject to a substantial likelihood of liability for purposes of demand futility. Plaintiffs’ federal securities claims, however, do not subject Griswold to a substantial likelihood of liability. Griswold was not a member of the Compensation Committee on July 23, 2002. The allegedly backdated stock options that Griswold approved as a member of the Compensation Committee from 1996 to 2001, the most recent of which was approved on July 24, 2001, are not actionable under Rule 10b-5 because such claims are time-barred. 22
ii. Timeliness — State Law Claims
Defendants argue that Plaintiffs’ state law claims also are time-barred with respect to Defendant Griswold. The state law claims against Griswold include causes of action for breach of fiduciary duty (Counts V
&
VII), waste of corporate assets (Count XI), and gross mismanagement (Count XII).
24
As Defendants point out, under Ohio law, corporate waste and gross mismanagement are ways in which fiduciary duty can be breached, not separate causes of action independent of a fiduciary breach.
25
See Prodan v. Hemeyer,
Defendants contend that the five-year statute of repose established by Ohio Blue Sky Law appliеs to all of Plaintiffs’ state law claims, and therefore renders any of Griswold’s conduct during his tenure on the Compensation Committee inactionable. According to Defendants, Ohio Rev.Code
No action for the recovery of the purchase price as provided for in this section, and no other action for any recovery based upon or arising out of a sale or contract for sale made in violation of Chapter 1707 of the Revised Code, shall be brought more than two years after the plaintiff knew, or had reason to know, of the facts by reason of which the actions of the person or director were unlawful, or more than five years from the date of such sale or contract for sale, whichever is the shorter period.
Ohio Rev.Code § 1707.43(B).
Plaintiffs counter that they have not asserted any claims under Ohio Blue Sky laws, and therefore the statute of repose contained in § 1707.43(B) is inapplicable.
26
Instead, according to Plaintiffs, their state law claims are subject to a four-year statute of limitations with a discovery rule, and therefore are timely. Defendants respond by arguing that the determination of the applicable statute of repose does not turn on the label applied to a particular cause of action. Rather, under Ohio law, “courts must look to the actual nature or subject matter of the case, rather than to the form in which the action is pleaded. The grounds for bringing the action are the determinative factors [;] the form is immaterial.”
Lawyers Coop. Publ’g Co. v. Muething,
Anstaett
27
involved claims by a federally-appointed receiver against a salesman of viatical settlement investments. The receiver asserted numerous federal securities claims, including violations of the Exchange Act, as well as several claims arising under Ohio state law, including common law fraud, fraud in the inducement, breach of contract, unjust enrichment, breach of fiduciary duty, and intentional or negligent misrepresentation.
Anstaett,
Rogers
was very similar to
Anstaett,
and expressly followed its reasoning.
Rogers
involved federal securities claims under Sections 10(b) and 20(a) of the Exchange Act, state securities law claims under Ohio, Florida, and Missouri securities laws, and common law claims for fraud, breach of fiduciary duty, and negligent supervision.
28
The plaintiffs’ initial complaint, which asserted only the federal and state securities law claims, was determined to be time-barred.
Rogers,
Plaintiffs contend that Anstaett is distinguishable on several grounds. First, Plaintiffs contend that this action does not involve the sale of securities, and therefore the Ohio Blue Sky provisions do not apply. Second, Plaintiffs argue that the claims in Anstaett were asserted by purchasers of securities, and are therefore distinguishable because Plaintiffs in this case bring claims on behalf of the company, which was the seller, not the purchaser. Third, Plaintiffs assert that Anstaett is distinguishable because it involved claims by shareholders against a company, whereas this case is a derivative action, asserting claims possessed by the company itself. Finally, Plaintiffs contend that if § 1707.43 applies, the state law claims nevertheless are timely because they are subject to a discovery rule, and Plaintiffs had no reason to know of the alleged misconduct prior to March 2006.
Of the bases for distinguishing
Anstaett
offered by Plaintiffs, only one has any merit. Plaintiffs argue that this case differs from
Anstaett
because the claims in that case were asserted by the purchasers of the securities, and Plaintiffs’ claims herein are brought on behalf of the company, which was the sеller of the security, not the purchaser. Although Plaintiffs fail to provide any, there is support for this position. In
Baker v. Pfeifer,
individual investors in oil and gas wells brought suit against the well operators, and the individuals who served as the officers, directors,
The Court agrees with the reasoning and the result in
Baker,
and finds that it applies equally in this case. Because Plaintiffs’ claims are brought on behalf of the seller of the security, not the purchaser, § 1707.43 does not apply. But, again, the analysis must go further. As the Court in
Baker
concluded, claims for breach of fiduciary duty are governed by § 2305.09, which provides a four-year statute of limitation.
