U.S. Charges 2 in Stock Option Case
In a case that struck fear in Silicon Valley, federal authorities Thursday filed the first of what could be a barrage of criminal and civil charges against technology company executives for allegedly manipulating stock option grants to make them more lucrative for employees.
The unfolding scandal over stock options -- a recruiting tool that was the ticket to riches for countless technology-industry employees over the last two decades -- is quickly becoming a major corporate black eye, just four years after the Enron Corp. accounting debacle.
The U.S. attorney in San Francisco accused two former Brocade Communications Systems Inc. executives of routinely giving options to employees from 2000 to 2004 at terms that guaranteed an immediate paper gain for the recipients.
An option is the right to buy a stock for a set amount -- the exercise price -- within a certain period of time. Normally, the exercise price is the stock’s market price on the day the option is granted. The practice alleged by prosecutors, known as backdating, would essentially cherry-pick, after the fact, favorable exercise prices for the options, authorities said.
The alleged backdating at San Jose-based Brocade was fraudulent, authorities said, because it was concealed from shareholders and because it involved falsifying documents and inflating Brocade’s earnings.
The criminal complaints were filed against Gregory L. Reyes, Brocade’s former chief executive, and Stephanie Jensen, former vice president of human resources. The Securities and Exchange Commission on Thursday filed civil charges against Reyes, Jensen and Antonio Canova, Brocade’s former chief financial officer.
Highlighting regulators’ intense focus on the issue, SEC Chairman Christopher Cox joined U.S. Atty. Kevin Ryan at a news conference here to announce the charges. Cox said the SEC was investigating the option practices of more than 80 companies.
“There are a fair number that are based in Silicon Valley, but there are many throughout the country,” said SEC Enforcement Director Linda Thomsen said.
Indeed, dozen of companies already have disclosed that they are under investigation.
Thomsen predicted more civil cases, and Ryan said a task force his office had formed was weighing additional criminal charges.
University of Iowa Professor Erik Lie, whose 2005 study pointed to widespread backdating of options, has estimated that hundreds of companies may have engaged in the practice as they sought to reward employees.
The case against Brocade, a maker of switches that help manage data storage, is likely to cause deep consternation in Silicon Valley as executives and companies face the once-unimaginable prospect of criminal charges and jail time if guilt is proved, some attorneys said.
Significantly, prosecutors did not allege that the Brocade executives enriched themselves -- merely that they enriched other employees.
“There are a number of boardrooms on the West Coast that are having ‘oh no’ moments right now,” said Scott Meyers, a securities lawyer at Levenfeld Pearlstein in Chicago.
In the criminal case against Reyes and Jensen, the government alleges that the executives backdated meeting minutes of a committee of Brocade’s directors “so that it appeared that the committee met and stock options were granted and priced at the market value of Brocade’s stock on dates when the value of the stock was relatively low, when in fact no such meetings occurred and the options were not granted on those dates.”
The executives also backdated employment-offer letters and other personnel records for some new employees so that those employees could get stock option grants at attractive prices that predated their actual employment at Brocade, prosecutors alleged.
In the process of backdating options, Reyes and Jensen misrepresented Brocade’s financial data and made false filings with the SEC, the government said.
In its civil case, the SEC said the majority of Brocade’s more than 1,000 employees had bogus dates attached to at least one option grant. And Reyes had the power to grant options and pick the award dates himself, forming a one-person compensation “committee,” the SEC said.
After an internal review of its option grants, Brocade in 2005 twice restated earnings for previous years to properly account for the grants. Profit for 1999 to 2001, for example, was slashed by $304 million.
Reyes, 43, resigned as CEO in January 2005, but remained an advisor to the company until July of that year. Jensen, 48, left in February 2004 but remained an advisor to the firm until August of that year.
Reyes’ attorney, Richard Marmaro of the law firm Skadden, Arps, Slate, Meagher & Flom, said in a statement that Reyes “is innocent, and we will prove his innocence in a court of law.”
Reyes “is not even alleged to have granted himself any of the options at issue in the case, nor is there any allegation that he made any money through the alleged option irregularities,” Marmaro said.
