In April 2006, a shareholder derivative action, alleging stock options backdating violations, was filed against certain directors and officers of Comverse Technology. The defendants moved to dismiss this litigation on demand futility grounds.
The Trial Court’s Dismissal
The New York trial court first applied the pleading standard for surviving a demand futility challenge enunciated by the New York court of appeals in Marx v. Akers, 88 N.Y.2d 189 (1996). Under Akers, shareholder derivative plaintiffs (who are technically acting on behalf of the company) may proceed with derivative claims, without demonstrating that they first attempted to persuade the board to themselves initiate such an action, if they plead that (1) the majority of the company’s directors are interested in the conduct at issue; (2) the directors failed to properly investigate the conduct at issue; or (3) the directors failed to exercise their business judgment in approving the conduct at issue. The trial court found that the plaintiffs sufficiently alleged that Comverse’s directors failed to exercise reasonably appropriate oversight of the stock options backdating process (prong no. 2) and that “the approval of a decade’s worth of backdated stock options simply does not qualify as a legitimate exercise of business judgment” (prong no. 3).
However, the New York trial court nevertheless granted the defendants’ motion to dismiss because it found that Comverse’s appointment of a special litigation committee before the shareholder litigation was commenced evidenced “the board’s willingness to take the actions necessary to protect the interests of the corporation.”
The First Department’s Decision
The First Department agreed with the trial court’s conclusion that the plaintiffs should survive a demand futility challenge based on the Akers factors. However, the First Department rejected the trial court’s ultimate conclusion and held that the creation of a SLC does not, in itself, necessarily demonstrate that a board is willing to take all necessary and appropriate actions on behalf of the company.
In support of its conclusion, the appellate court noted that the facts at the motion to dismiss phase did not demonstrate the board’s willingness to take all necessary actions on behalf of Comverse. The court specifically noted that one of the two members of Comverse’s SLC, Mr. Ron Hiriam, had been a member of the compensation committee and had allegedly failed to adequately oversee the awarding of stock options. The court further noted that the SLC had permitted one of Comverse’s terminated directors to retain backdated options. Most significantly, the First Department emphasized that although the SLC initially took action against Kobi Alexander and two other directors and officers, it did not officially terminate these individuals until after the SEC had taken actions against these individuals. Thus, the court stated that the SLC’s acts were “acts that in any event the board was essentially forced to take in the wake of the initial reporting and the subsequent SEC investigation and criminal prosecutions against those individuals.”