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St. Clair Shores General Employees Retirement System v. Eibeler

July 30, 2008

ST. CLAIR SHORES GENERAL EMPLOYEES RETIREMENT SYSTEM, PLAINTIFF,
v.
PAUL EIBELER, ET AL. DEFENDANTS.



The opinion of the court was delivered by: Shirley Wohl Kram, U.S.D.J.

OPINION AND ORDER

This litigation comes before the Court on a motion to dismiss filed by the Special Litigation Committee (the "SLC" or the "Committee") of the board of directors (the "Board") of Take-Two Interactive Software, Inc. ("Take-Two" or the "Company"). The SLC seeks dismissal of the derivative claims advanced by the plaintiff, St. Clair Shores General Employees Retirement System ("St. Clair"), on the grounds that the continued prosecution of these claims is not in Take-Two's best interests. Additionally, the SLC contends that St. Clair's purported direct claims are actually derivative in nature, and should be dismissed for failure to make a demand upon the Board. For the reasons that follow, the Court grants the SLC's motion to dismiss St. Clair's derivative claims, but denies the SLC's motion to dismiss St. Clair's purported direct claims.

I. BACKGROUND

Take-Two "develops, publishes and distributes interactive software games for personal computers, videogame consoles, and handheld videogame platforms." (Am. Compl. ("AC") ¶ 17.) The Company's premier product, the Grand Theft Auto line of video games, depicts "controversial" subject matter involving sex and violence. (AC ¶¶ 43-45.)

A. Factual Background of this Litigation

This litigation arises out of the leveling off and subsequent decline of Take-Two's share price in 2004 and 2005. The plaintiff, St. Clair, alleges that Take-Two enjoyed robust revenue growth (AC ¶ 47), coupled with a sharp increase in its share price (AC 15 graph; see also AC ¶ 46), in the years following the release of the initial installment of Grand Theft Auto in 1997 (AC ¶ 45). St. Clair's avers, however, that Take-Two's robust growth was founded at least in part upon fraudulent business and accounting practices, whose public revelation at the close of 2003, and throughout calendar years 2004 and 2005, caused the Company's share price to decline sharply. (AC ¶¶ 2-8.) These alleged fraudulent practices are manifold, but they fall into four basic categories: (1) the improper booking of sales on products that Take-Two knew would be returned; (2) the unlawful accounting for improperly-dated incentive options granted to Take-Two's officers and directors; (3) the wrongful institution of deficient internal financial controls; and (4) the mischaracterization of Take-Two's compliance with industry content-rating requirements for its video games. In the sections that follow, the Court outlines the contours of these four alleged fraudulent course of conduct.

1. The Channel-Stuffing Scheme

According to St. Clair, between October 31, 2000, and July 31, 2001, Take-Two engaged in a series of "parking" transactions in which certain of the Company's retail partners purchased Take-Two products at the end of fiscal periods, on the condition that Take-Two subsequently repurchase those products (the "Channel-Stuffing Scheme"). (AC ¶ 48.) The Channel-Stuffing Scheme produced a substantial overstatement of Take-Two's revenue (AC ¶ 48), which led the Securities and Exchange Commission (the "SEC") to conduct an informal investigation of the Company in November 2001 (AC ¶ 49). In February 2002, in response to the SEC's informal investigation and on the basis of a separate internal investigation conducted by Take-Two, the Company restated its financial results for fiscal years 2000 and 2001 (the "2002 Restatement"). (AC ¶ 50.) The 2002 Restatement eliminated some $26 million in improperly recognized net sales, and noted that the Company would take a $19 million charge to properly account for losses. (AC ¶ 51.) The 2002 Restatement also indicated that the SEC would pursue a formal investigation of Take-Two's financial reporting and accounting. (AC ¶ 52.)

The SEC's formal investigation ultimately culminated in Take-Two's announcement on December 18, 2003, that the SEC would pursue a civil enforcement action against the Company. (AC ¶¶ 53, 54.) The share price of Take-Two's stock dropped more than 8% in response to that announcement. (AC ¶ 55.)

