First came the probes of backdated stock option grants. Now come the lawsuits—dozens of them already, with many more inevitably on the way.

Winning those lawsuits, however, will be no easy task for shareholder activists and hungry plaintiff lawyers. Among the challenges they face: proving actual damages, getting around statutes of limitations, and showing that any wrongdoing was intentional.

“It’s going to be a case-by-case sort of thing. We just have to wait and see,” says Perrie Weiner, a partner with DLA Piper Rudnick Gray Cary. “The issues aren’t crystal clear.”

Freeman

The root of the problem, says William Freeman, head of the securities litigation practice at Cooley Godward, is that every company plans its compensation in its own way, so few sweeping statements can be made that apply to all. “You have to think about the fact that option backdating is not just one phenomenon,” he says. “There appears to be a range of behaviors, all the way from intentionally selecting a date to maximize the value of the option to casual, informal recordkeeping.”

Michael Piazza, a trial lawyer with Dorsey & Whitney, agrees that the merits of litigation over backdating are “going to be pretty fact-specific.” Much of the evidence in the cases is old; key personnel may have left the company or be otherwise unavailable.

At the same time, Piazza adds, plaintiffs do have some things in their favor. Foremost, U.S. attorneys across the country are conducting their own probes, obtaining information that might help plaintiff lawyers substantially should the documents become public. That the backdating scandal has exploded just as the Securities and Exchange Commission is emphasizing disclosure of executive compensation doesn’t hurt either.

“This is squarely in the crosshairs of regulators,” Piazza says. “That can’t be good for any company that finds itself in the position of defending [its] conduct.”

Obstacles In Plaintiff Litigation

Two types of lawsuits can be filed over backdating: private securities actions, brought by individual shareholders who claim they were misled by the company; and derivative claims, brought by shareholders seeking to recover on behalf of the corporation. Both, Freeman says, will be difficult battles for plaintiffs to fight.

Powers

An immediate hurdle in derivative lawsuits is “demand futility”—the legal principle that directors usually get first opportunity to address a problem before shareholders step in and sue on the company’s behalf. The board, says Marc Powers, a partner with Baker & Hostetler in New York, “has to decide whether it’s in the best interests of the company to go after the malefactors.” That principle generally gives boards time to investigate backdating allegations and decide on a course of action before shareholders hijack the company’s right to sue.

Both derivative and private securities suits will also need to prove actual damages. That could be tricky to do, especially in situations where backdating has not resulted in any financial restatements, Powers says. (Of the dozens of companies now ensnared in backdating probes—everyone from Apple Computer to Xilinx—so far less than 10 have announced restatements.)

“Where there has not been any kind of need for restatement because the effect is immaterial, there’s a real issue whether there’s any drop in price of stock or other damages flowing from this activity,” Powers says.

Statutes of limitations will also complicate the picture, Freeman says. When Sarbanes-Oxley was passed in 2002 it dramatically shortened the time to disclose equity-based compensation transactions—hence almost all backdating allegations refer to options granted in the 1990s. “Many of these claims are five, six and seven years old,” Freeman says. “I don’t think the recovery will be easy. A lot of these claims will be winnowed out by the statute of limitations and other issues.”

Hurdle Of Showing ‘Intent’

Wardell

The issue of scienter—intentional wrongdoing, and a key element to any successful securities litigation—will also be a barrier for shareholders who file private securities suits.

Tom Wardell, a lawyer with McKenna Long & Aldridge, says scienter will “undoubtedly … be an integral part of the case.” In particular, he says, some cases may well demonstrate that board members were not directly involved in granting stock options and did not know backdating was a potential problem.

RULE 9(b)

The Federal Rules Of Civil Procedure, promulgated by the U.S. Supreme Court, govern procedures for civil suits. The provision's "Rule 9(b)" has become especially important in recent years, as claims for fraud that do not satisfy its requirements for "particularity" must be dismissed. Below is an excerpt of the rule; we've included 9(a) and 9(c) as well:

Rule 9. Pleading Special Matters

(a) CAPACITY. It is not necessary to aver the capacity of a party

to sue or be sued or the authority of a party to sue or be sued in

a representative capacity or the legal existence of an organized association

of persons that is made a party, except to the extent required

to show the jurisdiction of the court. When a party desires

to raise an issue as to the legal existence of any party or the capacity

of any party to sue or be sued or the authority of a party

to sue or be sued in a representative capacity, the party desiring

to raise the issue shall do so by specific negative averment, which

shall include such supporting particulars as are peculiarly within

the pleader’s knowledge.

(b) FRAUD, MISTAKE, CONDITION OF THE MIND. In all averments of

fraud or mistake, the circumstances constituting fraud or mistake

shall be stated with particularity. Malice, intent, knowledge, and

other condition of mind of a person may be averred generally.

(c) CONDITIONS PRECEDENT. In pleading the performance or occurrence

of conditions precedent, it is sufficient to aver generally

that all conditions precedent have been performed or have occurred.

A denial of performance or occurrence shall be made specifically

and with particularity...

Source

The Federal Rules Of Civil Procedure (Dec. 31, 2004; See Page 35)

Scienter “is always going to be an issue in any private securities litigation,” adds Powers, citing the heightened pleading requirement under the Public Securities Litigation Reform Act and Rule 9(b) of the Federal Rules Of Civil Procedure (see below, right). That rule requires that defendants had a motive and opportunity to take some improper action, rather than merely waiting to finish some paperwork a week or two later.

Shearer

Robert Shearer, another lawyer at Baker Hostetler, notes that most companies will find instances where the timing of board or committee approval of an options grant doesn’t match with the date of the grant. “All companies have to go back and do this investigation,” he says. “Someone else is going to be looking at their records so [the companies] should convene teams and look back first … Most likely companies will find a one- or two-week difference in timing caused by paperwork,” rather than some nefarious intent.

One of the biggest risks for a company, Weiner says, is that the government will require it to turn over the results of internal investigations to demonstrate cooperation when prosecutors decide what sort of enforcement action to take, if any. Releasing the results of an investigation carries the risk that plaintiff lawyers will say privacy privileges have been waived and that they are entitled to the investigation results, too. That report can then serve as a blueprint for private plaintiffs in litigation against the company.

Weiner

Weiner, at DLA Piper Rudnick Gray Cary, hopes the SEC will not overdo its enforcement activities. “I think there’s more harm to shareholders in the revelation of this practice than in the practice itself,” he says. “It would be wonderful if the SEC would show some prosecutorial restraint, rather than punishing activities that happened a long time ago. The only ones who are going to be hurt if they do that are the shareholders.”

The SEC has not taken any enforcement actions so far based specifically on backdated stock options, although several companies have forced their chief executives and other high-level officers to resign after internal probes uncovered backdating practices.

In any event, companies with backdating issues shouldn’t expect the problem to go away anytime soon. The issue “is going to be around for a long time,” Piazza says. “The SEC investigations alone will take months if not a year or more.”