In support of their contention that the state law breach of fiduciary duty claims against Griswold are subject to a discovery rule, Plaintiffs cite two cases:
Nemeth v. Aced, Hobbs, Wassell and O’Connor,
No. 95APE06-768,
Estate of Schroer,
which clearly would support application of the discovery rule to breach of fiduciary duty claims, is no longer good law.
30
The statute of limitations is codified, and the statute expressly identifies certain claims as subject to the discovery rule.
See
Ohio Rev. Code § 2305.09.
31
Breach of fiduciary duty is not
Plaintiffs have raised a reasonable doubt regarding the interestedness of four KEI directors: Keithley, by virtue of his receipt of allegedly backdated options, and Bachman, Hendrix, and White by virtue of their service on the Compensation Committee when it approved the issuance of the allegedly backdated options on July 23, 2002. However, the remaining six directors on the Demand Board (Defendants Bartlett, Griswold, and Reddy, and non-parties Jackman, Saponas, and Scherer) are not subject to a substantial likelihood of liability, and therefore are not deemed interested. Thus, a majority of the Demand Board properly could have considered a demand. However, no demand was made, and Plaintiffs have failed to establish that the demand requirement should be excused.
III. Conclusion
Plaintiffs have not stated particularized allegations establishing a reasonable doubt as to the independence or disinterestedness of a majority of the Demand Board. Accordingly, Plaintiffs have failed to show that demand is excused. The motions to dismiss filed by the Individual Defendants
IT IS SO ORDERED.
Notes
. Although the Complaint is styled simply as an “amended” complaint, it is actually the second amended complaint. The first amended complaint was filed November 13, 2006. (Doc. No. 7.)
. KEI’s motion to dismiss simply adopts and incorporates section I of the motion to dismiss filed by Individual Defendants.
. The reply brief filed by KEI merely adopts and incorporates section I of the reply brief filed by the individual defendants.
. The first derivative action was filed by plaintiff Nathan Diamond six days earlier, on August 9, 2006. That action was consolidated under the caption of this case, along with two others. Diamond subsequently was dismissed as a party pursuant to his request. (Doc. No. 73.)
. In addition to Miller, the other named plaintiffs are Ralph Aquaro, Diamond, Edward P. Henry and Mike Marks.
. Plaintiffs’ Complaint alleges that Defendants engaged in several different fraudulent practices regarding the issuance of stock options. These practices fall generally into three categories: “backdating,” “spring loading” and "bullet dodging.” The Court refers to these practices, in the collective, as options "manipulation.”
. In the Complaint, Plaintiffs also allude to the issuance of “off-cycle” or discretionary option grants, which are distinguishable from the annual grants. Plaintiffs claim that these discretionary grants “technically” were not authorized by the Plans. (Compl. ¶ 56.) However, the off-cycle grants are mentioned only in passing in a single paragraph, and it is clear that Plaintiffs do not base any of their federal securities law claims on these grants.
. The terms "exercise price” and "strike price” are used interchangeably to mean the price for which a security will be bought or sold under an option contract if the option is exercised. Black's Law Dictionary (8th ed. 2004).
. Insiders are required to disclose any change in share ownership within ten days after the close of each calendar month in which the change occurs by reporting the change on a Form 4 filed with the SEC. The Form 4 is entitled Statement of Changes in Beneficial Ownership, and sets forth the insider's name, the date of the transaction, the number of shares sold or bought and the price per share.
See Payne v. DeLuca,
. The Court also will consult Delaware law regarding demand futility. The demand futility issues raised in this case are numerous, complex, and potentially dispositive. The issues are also rather new, given the recent emergence of stock option backdating, and there are no such cases interpreting Ohio law. By comparison, the body of case law inter
. Courts assessing demand futility under Delaware law apply one of two tests. Where the challenged transaction was approved by the board, demand is futile where, "under the particularized facts alleged, a reasonable doubt is created that (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”
Aronson v. Lewis,
. Rather paradoxically, Plaintiffs allege in the very same paragraph that Keithley is "subject to improper influence from members of the Compensation Committee.” (Complaint at ¶ 139.)
. Even if appropriately considered, this argument is a variation on one of two familiar demand excusal arguments, both of which frequently are rejected. One is that, in order to bring suit, the directors would be forced to sue themselves, which renders them sufficiently interested to excuse demand. “[T]he incantation thаt demand is excused because the directors otherwise would have to sue themselves, thereby placing the conduct of the litigation in hostile hands and preventing its effective prosecution [...] has been made to and dismissed by other courts.”
Aronson,
. The Sixth Circuit affirmed the district court on this point.
Ferro II,
. Plaintiffs have not challenged the independence or disinterestedness of non-party Board members Jackman, Saponas and Scherer, none of whom ever served on the Compensation Committee. In addition, while Reddy allegedly served on the Compensation Committee from 2002 to 2004, he apparently did not begin service until after the last allegedly backdated options were approved on July 23, 2002. (Compl. ¶¶20, 138.)