2. The Options-Backdating Scheme

St. Clair also charges that several officers and directors of Take-Two participated in a fraudulent, options-backdating scheme, which caused the Company millions of dollars in losses (the "Options-Backdating Scheme"). (AC ¶ 79.) Take-Two's stock option plans generally required that incentive options awarded to the Company's officers and directors carry an exercise price no less than the fair market value of Take-Two stock on the grant date. (AC ¶¶ 90, 93.) Nonetheless, on December 11, 2006, Take-Two reported that a special committee of the Board had found "improprieties in the process of granting and documenting stock options," and had determined "that incorrect measurement dates for certain stock option grants were used for financial accounting purposes." (AC ¶ 79 (internal quotation marks omitted).) On February 28, 2007, Take-Two filed its 2006 Form 10-K and its 2007 Proxy Statement, which restated Take-Two's financials for the period spanning April 1997 through October 2005 in order to account for $42.1 million in unrecorded compensation expenses on improperly-dated options. (AC ¶¶ 82, 99, 102.) The 2007 Proxy Statement also reported that directors who had received backdated options--including defendants Todd Emmel ("Emmel"), Robert Flug ("Flug"), Oliver Grace ("Grace"), Steven Tisch ("Tisch"), and Mark Lewis--had agreed to cancel or re-price approximately 196,000 improperly-dated options. (AC ¶¶ 83-84.) St. Clair alleges, however, that these cancellations and re-pricings barely scratched the surface of the underlying wrongdoing at Take-Two, which may have involved as many as 1 million stock options. (AC ¶¶ 84, 94, 96.) St. Clair also avers that three of Take-Two's executive officers pleaded guilty to crimes relating to the Options-Backdating Scheme, and that the Company may face criminal charges as well. (AC ¶ 81.)

3. Deficient Financial Controls

St. Clair claims that the Channel-Stuffing and Options-Backdating Schemes were possible in part because of material weaknesses in the Company's financial controls. (AC ¶ 132.) Indeed, although Take-Two represented in the 2002 Restatement that it had strengthened its internal controls (AC ¶ 132), St. Clair avers that the Company continued to engage in channel stuffing during the period from 2002 through 2004 (AC ¶¶ 133, 143, 156). Moreover, St. Clair alleges that the weaknesses in Take-Two's internal controls enabled several other improper accounting practices, including, but not limited to, (1) overly aggressive revenue recognition and cost capitalization (AC ¶¶ 132, 142, 152); (2) inaccurate inventory management (AC ¶¶ 132, 142, 152); (3) the improper capitalization of software-development costs (AC ¶¶ 134, 144); (4) the understatement of write-offs, uncollectible accounts, returns, price concessions, discounts, and cooperative advertising (AC ¶¶ 142, 152, 158); (5) the improper classification of internal development costs as long-term development costs (AC ¶¶ 145, 154); and (6) the overstatement of goodwill (AC ¶ 157).

4. The Re-rating of GTA:SA

In addition to the financial and accounting manipulations outlined in the preceding sections, St. Clair further avers that Take-Two improperly marketed its leading video game, Grand Theft Auto: San Andreas ("GTA:SA"), under an inappropriate content rating. (AC ¶ 62.) The Entertainment Software Ratings Board (the "ESRB") is a self-regulatory body that "applies and enforces ratings, advertising guidelines, and online privacy principles adopted by the computer and video game industry." (AC ¶ 60.) When Take-Two submitted GTA:SA for rating prior to its public release in the fall of 2004 (AC ¶ 59), the Company failed to inform the ESRB that the game contained hidden, sexually explicit content (the "Sex Minigame") (AC ¶ 62). As a result, the ESRB assigned GTA:SA an "M" rating (AC ¶ 61), rather than the more restrictive "Adults Only 18" ("AO") rating, which would have prevented the game from being sold in some large retail outlets, including Wal-Mart and Target (AC ¶ 60).