But Ryan, the U.S. attorney, said prosecutors “don’t have to show personal gain necessarily.” The government is “prepared to establish the motivations and the materiality” of the fraud through other means, such as the concealment of millions of dollars in expenses, he said.
Jensen’s lawyer, Jan Nielsen Little, also proclaimed her client’s innocence, saying Jensen “had no responsibility for finance or accounting. These charges are completely wrong-headed.”
The maximum sentence for criminal securities fraud as alleged by prosecutors is 20 years in prison and a fine of $5 million, plus restitution.
An attorney for Canova could not be reached Thursday. In its civil case against the 44-year-old Canova, the SEC alleged that he learned of the backdating practices but failed to advise the company’s auditors.
The technology industry is a key focus of regulators’ backdating probes because stock options long have been a common form of compensation for tech executives and rank-and-file employees.
As the industry boomed in the 1990s, up-and-coming companies often couldn’t afford to pay lavish salaries to staff, but they could offer stock options.
If the stock’s market price soared, employees could buy the shares at the exercise price from the company and sell them in the market for a capital gain.
Backdating can be a legal practice, but only if it’s properly disclosed and accounted for.
Under accounting rules in effect at the time of the alleged Brocade fraud, the company did not have to record the value of options granted as an expense if the exercise price of the options was the same as the stock’s market price on the day of the grant.
But if the options were backdated so that the recipient had an automatic paper gain at the time of the actual grant, the rules required the company to record that gain as a compensation expense, thus reducing profit.
Because option expensing amounts to an accounting entry -- as opposed to a cash outlay -- the technology industry contended for many years that there was no reason to formally count options as a compensation cost. Although the expense is noncash, heavy issuance of options can hurt shareholders by diluting their ownership of the company, and by reducing earnings per share, as profit is spread over a larger number of shares.
Keith Bishop, former California corporations commissioner and now a partner at the law firm of Buchalter, Nemer, Fields & Younger, said he believed the tech industry got caught in a grey area of the law.
“I think there was a lot of ambiguity under the accounting standards and many of the option plans, in general,” he said. He contends that the SEC and the Justice Department are changing the law retroactively.
“By and large, I think it’s unfair to come back and say that we are going to put somebody in jail because we have now decided to focus and rewrite some rules that were never clearly written,” Bishop said.
In Silicon Valley, stock options were the ticket to great wealth in the boom years of the 1990s, as stocks of many tech companies rocketed. That made option awards a key recruiting tool.
“During a time when competition was extremely high in Silicon Valley for employees, [Reyes] awarded options to new and current employees of the company -- from receptionists to engineers -- to attract and retain talent,” Marmaro said.
“All he did was what his board authorized him to do,” he said.
Timothy J. Coleman, a former Justice Department lawyer who supervised the Enron Task Force and the criminal fraud section, said he believed that prosecutors “wanted to make an example out of Brocade and its top executives, and they believe they have a strong case against a chief executive officer.”
Reyes became Brocade’s chief in 1998. The company went public in 1999. Its stock soared from $2.38 at the offering price to as high as $133 in 2000, before crashing with the general plunge in tech shares. The stock closed at $5.91 on Thursday, down 11 cents.
Reyes comes from a family of technology entrepreneurs. His uncle, George Reyes, is chief financial officer of Google Inc., the Internet search giant.
In a statement Thursday, Brocade said that “no executive officers involved in the historical stock option granting practices remain employed with Brocade.” The company also said that it had “no comment with respect to the former executive officers.”
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Menn reported from San Francisco and Petruno reported from Los Angeles. Times staff writers Walter Hamilton in New York and Dawn C. Chmielewski, James S. Granelli and Kathy M. Kristof in Los Angeles contributed to this report.
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Begin text of infobox
How it works
An example of backdating of stock options:
1. On July 20, a CEO gets the option to buy 1,000 shares of his company’s stock, which are priced that day at $20 each in the market.
2. But two months earlier, the stock had traded in the low $10s.
3. The company backdates the option grant to May 21, when the stock was at $12.
4. The CEO now could buy the shares for $12 each instead of $20.
5. The CEO then has an instant paper gain of about $8 a share on the options if the market price stays around $20.
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Source: Times Research
Los Angeles Times
