In re Cnet Networks, Inc.

• Decision Date: 11 April 2007
• Docket Number: No. C 06-03817 WHA.,C 06-03817 WHA.
• Citation: 483 F.Supp.2d 947
• Court: U.S. District Court — Northern District of California
• Parties: In re CNET NETWORKS, INC. Shareholder Derivative Litigation. This Document Relates To: All Actions.

483 F.Supp.2d 947

In re CNET NETWORKS, INC. Shareholder Derivative Litigation.

This Document Relates To: All Actions.

No. C 06-03817 WHA.

United States District Court, N.D. California.

April 11, 2007.

Darren J. Robbins, Travis E. Downs, III, William S. Lerach, Benny Copeline Goodman, III, Kathleen Ann Herkenhoff, Lerach Coughlin Stoia Geller Rudman & Robbins LLP, San Diego, CA, for Plaintiffs.

Patrick Gibbs and Philip Wang, Latham & Watkins LLP, Silicon Valley, CA, for CNET.

Maura T. Healey, Wilmer Cutler Pickering Hale & Darr LLP, Boston, MA, Michael Bongiorno, Wilmer Cutler Pickering

Hale & Dorr LLP, New York, NY, Nathan L. Walker, Wilmerhale, Benjamin Daniel Singerman, Cooley Godward Kronish LLP, Palo Alto, CA, Kenneth J. Philpot, Reed Smith Crosby Heafey LLP, San Francisco, CA, Anissa D. Seymour, Katten Muchin Rosenman LLP, Amy S. Park, Skadden, Arps, Slate, Meagher & Flom, LLP, Los Angeles, CA, James E. Lyons, Skadden, Arps, Slate, Meagher & Flom, LLP, San Francisco, CA, for Defendants.

ORDER GRANTING NOMINAL DFENDANT'S MOTION TO DISMISS AND REQUESTING SUPPLEMENTAL BRIEFING

ALSUP, District Judge.

INTRODUCTION

In this shareholder derivative action, individual defendants and nominal defendant move to dismiss plaintiffs' second amended verified complaint. The complaint alleges claim under Section 10(b), Section 14(a), and Section 20(a) of the Securities Exchange Act of 1934 and Section 304 of the Sarbanes-Oxley Act of 2002. As this action was brought as a derivative action, plaintiffs are required to make a demand on the board, or else plead with particularity that demand was futile. Plaintiffs have failed to plead with particularity that demand on the board was excused as futile under FRCP 23.1. Accordingly, nominal defendant's motion to dismiss for failure to plead demand futility is GRANTED. Because of this, this order does not address the merits of the individual defendants' motions to dismiss. Plaintiffs and nominal defendant are requested to submit supplemental briefing a narrow discovery issue.

STATEMENT

1. THE MECHANICS OF STOCK-OPTIONS BACKDATING.

In March of 2006, the Wall Street Journal published a series of newspaper articles analyzing certain stock options granted by companies to their executives. By analyzing patterns in price movements and stock returns, the articles found that some of the grant dates for the options eventually yielded extraordinarily high returns versus what would have been expected by pure chance. The grant date for these options fell on a date when the stock price was at a periodic low point, followed by a rapid increase in price. In some instances, the odds of achieving such buy-low-sell-high returns were slimmer than winning the lottery. In a few instances, the odds were less than winning the lottery several times over. Charles Forelle and James Bandler, "The Perfect Payday," Wall St. J., March 18, 2006, at Al. Subsequent articles revealed such exquisitely timed grants to be widespread. Since these articles, stock options backdating has been on page one of the financial press.

A company grants stock options to its employees at a certain exercise price. This gives the employee the right to purchase the stock at the exercise price at a later date after the option vests. If the stock price rises, the employee stands to make a profit. If the stock price falls below the exercise price, the option is worthless to the employee. Options where the exercise price is at the market price as of the date of the grant are referred to as "at-the-money" options. Options where the exercise price is lower than the market price as of the grant date are referred to as "in-the-money" options. For financial reporting purposes, companies are required to record compensation costs for granting in-the-money options because the company effectively receives a lower price than it could get for the shares on the open market. No compensation costs need be recorded for at-the-money options because the exercise price is the same as the market price. The company is not foregoing any revenue. Because they are so closely tied with the company's stock price, and in turn the company's fortunes, stock options have been considered by some to be an important part of incentive-based compensation.