In June 2005, a downloadable software program called the Hot Coffee Mod became widely available, allowing GTA:SA users to play the Sex Minigame. (AC ¶ 62.) Although the Company initially denied that it had created the Sex Minigame (AC ¶ 65), on July 20, 2005, a spokesperson for Take-Two conceded that programmers at Take-Two's subsidiary, Rockstar Games, Inc. ("Rockstar"), had created the relevant content (AC ¶ 68). On that same day, the ESRB announced that it would change GTA:SA's rating to AO on the grounds that the Sex Minigame was present on the game's disc "in a fully rendered, unmodified form." (AC ¶ 69.) The ratings change prompted several large retailers, including Wal-Mart, Best-Buy, and Target, to pull GTA:SA from their shelves. (AC ¶ 70.) Thereafter, Take-Two lowered its net sales guidance for the third fiscal quarter of 2005 from $170 million to $160 million, and revised its guidance for the fiscal year 2005 from $1.31 billion to $1.26 billion. (AC ¶ 71.) On July 26, 2005, Take-Two announced that the Federal Trade Commission (the "FTC") had commenced an investigation into the advertising for GTA:SA. (AC ¶ 73.) On July 29, 2005, Take-Two disclosed that two consumer class actions had been filed against the Company in connection with the GTA:SA scandal (AC ¶ 74). Also on July 29, 2005, Australia's Office of Film and Literature Classification revoked GTA:SA's classification, thereby foreclosing further advertising or sales of the game in Australia. (AC ¶ 74.) The events surrounding the re-rating of GTA:SA provoked a 13% decline in the value of Take-Two's stock between July 20, 2005, and July 26, 2005. (AC ¶ 75.)

B. Procedural History of this Litigation

St. Clair filed the original complaint (the "Complaint") in this matter on January 30, 2006. See 06 Cv. 688 (SWK), Dkt. No. 1. The Complaint advanced various claims arising out of the Channel-Stuffing Scheme (Compl. ¶¶ 33-43, 106), the re-rating of GTA:SA (Compl. ¶¶ 44-63, 110), and Take-Two's deficient internal controls (Compl. ¶¶ 65-83). On March 8, 2006, the Board established the SLC with one original member, Michael J. Malone ("Malone"), who had been named a Take-Two director in January 2006. On March 14 and March 24, 2006, respectively, John F. Levy ("Levy") and Grover C. Brown ("Brown") were appointed to the Board and named to serve on the SLC. Shortly thereafter, the SLC moved for a discovery stay, which the Court granted in an Opinion and Order filed on October 4, 2006. See St. Clair Shores Gen. Employees Ret. Sys. v. Eibeler, 06 Cv. 688 (SWK), 2006 WL 2849783 (S.D.N.Y. Oct. 4, 2006). On February 16, 2007, the SLC completed its Report, which concludes that the maintenance of the instant litigation is not in Take-Two's best interests. See 06 Cv. 688 (SWK), Dkt. No. 44.

On the basis of that Report, the SLC moved to dismiss the instant litigation on March 23, 2007. 06 Cv. 688 (SWK), Dkt. Nos. 42-44. In response, St. Clair propounded various discovery requests concerning the SLC's investigation. In an Opinion and Order filed on October 17, 2007, the Court resolved certain outstanding discovery disputes, granting St. Clair's request to compel SLC member Malone to sit for a deposition, but denying St. Clair's request to view all documents reviewed by the SLC. St. Clair Shores Gen. Employees Ret. Sys. v. Eibeler, 06 Cv. 688 (SWK), 2007 WL 3071837, at *1 (S.D.N.Y. Oct. 17, 2007). Meanwhile, St. Clair filed an amended complaint (the "AC") on August 24, 2007. See 06 Cv. 688 (SWK), Dkt. No. 50. In addition to supplementing the Complaint's allegations regarding the Channel-Stuffing Scheme, Take-Two's deficient internal controls, and the re-rating of GTA:SA, the AC adds claims arising out of the Options-Backdating Scheme. The AC, like the Complaint, advances both derivative and direct claims against various former Take-Two officers and directors: Counts I through VI of the AC plead derivative claims (the "Derivative Claims"), while Counts VII through XI plead direct claims for relief (the "Direct Claims").

