In re Zoran Corp. Derivative Litigation

• Citation: 511 F.Supp.2d 986
• Decision Date: 05 June 2007
• Docket Number: No. C 06-05503 WHA.,C 06-05503 WHA.
• Parties: In re ZORAN CORPORATION DERIVATIVE LITIGATION. This Document Relates To: All Actions.
• Court: U.S. District Court — Northern District of California

511 F.Supp.2d 986

In re ZORAN CORPORATION DERIVATIVE LITIGATION.

This Document Relates To: All Actions.

No. C 06-05503 WHA.

United States District Court, N.D. California.

June 5, 2007.

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ORDER GRANTING IN PART AND DENYING IN PART MOTION TO STRIKE AND GRANTING IN PART AND DENYING IN PART MOTION TO DISMISS

WILLIAM ALSUP, District Judge.

INTRODUCTION

In this shareholder derivative action alleging backdating of stock options, individual defendants and nominal defendant move to dismiss plaintiff's consolidated verified derivative complaint. The complaint alleges claims under Section 10(b), Section 14(a) and Section 20(a) of the Securities Exchange Act of 1934 as well as a number of claims under Delaware state law. Because this is a derivative action, plaintiff is required to either make a demand on the board or adequately plead why such demand was excused. This order holds that plaintiff has succeeded in pleading that demand was excused under Delaware law. Plaintiff has pled with particularity facts that, if true, would show that a majority of Zoran's directors received backdated stock options, thus they engaged in self-dealing.

Turning to the merits of plaintiff's securities claims, this order further holds that plaintiff has pled all the necessary elements of a claim under Section 14(a). Plaintiff has also pled claims under Section 10(b) against defendants Gerzberg and Schneider. Plaintiff has not stated a claim for control-person liability under Section 20(a) because he did not allege facts that there were any primary violators controlled by Gerzberg and Schneider. As to the Delaware state law claims, plaintiff has stated claims for breach of fiduciary duty based on the granting of backdated stock options and based on insider trading, corporate waste and unjust enrichment. Plaintiff has failed to plead claims for aiding and abetting breach of fiduciary duty, constructive fraud, gross mismanagement, abuse of corporate control, and rescission. Plaintiff's motion to strike exhibits to the declaration of Felix Lee is GRANTED IN PART AND DENIED IN PART.

In sum, nominal defendant's motion to dismiss for failure to make demand will be DENIED. Once plaintiff makes conforming amendments to the complaint, as explained below in this order, then plaintiff will have successfully pled that demand was excused. Individual defendants' motion to dismiss under Rule 12(b)(6) is GRANTED IN PART AND DENIED IN PART.

STATEMENT

By now, the story of stock-options backdating is familiar. A year ago, a series of articles noted extraordinary returns on stock options granted to officers, directors and employees of some companies. A suspiciously high number of options were ostensibly granted at times where stock prices were at periodic lows followed by sharp increases in price. Such patterns were particularly common in the high-technology sector. These articles noted that the chances of such exquisite timing were slimmer than winning the lottery, and for some company's patterns, much slimmer than winning the lottery several times over. Eventually it was determined that such buy-low-sell-high returns simply could not be the product of chance. In some instances, the grant dates were obviously backdated to maximize returns for the grantees and minimize the compensation expense reported by the company.¹

Normally, a company grants stock options to its officers, directors and employees at a certain exercise price giving the recipient the right to buy shares at that price (once the option has vested). If the stock price rises, the options have value. Once exercisable, the options are worth the difference between the exercise price and the current market price. If the stock price falls, the options are worthless. Options with an exercise price equal to the stock's price as of the grant date are referred to as "at-the-money" options. Those with an exercise price lower than the stock's market price are referred to as "in-the-money" options.

One key aspect is the financial reporting of options. For financial reporting purposes, companies granting in-the-money options have to recognize compensation expenses equal to the difference between the market price and the exercise price. No compensation costs need be recognized for at-the-money options, for the company does not forego any revenue by granting them. The motive for backdating is to avoid a "hit to the earnings," i.e., a compensation expense, while still awarding inthe-money options. Those responsible simply backdate the grants to a date where the stock price was attractively low and pretend that the grant was awarded on the earlier date rather than the real date. Since the paperwork shows that the exercise price is the same as the market price on the phony grant date, they pretend no need exists to recognize an expense.

