Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty and Unjust Enrichment Related to Stock Option Repricing | Practical Law

Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty and Unjust Enrichment Related to Stock Option Repricing | Practical Law

In Howland v. Kumar, the Delaware Chancery Court ruled that the plaintiff's derivative action largely survived a motion to dismiss because it is reasonably conceivable that several directors and officers of Anixa Biosciences, Inc. breached their fiduciary duties and were unjustly enriched by delaying the announcement of a key patent's issuance, permitting the repricing of the defendants' stock options for their benefit before the public announcement was made.

Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty and Unjust Enrichment Related to Stock Option Repricing

by Practical Law Employee Benefits & Executive Compensation
Published on 17 Jun 2019 • USA (National/Federal)
In Howland v. Kumar, the Delaware Chancery Court ruled that the plaintiff's derivative action largely survived a motion to dismiss because it is reasonably conceivable that several directors and officers of Anixa Biosciences, Inc. breached their fiduciary duties and were unjustly enriched by delaying the announcement of a key patent's issuance, permitting the repricing of the defendants' stock options for their benefit before the public announcement was made.
On June 13, 2019, in Howland v. Kumar, the Delaware Chancery Court ruled that the plaintiff stockholder's derivative action against several directors and officers of the publicly traded biotechnology company Anixa Biosciences, Inc. (Anixa) survived the defendants' motion to dismiss because:
  • It is reasonably conceivable that the defendants breached their fiduciary duties and were unjustly enriched by delaying the public announcement of the issuance of an important patent to a subsidiary of Anixa, permitting the repricing of the defendants' stock options at an artificially low exercise price, to the financial benefit of the directors and officers.
  • Demand is excused because a majority of the company's board of directors in office when the complaint was filed was interested by virtue of having received the repriced options.
( (Del. Ch. June 13, 2019).)

Background

At the heart of this case is the timing of several actions by certain directors and officers of Anixa.
Anixa develops biotechnology used to diagnose and fight cancer. To protect its technology, it filed patent applications with the United States Patent and Trademark Office (USPTO). On May 10, 2017, Anixa issued a press release announcing that the USPTO issued a Notice of Allowance on the first of Anixa's patent applications. Anixa's stock price increased by 48% on May 10, closing at $1.70, but it steadily declined afterward and reached a price of $0.84 by the end of May.
The USPTO issued the patent (the '783 Patent) to Anixa on August 22, 2017, at which time the stock options held by Anixa's directors and officers were underwater. The board then called a special meeting of the compensation committee to consider a proposal to reprice certain stock options. The compensation committee met on September 6, 2017, and approved the repricing of 2,029,600 stock options (nearly 95% of which belonged to Anixa's directors or officers) to $0.67, which was the closing price of Anixa stock on that day. (The original strike prices ranged from $0.82 to $5.30.)
On September 8, 2017, Anixa filed a Form 10-Q with the SEC, publicly disclosing the stock option repricing. On September 18, 2017, Anixa issued a press release publicly announcing the issuance of the '783 patent. In the weeks that followed, the price and trading volume of Anixa stock increased significantly. The stock price increased from $0.69 on September 15, 2017 (the day before the press release publicly announcing the patent) to a peak of $4.99 on September 26, 2017. In October 2017, two board members exercised thousands of repriced stock options.
The plaintiff, an Anixa stockholder, filed the derivative action against several directors and officers, alleging that they:
  • Breached their fiduciary duties by delaying the public announcement of the issuance of the '783 Patent to permit the repricing of their stock options before the announcement was made, which had the effect of repricing the options at an artificially low exercise price for the individual defendants' financial benefit.
  • Were unjustly enriched by the 2017 repricing.
The defendants moved to dismiss the plaintiff's complaint under Delaware Court of Chancery Rules 12(b)(6) and 23.1.

