Lewis v. Vogelstein

• Decision Date: 29 October 1996
• Docket Number: No. 14954,14954
• Citation: 699 A.2d 327
• Parties: 22 Employee Benefits Cas. 1052 Harry LEWIS, Plaintiff, v. John L. VOGELSTEIN, Edward H. Malone, William D. Rollnick, John W. Amerman, Jill E. Barad, Harold Brown, James A. Eskridge, Tully M. Friedman, Ronald M. Loeb, Edward N. Ney, Christopher A. Sinclair and Mattel, Inc., Defendants. Civil Action . Submitted:
• Court: Court of Chancery of Delaware

Page 327

699 A.2d 327

22 Employee Benefits Cas. 1052

Harry LEWIS, Plaintiff, v. John L. VOGELSTEIN, Edward H. Malone, William D. Rollnick, John W. Amerman, Jill E. Barad, Harold Brown, James A.

Eskridge, Tully M. Friedman, Ronald M. Loeb, Edward N. Ney,

Christopher A. Sinclair and Mattel, Inc., Defendants.

Civil Action No. 14954.

Court of Chancery of Delaware,

New Castle County.

Submitted: Oct. 29, 1996.

Decided: March 7, 1997.

Revised: March 11, 1997.

Joseph A. Rosenthal, and John G. Day, of Rosenthal, Monhait, Gross & Goddess, P.A., Wilmington; A. Arnold Gershon, P.C., New York City, Of Counsel, for Plaintiff.

Daniel A. Dreisbach, and Luke E. Dembosky, of Richards, Layton & Finger, Wilmington, for Defendants.

ALLEN, Chancellor.

This shareholders' suit challenges a stock option compensation plan for the directors of Mattel, Inc., which was approved or ratified by the shareholders of the company at its 1996 Annual Meeting of Shareholders. Two claims are asserted.

First, and most interestingly, plaintiff asserts that the proxy statement that solicited shareholder proxies to vote in favor of the adoption of the 1996 Mattel Stock Option Plan ("1996 Plan" or "Plan") was materially incomplete and misleading, because it did not include an estimated present value of the stock option grants to which directors might become entitled under the Plan. Thus, the first claim asserts that the corporate directors had, in the circumstances presented, a duty to disclose the present value of future options as estimated by some option-pricing formula, such as the Black-Scholes option-pricing model. ¹

Second, it is asserted that the grants of options actually made under the 1996 Plan did not offer reasonable assurance to the corporation that it would receive adequate value in exchange for such grants, and that such grants represent excessively large compensation for the directors in relation to the value of their service to Mattel. For these reasons, the granting of the option is said to constitute a breach of fiduciary duty.

On this motion, this substantive liability theory is also pressed as an "entire fairness" claim. Plaintiff maintains that because the Plan constitutes a self-interested transaction by the incumbent directors, all of whom qualify for grants under the 1996 Plan, they must justify it as entirely fair in order to avoid liability for breach of loyalty, which it is said they cannot do. As shown below, this approach does not constitute a different claim than that stated above.

Pending is defendants' motion to dismiss the complaint for failure to state a claim upon which relief may be granted. A motion of this type may be granted only when it appears reasonably certain that plaintiff would not be entitled to the relief requested, even if all the facts as stated in the complaint are true and all inferences fairly inferable from those allegations are drawn in plaintiff's favor. Rabkin v. Philip A. Hunt Chem. Corp., Del.Supr., 498 A.2d 1099 (1985).

For the reasons set forth below I conclude that there is no legal obligation for corporate directors who seek shareholder ratification of a plan of officer or director option grants, to make and disclose an estimate of present value of future options under a plan of the type described in the complaint. There is, therefore, no basis to conclude that failure to set forth such estimate constitutes a violation of any board obligation to set forth all material facts in connection with a ratification vote. Second, I conclude that the allegations of the complaint are not necessarily inconsistent with a conclusion that the 1996 Plan constitutes a waste of corporate assets. Thus, the complaint may not be dismissed as failing to state a claim.

I.

The facts as they appear in the pleading are as follows. The Plan was adopted in 1996 and ratified by the company's shareholders at the 1996 annual meeting. It contemplates two forms of stock option grants to the company's directors: a one-time grant of options on a block of stock and subsequent, smaller annual grants of further options.