The price on the true grant date, of course, is higher than the price on the phony grant date. The company is in effect granting in-the-money options without recognizing the attendant compensation expense. Because the company is underreporting its compensation expenses, the company's earnings appear higher than they truly are. The company also receives a lower price in exchange for the options than it would if the price were measured from the proper grant date.

Options pricing also has tax consequences. Under the so-called "million dollar rule," publicly-held companies do not pay taxes on the first one million dollars in non-incentive-based compensation paid to an employee. 26 U.S.C. 162(m). At-themoney options are incentive-based compensation. In-the-money options are not incentive-based compensation to the extent of the difference between the exercise price and the market price.

1. ZORAN CORPORATION.

On May 16, 2006, the Center for Financial Research and Analysis issued a report titled "Options Backdating — Which Companies are at Risk?" (Lee Decl. Exh. B). The report identified a number of companies concentrated in the high-technology sector at risk for having issued backdated stock options. Zoran was among them. The report identified three specific suspect grants. These were purportedly made on August 4, 1998, August 4, 1999, and September 19, 2001. Zoran responded in a press release dated May 23, 2006, stating that the company had conducted an internal investigation that had concluded that no grants were backdated (Compl. ¶ 71).

Nonetheless, Zoran formed a committee of outside directors on July 3, 2006, to investigate the company's historical options granting practices (Compl. ¶¶ 299-300). The committee consisted of directors David Rynne and Ray Burgess. The company also announced that it had received an informal inquiry from the SEC and the United States Attorney's Office regarding its options-granting practices (id. at ¶ 73). Because of the ongoing investigation, Zoran delayed in issuing its financial reports. This caused Zoran to be faced with possible delisting from the NASDAQ. As a result of Zoran's investigation, on December 22, 2006, Zoran's CEO Levy Gerzberg and CFO Karl Schneider made Form 4 filings with the SEC that repriced some options granted to them (id. at ¶ 80).²

The final results of Zoran's internal investigation were announced on February 20, 2007. A press release stated that there was no evidence of wrongdoing by any member of the company's senior management. Some grant dates, however, had been readjusted to reflect the correct measurement date. Moreover, contrary to the earlier statement, the press release revealed that "the dates of a small number of stock options grants to non-executives were established retroactively." Zoran eventually restated a number of its financial statements to reflect correct accounting methods. The company took a charge of between $12 million and $15 million against its earnings for the relevant time period (Lee Decl. Exh. C). Zoran filed a Form 8K to this effect on February 21, 2007. Zoran also filed its Form 10K for 2006 on April 20, 2007 (Lee Decl. Exh. A).

2. THE PARTIES.

Plaintiff Gerald del Rosario is a current holder of Zoran stock. He acquired his Zoran shares pursuant to Zoran's merger with Oak Technology, Inc., in August 2003 (Compl. ¶ 20).

Nominal defendant Zoran is incorporated in Delaware and is currently headquartered in Sunnyvale. Its stock is publicly traded on NASDAQ. Zoran provides products and services in the areas of highperformance digital entertainment and digital imaging (id. at ¶ 21).

Individual defendants are current and former officers and directors of Zoran. They are alleged to have received backdated stock options. All board-member defendants are alleged to have knowingly ratified or participated in granting backdated stock options. Additionally, all defendants are alleged to have contributed to the dissemination of false statements in financial statements, proxy statements and other SEC filings during their tenures at Zoran. For each individual defendant exercising stock options, plaintiff alleges that at least some of the options exercised were granted during the period in which backdating was taking place at Zoran between 1997 and 2006. For each individual defendant who sold Zoran shares during that time period, plaintiff alleges that those sales included shares obtained by exercising Zoran stock options. Plaintiff alleges that defendants received, money from the sale of Zoran stock. Plaintiff's allegations do not trace what portion of the proceeds is attributable to the exercise of allegedly backdated stock options.

A. Zoran's Board.

Defendants Levy Gerzberg, Uzia Galil, James A. Meindl, Philip Young, Arthur B. Stabenow, James B. Owens, Jr., David Rynne and Raymond A. Burgess were members of Zoran's board at the time the complaint was filed. All board members...