Decision

The Chancery Court held that:
  • The plaintiff's claims for breach of fiduciary duty and unjust enrichment survived (with one exception) the defendants' motion to dismiss.
  • The plaintiff adequately pled demand excusal under Chancery Court Rule 23.1

Breach of Fiduciary Duty

Under Delaware law, a corporate officer or director can breach fiduciary duties in the compensation context either by:
  • Accepting compensation that is clearly improper.
  • Wrongfully influencing compensation decisions.
Furthermore, the essence of a duty of loyalty claim is that a corporate officer or director misused corporate property or processes to benefit himself instead of the corporation.
Accepting the well-pleaded allegations in the plaintiff's complaint as true, and drawing all inferences in favor of the plaintiff, the Chancery Court held that it is reasonably conceivable that each of the individual defendants (except one) breached their fiduciary duty of loyalty by misusing corporate information and processes to benefit themselves rather than Anixa. It is reasonable to infer from the facts alleged that the defendants delayed publicly announcing the patent's issuance (which was material, as demonstrated by the increase in stock price that followed the announcement) to further their financial interests.
Since two of the board members (who were also compensation committee members) approved their own compensation under the stock option repricing, the court held that they rendered themselves interested in the transaction, and therefore the entire fairness standard of review applies to the case, as it did in Calma v. Templeton, where the members of the compensation committee approved their own compensation and that of other non-employee directors (114 A.3d. 563 (Del. Ch. 2015); see Legal Update, Delaware Court of Chancery Applies Entire Fairness to Breach Claim Relating to Non-Employee Director Equity Awards). The court noted that the possibility that the entire fairness standard of review may apply precludes dismissal of a complaint under Rule 12(b)(6).
The court held that the plaintiff adequately alleged facts sufficient to support an inference that the stock option repricing was the product of an unfair process, and that the process affected the stock price. Therefore, the court denied the defendants' motion to dismiss as to all defendants except for one, an officer of Anixa, because the complaint provides no basis to infer wrongdoing on his part.

Unjust Enrichment

Regarding the claim that the individual defendants were unjustly enriched by the repricing, the Chancery Court held that the complaint alleges facts sufficient to support the elements of an unjust enrichment claim. Specifically, the facts support an inference:
  • Of an enrichment because on any given date after the repricing, each individual defendant was enriched by each repriced option he held by at least the difference between:
    • the lower of Anixa's trading price and the option's original strike price; and
    • the $0.67 strike price set by the repricing.
  • Of an impoverishment, because Anixa suffered a $261,000 non-cash charge as a result of the repricing.
  • Of a direct relationship between the alleged enrichment and the impoverishment because the complaint alleges that the purpose of the repricing was to provide a financial benefit to the individual defendants at the expense of Anixa and its non-employee stockholders.
  • That the individual defendants acted without justification.

Demand Excusal

Under Court of Chancery Rule 23.1, before a plaintiff can bring a derivative action, he must either:
  • Make a demand on the board before filing its complaint.
  • Allege with particularity that demand on the board would be futile and therefore the failure to make a demand should be excused.
The plaintiff in Howland asserted that the pre-suit demand was excused as a matter of law.
To determine whether demand was excused, the court applied the Rales test for reviewing board inaction (Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993)). Under Rales, the plaintiff must allege facts that create a reasonable doubt that the board could have exercised its independent and disinterested business judgment when responding to the shareholder's demand. In Howland, the plaintiff claimed that four of the five board members were interested because they held stock options affected by the repricing.
The defendants argued that:
  • The Anixa directors should not be considered interested solely because they received compensation from the company.
  • An Anixa director who did not participate in a challenged decision should only be deemed interested if his compensation is material to him.
The defendants contended that three of the five members of the board in place at the time the plaintiff filed the complaint did not participate in the challenged repricing decision, and therefore the plaintiff's complaint must, but does not, plead that the repricing provided material benefits to those three directors.
The court rejected the defendant's argument because the plaintiff alleged facts from which it is reasonable to infer that the repricing generated material benefits of approximately $1.7 million and $70,000, respectively, for two of the directors who did not participate in the contested decision. It is reasonably conceivable that these amounts were material to the directors who received them. Furthermore, two of the directors did participate in the challenged decision, and therefore they are deemed interested without regard to whether they benefited materially from the repricing.
Because the plaintiffs alleged that four of the five members of the demand board were interested in the repricing, demand was excused.

Practical Implications

While it remains to be seen how this case will ultimately be decided, Howland v. Kumar is an important reminder for boards of directors and compensation committees to be careful about the timing of decisions to reprice stock options held by directors and officers, particularly if a significant development that could materially affect the company's stock price is either about to occur or has occurred and has not yet been publicly announced.