Backdating occurs when the option's grant date is altered to an earlier date with a lower, more favorable price to the recipient. The option price is normally the market price as of the grant date. If the option's price is below the price on the market as of the grant date, the company has to recognize the difference between the two as a compensation expense. If the option's price is at or above the price on the market at the grant date, the company recognizes no compensation expense. For options backdated to a lower price, the proper accounting is to recognize an expense. This, of course, will lower or eliminate the company's earnings for the period of the backdated grants.

2. CNET.

On May 16, 2006, the Center Financial Research and Accountability published a report titled "Options Backdating — Which Companies Are at Risk?" The report identified certain companies that were at risk for having granted backdated stock options, including nominal defendant CNET (Herkenhoff Decl. Exh. A). In an effort to address the ensuing storm at CNET, its board of directors announced on May 22, 2006, that it had appointed a special committee of independent directors to investigate stock options granting practices (CNET Req. Jud. Not. Exh. A). On July 10, 2006, CNET announced that pursuant to the investigation, it would have to restate its financial statements for the years 2003, 2004, and 2005 (Compl. ¶ 5). Lawsuits, including this action, quickly followed.

By October 11, 2006, the internal investigation was completed culminating in the special committee report. The entire contents of the report were not released to the public. CNET issued a press release summarizing some of the special committee's findings. It stated that `Where were deficiencies with the process by which options were granted at CNET, including in some instances the backdating of option grants, during the period from the Company's IPO in 1996 through at least 2003." It also stated that "[t]he report does not conclude that any current employees of the Company or any recently resigned employees engaged in intentional wrongdoing" (CNET Req. Jud. Not. Exh. G). The entire report itself was circulated internally at CNET and was given to various agencies, including the SEC, the United States Attorney's Office for the Northern District of California, and NASD. At the same time, CNET was facing delisting proceedings by the NASDAQ because of delays in its financial statements. Only a bulletpoint summary of the report was included in the press release.

On December 26, 2006, CNET disclosed in a Form 8K filed with the SEC that some employees, including moving defendants Ashe, Briggs, Colligan, and Robison had entered into agreements amending the exercise price of stock options that may have been granted to them at below-market value to the extent those options had not yet vested (Singerman Decl. Exh. E). Additionally, Currie, Nelson, Mohn, Colligan and Robison allegedly entered into agreements with the company to repay the difference between the exercise price and the stock's price on the true date of the grant for options that had been exercised (ibid.).

CNET filed its restated financial statements with the SEC on January 29, 2007. Plaintiffs allege that CNET admitted in these statements to granting backdated stock options, while defendants state that the stock options were merely mispriced for accounting purposes and that no intentional wrongdoing took place. The restated financial statement said "we [CNET's management and the special committee] identified instances where the grant date used by us as the measurement date for accounting purposes, differed from the measurement date as defined in Accounting Principles Board Opinion No. 25 ... for more than the grants identified in the CFRA report" (id. at Exh. F). The amended 10K described CNET's process in correcting grant dates, and the evidence on which it relied in doing so. As a result of the adjustments, CNET recognized an additional stock-compensation expense of $105.7 million over the years from 1996 through 2005. CNET reiterated that the committee had found that no current or recently resigned employees or directors had engaged in any intentional wrongdoing (ibid.).

3. PARTIES.

Plaintiffs Martin Melzer and James L. Finn were (and remain) shareholders of nominal defendant CNET Networks, Inc., at all times relevant to this action (Compl. ¶ 23-24). Defendants are current and former CNET directors and officers.

As to all individual defendants, plaintiffs allege that each of the directors helped prepare all financial statements and proxy statements for filing with the SEC during their respective tenures at CNET. Plaintiffs plead that each director "ratified" all allegedly backdated stock options granted during his or her time on the board. Each of the proxy statements and financial statements issued from 1998 until 2006 is alleged to contain misrepresentations as a result of backdating and for the purpose of continuing the alleged backdating scheme. Plaintiffs make no allegations that any defendant exercised backdated options or sold stock acquired from those options. Plaintiffs also do not allege how they arrived at the value of plaintiffs' stock options or at what time the alleged value was measured.

The following individual defendants were members of CNET's board of directors at the time the complaint was filed on June 19, 2006.

Defendant Shelby Bonnie served on CNET's board of directors since 1993, as its CEO since March 2000, and as its chairman of the board since November 2000 (Compl. ¶ 27). He resigned from the company in October 2006, allegedly because of his role in the backdating scheme. Plain...