In “Spring-Loaded” Options Case, Court Finds Failure to Disclose Board’s “Unclean Heart” Does Not Violate Federal Securities Laws But Allows Common Law Fiduciary Duty Claims to Proceed Against Directors Approving Options

In a far-reaching opinion addressing a host of issues relating to the granting of so-called “spring-loaded” stock options to a corporation’s board of directors, the District of New Jersey dismissed a claim under Section 14(a) of the Exchange Act because federal securities laws do not require the corporation to disclose in its proxy statement that the options were part of a “spring-loading” scheme. But the court allowed common-law breach of fiduciary duty claims to proceed against the directors who served on the board’s compensation committee under the entire-fairness doctrine.

A “spring-loaded” stock option is an option that is issued just before the company is to announce positive news that will increase its share price. If the strike price for the options is set at the share price at the time the option is issued, then the recipients of the options will be quickly “in the money” when the positive news is announced and the share price increases.

On March 30, 2015, the board of Advaxis, Inc. approved a new equity-incentive plan for its members. The approval of the plan was subject to shareholder approval, which was obtained nearly two months later at an annual shareholder meeting. Also on March 30, 2015, the board’s compensation committee issued more than 1 million stock options to the company’s directors and officers, pursuant to the new incentive plan. The next month, the company made three positive public announcements, causing the company’s shares to increase more than 75%, thereby generating for the recipients of the stock options millions of dollars in “paper profits.”

A shareholder sued the company and its board, alleging a violation of section 14(a) of the Securities Exchange Act (and related regulations) in that the proxy statement the company filed seeking shareholder approval of the incentive compensation plan was materially misleading. The suit also alleged that the members of the board breached their fiduciary duties by issuing the spring-loaded options.

The essence of the shareholder’s alleged Section 14(a) violation was that the directors failed to disclose in the proxy statement that the incentive compensation plan was part of a nefarious scheme to award themselves with spring-loaded options. In particular, the complaint alleged that the proxy statement was materially false and misleading in two ways: 1) by asserting that the incentive compensation plan would promote “sound corporate governance,” when in fact the plan was intended to enrich the directors through a spring-loaded option scheme, and 2) by stating that options could not be granted for less than the stock’s fair market value on the grant date, when in fact the board knew that the share price would soon increase substantially on the disclosure of positive news.

The District Court dismissed the Section 14(a) claim, reasoning that “corporate officers and directors do not violate federal securities law by failing to disclose a bad motive or scheme underlying their actions [because] the unclean heart of a director is not actionable.”

As for the fiduciary duty claim, the court held first that the only directors engaged in self-dealing were those on the compensation committee that approved the grant of the options. Those directors thus were subject to an entire-fairness standard, while the remaining members of the board were subject to a traditional business-judgment standard. While the business-judgment rule typically applies when shareholder ratification of a grant of equity to company directors is under review, that principle of Delaware law did not apply to the committee directors because the shareholders approved the overall incentive plan, not the specific grants of options that the committee made under the plan. In addition, because the complaint sufficiently alleged that the grants were not made in compliance with the shareholder-approved plan, the court held that the complaint sufficiently alleged that the shareholders had not ratified, explicitly or implicitly, the grant of the options.

In sum, the court allowed the suit against the committee directors to proceed for a determination whether they could meet their burden of showing the fairness of the issuance of the options. The court dismissed the case without prejudice against the remaining directors, however, finding that the shareholder failed to overcome the presumption of the business-judgment rule in that the complaint lacked facts showing that they knew or, absent reckless conduct, should have known that the option grants violated the board’s incentive compensation plan.

This case serves as a reminder of courts’ reluctance to apply federal securities laws to matters of corporate governance. It also serves as a reminder of the importance of obtaining shareholder approval of specific grants of equity to management.

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