In re F5 Networks, Inc.
| Citation | 207 P.3d 433,166 Wn.2d 229 |
| Decision Date | 21 May 2009 |
| Docket Number | No. 81817-7.,81817-7. |
| Court | United States State Supreme Court of Washington |
| Parties | In re F5 NETWORKS, INC., Derivative Litigation. Locals 302 and 612 of the International Union of Operating Engineers-Employers Construction Industry Retirement Trust, Glenn Hutton and Allen Easton, derivatively on behalf of F5 Networks, Inc., Plaintiffs, v. John McAdam, Alan J. Higginson, Karl D. Guelich, Keith D. Grinstein, Rich Malone, A. Gary Ames, Joann M. Reiter, Carlton Amdahl, Steven Goldman, Brett L. Helsel, Jeff Pancottine, Tom Hull, Steven B. Coburn, Edward J. Eames, Andy Reinland, Jeffrey S. Hussey, John Rodriguez, Defendants, and F5 Networks, Inc., a Washington corporation, Nominal Defendant. |
John G. Emerson Jr., Emerson Poynter LLP, Houston, TX, William B. Federman, Sara E. Collier, Federman & Sherwood, Oklahoma City, OK, Benny Goodman, Kevin K. Green, Travis E. Downs, Coughlin, Stoia, Geller, San Diego, CA, Kip B. Shuman, Shuman & Berens, Denver, CO, Kirk Robert Mulfinger, Mulfinger Law Group, Bellevue, WA, Tamara J. Driscoll, Attorney at Law, Seattle, WA, Daniel Morrissey, Spokane, WA, for Plaintiffs.
Brian D. Buckley, Christopher Michael Huck, Jeffrey Bruce Coopersmith, Stellman Keehnel, Russell Brent Wuehler, Kit William Roth, Patrick Timothy Jordan, DLA Piper LLP, Gregory J. Hollon, Robert M. Sulkin, McNaul Ebel Nawrot & Helgren, John Alan Knox, Randy Jarl Aliment, William Kastner & Gibbs, PLLC, Hugh Frederick Bangasser, Philip Mosby Guess, George E. Greer, Lori Lynn Phillips, Orrick Herrington & Sutcliffe LLP, Seattle, WA, Richard A. Kirby, K & L Gates LLP, Washington, DC, for Defendants.
Kristopher Ian Tefft, Association of Washington Business, Olympia, WA, Amicus Curiae on behalf of Association of Washington Business.
Clifford Allen Cantor, Law Offices of Clifford A. Cantor PC, Sammamish, WA, Counsel for Other Parties.
¶ Judge Robert S. Lasnik of the United States District Court, Western District of Washington, asked us to answer two certified questions:
Order Certifying Question at 2. We conclude that Washington follows the Delaware demand futility standard and the reasoning of Ryan.
¶ 2 In 2006, The Wall Street Journal published an article by Charles Forelle & James Bandler, The Perfect Payday — Some CEOs reap millions by landing stock options when they are most valuable. Luck — or something else? WALL ST. J., Mar. 18, 2006, at A1. It would go on to win the Pulitzer Prize for public service.1 The article explored what seemed to be a widespread practice of improper backdating of stock options in favor of corporate insiders. As the article explained, stock options
give recipients a right to buy company stock at a set price, called the exercise price or strike price. ... Naturally, the lower it is, the more money the recipient can potentially make someday when exercising the options.
Which day's price the options carry makes a big difference. Suppose an executive gets 100,000 options on a day when the stock is at $30. Exercising them after it has reached $50 would bring a profit of $20 times 100,000, or $2 million. But if the grant date was a month earlier and the stock then was at, say, $20, the options would bring in an extra $1 million.
A key purpose of stock options is to give recipients an incentive to improve their employer's performance, including its stock price. No stock gain, no profit in the options. Backdating them so they carry a lower price would run counter to this goal, by giving the recipient a paper gain right from the start.
Forelle & Bandler, supra, at A1. Based on governmental, academic, and their own research, the authors noticed that stock options in many corporations were much more likely to be reported and priced as if they were granted on days that the stock was trading comparatively low. They observed:
Suspecting such patterns aren't due to chance, the Securities and Exchange Commission is examining whether some option grants carry favorable grant dates for a different reason: They were backdated. The SEC is understood to be looking at about a dozen companies' option grants with this in mind.
