Corporate Governance

The SEC, Outside Directors, and the Preemption of Delaware Law: Mercury Interactive

By J. Robert Brown

We have noted that the SEC has increasingly been turning its attention to outside and independent directors. It may be an aberration but more likely it reflects the failure of Delaware law to impose meaningful standards on these directors. Increasingly, therefore, the SEC has gotten into the business of defining and enforcing director independence and imposing more meaningful standards on their behavior.

In In re Mercury Interactive, Litigation Release No. 20724 (SD CA Sept. 17, 2008), a settled injunctive proceeding, the complaint "alleges that the outside directors recklessly approved backdated stock option grants and reviewed and signed public filings that contained materially false and misleading disclosures about the company?s stock option grants and company expenses." The directors served on the compensation committee. As part of that assignment, they approved 21 stock option grants that were backdated. According to the complaint, they knew that the stock option plan required pricing to be at the closing price of the company?s stock on the day that they approved and that they "repeatedly executed documents approving grants of stock options while failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company?s stock at the time of approval."

The directors were apparently duped by other officials in the company. As an example, the SEC's complaint describes the following approval of options:

• Shamir, Yaron and Kohavi were repeatedly asked to sign written consents memorializing option grants with grant dates months before they had even been contacted by management with respect to approval of a grant. For example, management began assembling a list of grant recipients on March 7, 1999, and contacted the directors by phone that same day to approve the options. Yet the directors signed written consents just two weeks later memorializing the grant with a grant date of January 21,1999, two months prior.

The SEC stopped short of saying that the outside directors knew that the options were backdated. Instead, the backdating was apparent from the documentation. Thus, the directors failed to examine the paperwork before approving the options. In other words, it looks like a Radar O'Reilly type of approval process. The directors were presented with paper work that they simply signed without examining it closely.

In Delaware, this type of behavior would be dismissed out of hand. Shareholders would need to show that demand was excused, which mostly means they must establish a lack of board independence. As a result, the case would be dismissed and the merits never addressed.

At the federal level, however, the merits matter more. With respect to securities matters, directors in fact will be expected to understand the contents of the documents put before them. This effectively amounts to an example of SEC preemption of state law by imposing subsantive standards on directors. Given the lack of standards under Delaware law, this can be expected to happen more and more.

For more on the subject, the D&O Diary has a nice post. 

Full post as published by The Race to the Bottom on September 22, 2008 (boomark / email).