Count I alleges that various Take-Two officers and directors*fn1 breached fiduciary duties owing to the Company by engaging in insider trading while in possession of material, nonpublic information. (AC ¶¶ 56-58; 201-04.) In particular, St. Clair claims that these defendants sold hundreds of thousands of shares of Take-Two stock while in possession of information about the likelihood that the SEC would bring an enforcement action in connection with the Channel-Stuffing Scheme. (AC ¶ 203.)

Count II alleges that several of the Company's officers and directors*fn2 breached fiduciary duties owing to Take-Two by selling shares of the Company's stock while in possession of material, nonpublic information regarding the presence of the Sex Minigame in GTA:SA's code, and the likely effect of the Sex Minigame on the GTA:SA's rating and ultimate marketability. (AC ¶¶ 76-78; 207.) Count VI further alleges that Take-Two officers and directors*fn3 breached their fiduciary duties by allowing the Company to submit GTA:SA to the ESRB without disclosing the presence of the Sex Minigame. (AC ¶¶ 225-26.)

Count III through V of the AC aver that various Take-Two officers and directors*fn4 violated Section 14(a) of the Securities Exchange Act (the "Exchange Act") and Rule 14a-9 thereunder by promulgating materially misleading proxy statements in order to secure shareholder approval of amendments to Take-Two's 2002 Stock Option Plan. (AC ¶¶ 210-23.) Counts III and IV allege that the 2003 and 2004 Proxy Statements failed to disclose material information concerning the Company's deficient internal controls, its improper capitalization of external development costs, and its ongoing perpetration of the Channel-Stuffing Scheme. (AC ¶¶ 211, 216.) Count V alleges that the 2005 Proxy Statement failed to disclose material information regarding these same matters, in addition to information concerning the evanescence of the Company's tax profits, the Company's overstatement of goodwill, its manipulation of discretionary account accruals, the reasons for the departure of the Company's Chairman, Richard Roedel, and the presence of the Sex Minigame in GTA:SA's code. (AC ¶ 221.)

Counts VII and VIII of the AC aver that several Take-Two officers and directors*fn5 breached their fiduciary duty to the putative class by omitting from the 2001 and 2002 Proxy Statements that certain officers had received backdated options, which caused Take-Two to overstate its net income. (AC ¶¶ 229-236.) St. Clair claims that these omissions infringed putative class members' right to cast an informed vote (AC ¶¶ 231, 238), and caused an unwarranted dilution of putative class members' ownership interest through the addition of millions of shares to the Company's 1997 Stock Option Plan. (AC ¶¶ 232, 239.)

Counts IX through XI of the AC allege that various Take-Two officers and directors*fn6 breached fiduciary duties owing to the putative class by issuing the 2003, 2004, and 2005 Proxy Statements, which omitted information about the Options-Backdating Scheme and the information set forth in Counts III through V. (AC ¶¶ 243, 250, 257.) St. Clair claims that these materially misleading proxy statements violated putative class members' right to cast an informed vote (AC ¶¶ 246, 253, 260), and diluted putative class members' ownership interest through the addition of shares to Take-Two's Stock Option Plans (AC ¶¶ 245, 252, 259).

On September 24, 2007, the SLC filed a motion to dismiss the newly-pleaded claims set forth in the AC, and renewed its motion to dismiss those claims that initially appeared in the Complaint. See 06 Cv. 688 (SWK), Dkt. Nos. 57-61. The SLC's motions to dismiss are the subject of the instant Opinion.

II.Discussion

"A special litigation committee has the power to terminate a derivative action to the extent allowed by the state of incorporation." Struogo v. Padegs, 27 F. Supp. 2d 442, 447 (S.D.N.Y. 1998) (citing Burks v. Lasker, 441 U.S. 471, 486 (1979)). Under the law of Delaware, Take-Two's state of incorporation, a special litigation committee may file a motion to dismiss derivative litigation based on its determination of the best interests of the corporation. See Zapata Corp. v. Maldonado, 430 A.2d 779, 788 (Del. 1981). Courts employ a two-step process to evaluate such a motion.