With respect to the one-time grant, the Plan provides that each outside director will qualify for a grant of options on 15,000 shares of Mattel common stock at the market price on the day such options are granted (the "one-time options"). The one-time options are alleged to be exercisable immediately upon being granted although they will achieve economic value, if ever, only with the passage of time. It is alleged that if not exercised, they remain valid for ten years. ²

With respect to the second type of option grant, the Plan qualifies each director for a grant of options upon his or her re-election to the board each year (the "Annual Options"). The maximum number of options grantable to a director pursuant to the annual options provision depends on the number of years the director has served on the Mattel board. Those outside directors with five or fewer years of service will qualify to receive options on no more than 5,000 shares, while those with more than five years service will qualify for options to purchase up to 10,000 shares. ³ Once granted, these options vest over a four year period, at a rate of 25% per year. When exercisable, they entitle the holder to buy stock at the market price on the day of the grant. According to the complaint, options granted pursuant to the annual options provision also expire ten years from their grant date, whether or not the holder has remained on the board.

When the shareholders were asked to ratify the adoption of the Plan, as is typically true, no estimated present value of options that were authorized to be granted under the Plan was stated in the proxy solicitation materials.

II.

As the presence of valid shareholder ratification of executive or director compensation plans importantly affects the form of judicial review of such grants, ⁴ it is logical to begin an analysis of the legal sufficiency of the complaint by analyzing the sufficiency of the attack on the disclosures made in connection with the ratification vote.

A. Disclosure Obligation:

I first note a preliminary point: The complaint's assertion is not simply that the ratification of the 1996 Plan by the Mattel shareholders was ineffective because it was defective. If that were the whole of plaintiff's theory, the effect of any defect in disclosure under it would be only to deny to the board the benefits that ratification bestows in such a case. See In re Wheelabrator Tech., Inc. Shareholders Litig., Del.Ch., 663 A.2d 1194 (1995). The thrust of the allegation, however, is that in seeking ratification and in, allegedly, failing fully to disclose material facts, the board has committed an independent wrong. Despite the fact that shareholder approval was not required for the authorization of this transaction and was sought only for its effect on the standard of judicial review, there is language in Delaware cases dealing with "fair process", suggesting that a misdisclosure may make available a remedy, even if the shareholder vote was not required to authorize the transaction and the transaction can substantively satisfy a fairness test. Cf. In re Tri-Star Pictures, Inc., Litig., 634 A.2d 319, 333 (1993) (nominal damages available for misdisclosure in all events.) ⁵

In all events, in this instance, the theory advanced is that the alleged non-disclosure itself breaches a duty of candor and gives rise to a remedy. The defect alleged is that the shareholders were not told the present value of the compensation to the outside directors that the Plan contemplated i.e., the present value of the options that were authorized. It is alleged that the present value of the one-time options was as much as $180,000 per director and that that "fact" would be material to a Mattel shareholder in voting whether or not to ratify the board's action in adopting the 1996 Plan. According to plaintiff, the shareholders needed to have a specific dollar valuation of the options in order to decide whether to ratify the 1996 Plan. Such a valuation could, plaintiff suggests, be determined by application of formulas such as the widely-used option-pricing model first devised by Professors Fischer Black and Myron Scholes. ⁶ Plaintiff urges that this court should hold that because no such valuation was provided to the shareholders, the proxy statement failed to disclose material matter and was, therefore, defective.

B. Disclosure of Estimated Present Value of Options to be Granted:

Estimates of option values are a species of "soft information" that would be derived from sources such as the specific terms of a plan (including when and for how long options are exercisable), historical information concerning the volatility of the securities that will be authorized to be optioned, and debatable assumptions about the future. Permissible and mandated disclosure of "soft information"--valuation opinions and projections most commonly--are problematic for federal and state disclosure law. ⁷ Such estimates are inherently more easily subject to intentional manipulation or innocent error than data concerning historical facts. Such estimates raise threats to the quality and effectiveness of disclosure not raised by disclosure of historical data.

As the terms of the options granted under the 1996 Plan demonstrate, option-pricing models, when applied to executive or director stock options, are subject to special problems. Significant doubt exists whether the Black-Scholes option-pricing formula, or other, similar option-pricing models, provide a sufficiently reliable estimate of the value of options with terms such as those granted to the outside directors of Mattel. ⁸

First, the Black-Scholes formula assumes that the options being valued are issued and publicly traded. Publicly-traded options have certain common characteristics that are important in assessing their value. Steven Huddart & Mark Lang, Employee Stock Exercises: An...