The Journal's analysis of grant dates and stock movements suggests the problem may be broader. It identified several companies with wildly improbable option-grant patterns. While this doesn't prove chicanery, it shows something very odd: Year after year, some companies' top executives received options on unusually propitious dates. ...
The analysis bolsters recent academic work suggesting that backdating was widespread, particularly from the start of the tech-stock boom in the 1990s through the Sarbanes-Oxley corporate reform act of 2002. If so, it was another way some executives enriched themselves during the boom at shareholders' expense.
Id. Shortly afterward, the Center for Financial Research and Analysis (CFRA) issued a report titled "Options Backdating, Which Companies Are At Risk?" (CFRA Report), where it "reviewed the option prices of 100 public companies and, based upon an analysis of the exercise prices of option grants with reference to the companies' stock prices, concluded that 17% of the subject companies, were in CFRA's view, `at risk for having backdated option grants.'" Order to Show Cause at 2 (quoting CFRA Report). F5 Networks, Inc., was identified as one of those at-risk companies. In May 2006, a federal grand jury in New York subpoenaed documents relating to its granting of stock options. At about the same time, the Securities and Exchange Commission (SEC) began a similar informal investigation, and this suit was filed. The plaintiffs did not ask the corporation to pursue these claims first, commonly known as making a demand. See Williams v. Erie Mountain Consol. Min. Co., 47 Wash. 360, 362, 91 P. 1091 (1907) (citing 26 Am. & Eng. Enc. of Law 976 (2d ed.1905)).
¶ 3 The plaintiffs are three individual shareholders and two shareholding local affiliates of the International Union of Operating Engineers-Employers Construction Industry Retirement Trust. The defendants are 17 current and former officers and directors of F5. The plaintiffs brought suit under the federal Securities and Exchange Act of 1934 §§ 10(a)-(b), 20(a), 15 U.S.C. §§ 78j(a)(1)-(b), 78t(a), and the Sarbanes-Oxley Act of 2002 § 304, 15 U.S.C. § 7243, for insider trading and filing false and misleading proxy statements and under Washington State law for breach of fiduciary duty, among other things. Plaintiffs also assert violations of the corporation's own policies and of generally accepted accounting principles.
¶ 4 The core of the plaintiffs' case is the claim that there was a pattern of backdating stock options to hide insider compensation. They have identified 26 stock option grants made between 1999 and 2006. Plaintiffs allege the exercise price of the stock was set for the day of the month it was trading at its lowest 9 of those 26 times, and for the second lowest day of the month 3 of those 26 times. Plaintiffs assert that the odds of this happening randomly are 1 in 2,764,905 and that "on average, between 1999 and 2006, defendants received a 788.6% return on their backdated stock option grants while shareholders received, on average, only a 19.9% return over the same time period." Am. Consolidated Verified Shareholders Derivative Compl. at 22 (Amended Complaint). They claim this was part of "a secret and undisclosed scheme to grant in-the-money stock options to themselves and other F5 insiders by backdating stock option grants to coincide with monthly low closing prices for the Company's common stock and falsify F5's financial and proxy statements." Id. at 1. They claim that the defendants were "materially overstating the Company's net income and earnings per share and understating its net losses and losses per share." Plaintiffs allege defendants "collectively realized over $161.2 million in illicit compensation through the exercise of illegally backdated options grants and subsequent sale of F5 stock." Id. at 2.
¶ 5 While plaintiffs have little direct evidence of wrongdoing, they stress these numbers. They also cite to a Merrill Lynch report that said "`the most effective way to consistently capture low-price days for option grants is to wait until after a stock has risen, then backdate a grant to a day prior to that rise.'" Id. at 21 ().2 They also note long lags between the time the options were granted and the time they were reported to the SEC, which they claim is evidence of improper backdating. Id. at 23 (quoting M.P. Narayanan, Cindy A. Schipani & H. Nejat Seyhun, The Economic Impact of Backdating of Executive Stock Options, 105 MICH. L.REV. 1597, 1603 (2007)). The Amended Complaint asserts that while "the price of F5 stock was artificially inflated, defendants engaged in a massive insider trading bailout, selling more than $161.2 million worth of F5 stock in violation of securities laws." Id. at 4.
¶ 6 F5 is a Washington technology company. After its compensation practices were identified as being potentially problematic, F5 hired outside legal counsel and accountants and began its own investigation. While that investigation was pending, this suit was filed. Soon afterward, F5 announced that its internal investigation had uncovered stock option irregularities and...
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