First, courts must "inquire into the independence and good faith of the committee and the bases supporting its conclusions." Id. In conducting this inquiry, courts should apply the standard that governs motions for summary judgment. Lewis v. Fuqua, 502 A.2d 962, 966 (Del. Ch. 1985). Accordingly, the special litigation committee bears the burden of showing the absence of any genuine issue of material fact concerning the independence of the committee's members, the good faith of its investigation, and the reasonableness of the bases for its conclusions. Kaplan v. Wyatt, 484 A.2d 501, 507 (Del. Ch. 1984). Second, courts may, in their discretion, apply their own business judgment to determine whether derivative litigation is in the corporation's best interests. Zapata, 430 A.2d at 789.

Here, the SLC has conducted an investigation of the Derivative Claims and has concluded that their continued prosecution is not in Take-Two's best interests. Therefore, the SLC requests that the Court dismiss the Derivative Claims in conformity with the standards set forth above. Additionally, the SLC contends that the Direct Claims are actually derivative in nature. Consequently, the SLC asks the Court to dismiss the Direct Claims for failure to make a demand on the Board. For the reasons that follow, the SLC has persuaded the Court that the Derivative Claims should be dismissed pursuant to Zapata. Nevertheless, the SLC has failed to show that the Direct Claims are subject to dismissal at this stage of the proceedings.

A. The Derivative Claims Are Dismissed

St. Clair challenges the independence of the SLC's members, the good faith of their investigation, and the reasonableness of the bases for their conclusions. Before addressing the independence, good-faith, and reasonableness factors, however, the Court must consider an antecedent issue. Under Delaware law, "the sole member of a one-person special committee [must] meet unyielding standards of diligence and independence." Sutherland v. Sutherland, Civ. A. 2399 (VCL), 2007 WL 1954444, at *3 n.10 (Del. Ch. July 2, 2007) (citations omitted). In the instant case, St. Clair contends that "Brown functioned as a one person committee investigating St. Clair's insider trading allegations and Levy functioned as a one person committee investigating St. Clair's accounting-based allegations," thereby necessitating stricter scrutiny of the SLC's request for dismissal. (Pl.'s Opp'n 12). The Court disagrees.

Brown testified that his investigation focused upon the AC's insider-trading allegations, which related to his legal training. (Pl.'s Opp'n, Declaration of Sidney S. Liebesman ("Liebesman Decl.") Ex. E, at 38.) Levy attested that his work concentrated on the AC's accounting-based allegations, which fell within his area of expertise. (Liebesman Decl. Ex. F, at 80.) Nevertheless, Levy and Brown testified that they had spoken frequently, and exchanged updates and drafts of their work throughout the SLC's investigation. (Liebesman Decl. Ex. E, at 37, 39-40; Liebesman Decl. Ex. F, at 77.) Although Malone did not play an active role in the SLC's investigation (Liebesman Decl. Ex. G, at 130), Malone testified that he attended two meetings of the SLC (Liebesman Decl. Ex. G, at 48-49, 51), and that he had reviewed drafts of the SLC's work and commented thereupon (Liebeman Decl. Ex. G, at 130-32.) Given that Brown and Levy actively participated in generating the Report, and that Brown, Levy, and Malone exchanged drafts and comments throughout the SLC's investigation, they comprised a three-person special litigation committee. The Court finds no occasion or authority to specify further the particular roles individual committee members must play in order for the committee to be treated as a multimember entity.

Accordingly, in evaluating the independence, good-faith, and reasonableness factors, the Court will not apply the more stringent scrutiny owing to single-member committees. Moreover, as the following sections demonstrate, the SLC has carried its burden of showing the absence of a triable issue regarding the Committee's independence and good faith, and the reasonableness of its conclusions. Because the Court declines to exercise its own business judgment to determine whether continued pursuit of the Derivative Claims is in Take-Two's best interests, the Court therefore dismisses the Derivative Claims.

1. The SLC's Members Are Independent

"[T]he question of independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind." In re Oracle Corp. Derivative Litig., 824 A.2d 917, 938 (Del. Ch. 2003) (quotation marks and citation omitted). In assessing a special litigation committee's independence, courts "investigate[] the members' personal interest in the disputed transactions, and 'scrutinize[] the members' relationship with the interested directors.'" Sutherland v. Sutherland, Civ. A. 2399 (VCL), 2008 WL ...


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