. It is not clear exactly what the court in Ryan meant when it said that the options were granted "during” the lowest market price of thе month (or year). Use of the word "during,” rather than "at,” implies that the options were granted at some price in a range of prices prevailing in a discrete period of time characterized by relatively low prices, but not necessarily the lowest price in the range.
. Although, the Verisign decision is reported, at the time of the issuance of this memorandum opinion, the pagination of that decision was unavailable. Accordingly, all further references to Verisign herein are to the Westlaw-formatted citation.
. In
Computer Sciences,
the court dismissed the complaint without prejudice and granted leave to amend. The plaintiff filed an amended complaint, and on a subsequent motion to dismiss, the court found that demand was not excused. The court determined that the plaintiff had shown only that two directors had disqualifying interests. A third director previously found to have a disqualifying interest served on the compensation committee and approved allegedly backdated options at a time when the plaintiff did not own stock,
. This is, at least arguably, an overly narrow reading of Ryan. As in Verisign, the complaint in Ryan did not include particularized allegations regarding actual knowledge or conscious disregard of the backdating on the part of the directors. Accordingly, distinguishing Ryan on this basis alone would not have been appropriate.
. It is for this reason that Ryan does not support a finding of interestedness based merely on board membership at the time allegedly manipulated options are approved. As in Ryan, in this case the company delegated responsibility for stock option granting to the Compensation Committee. Therefore, the Compensation Committee, not the board at large, is chargeable with knowledge of the Plans and of the contents of the grants it approves. Moreover, under Ohio law the board is entitled by statute to rеly upon information presented to it by an authorized committee of the board. See Ohio Rev.Code § 1701.59(B)(3).
. For purposes of this analysis, the Court focuses on the potential liability of Griswold. Any claims against Griswold found to be time-barred also would be time-barred as asserted against Bartlett. Due to the timing of Gris-wold’s Compensation Committee service, issues regarding timeliness present closer questions on the facts pertaining to Griswold than they do with respect to Bartlett, whose last alleged approval of backdated options occurred in 1996.
. Plaintiffs’ claims for control person liability under Section 20(a), which assert derivative liability for other violations of the Exchange Act, are subject to the same statute of repose as the Rule 10b-5 claims.
In re MBIA Inc. Sec. Litig.,
No. 05 Civ. 03514(LLS),
. Plaintiffs effectively concede this point by failing to address the Section 14(a) claims in their opposition.
. Counts IV and X are asserted only against the Option Recipient Defendants, which subclass does not include Griswold. Count VII, against the Insider Selling Defendants, likewise does not include Griswold. Counts IX (accounting) and XIII (constructive trust) are remedies, not independent causes of action.
. See Ohio Drill & Tool Co. v. Johnson,
. Plaintiffs also argue that the claims nevertheless are timely even if § 1707.43 applies. This contention is, as Defendants point out, incorrect. Plaintiffs’ argument misapprehends the effeсt of a statute of repose as distinguished from a statute of limitation. Plaintiffs argue that § 1707.43 contains a two-year statute of limitation subject to a rule of discovery, and because Plaintiffs could not have known of the conduct underlying their claims until March 2006, and filed this action in 2006, it is timely. But Plaintiffs ignore the repose aspect of § 1707.43, which provides a two-year statute of limitations with a discovery rule, or a five-year statute of repose, whichever is shorter. The statute of repose, as applied to the conduct at issue, (specifically the approval of the July 24, 2001 stock option grant, which was approved by the Compensation Committee which included Griswold), expired on July 24, 2006. This action was commenced on August 9, 2006, and therefore claims based on the stock options granted on July 24, 2001 are barred by the statute of repose.
. The Court refers to this case by the defendant’s name because a number of decisions exist which arose out of the same set of facts involving viatical settlements and bear the name of the receiver, Wuliger.
. One difference between Rogers and An-staett (and the instant case) is that the Rogers plaintiffs expressly pleaded claims for violations of Ohio state securities laws. That is not the case here, and was not the case in Anstaett.
.The defendants in
Nemeth
cross-appealed, arguing that the trial court erred in failing to find the plaintiff's fraud claim barred by the statute of limitation. The court in
Nemeth
sustained the plaintiff’s assignment of error and overruled the defendants’ assignment, holding that fraud claims were subject to the discovery rule expressly set forth in § 2305.09(D), and the plaintiff’s claims therefore were not time-barred.
. The Court need not decide whether Estate of Schroer was decided correctly at the time it was issued.
. Ohio Rev.Code § 2305.09 applies a discovery rule to the statute of limitations under the following circumstances: "If the action is for