Backdating Is Seen as Option in Tech Realm
Gregory Reyes was facing a personnel crisis. The executive he had just hired for a top sales job at his Silicon Valley company suddenly was threatening to jump to a competitor.
So Reyes, then chief executive of computer networking firm Brocade Communications Systems Inc., decided to offer the recruit a much bigger pay package. Instead of options to buy 285,000 Brocade shares -- the initial offer -- Reyes anted up 500,000.
He didn’t stop there, according to federal prosecutors. They say Reyes dangled a sweetener: The purchase price of the options would be fudged -- “backdated” -- so that the employee would have an immediate paper profit of $2.5 million on the shares.
The government says that was a crime, one that could put Reyes behind bars for 20 years if the charges stick. And more executives could find themselves joining Reyes in court dockets, as prosecutors and securities regulators examine past option grants at more than 100 companies nationwide, most of them technology firms.
The widening probe is of particular concern in the nation’s tech center -- Silicon Valley and the San Francisco Bay Area -- where options have long been the coin of the realm. At least 30 firms in the area have disclosed federal inquiries.
But even as the Justice Department and the Securities and Exchange Commission bear down in their investigations, there is a sense of disbelief among many in the tech sector that companies’ option practices of the last decade have literally become a federal case.
“Clearly, they did something wrong, but it’s very different from a WorldCom or Enron situation, where it appeared the fraud was just to fleece investors,” said Tom LaWer, an executive compensation lawyer in East Palo Alto. “It seems as if there was a bit of laziness and stupidity involved.”
In the hard-charging entrepreneurial culture of Silicon Valley, the creative use of stock options to reward favored employees is seen by many as a reasonable means to further a company’s goals -- not the basis of a criminal conspiracy.
“I’m reluctant to read a gigantic morality tale into this,” said Paul Kedrosky, a former tech stock analyst who now runs the von Liebig Center for Entrepreneurism and Technology Advancement at UC San Diego. “It’s more like speeding on the highway. Everyone saw other people doing it and thought it was OK.”
That doesn’t wash with many big investors and corporate governance experts, who note that the crux of the government’s concern is that executives flat-out lied to shareholders and handed out unauthorized stock wealth to colleagues and to themselves.
To some critics, it’s no surprise that the tech industry is playing a starring role in the option scandal. Silicon Valley has long had a reputation for being disdainful of outside shareholders’ demands for accountability.
“They thought they lived by different rules,” said Jeffrey Sonnenfeld, a professor of management at Yale and founder of the Chief Executive Leadership Institute in Atlanta. “They said e-governance was different.”
A stock option is the right to buy shares for a set amount -- the exercise price -- within a certain period of time. For the tech industry, options were a favored compensation tool beginning in the 1980s because many up-and-coming firms couldn’t afford to pay big salaries to workers. Stock was the logical alternative.
A key argument for using options as a carrot has been that they aligned workers’ interests with those of shareholders. With skin in the game, employees would have a greater incentive to work hard and boost sales and earnings, thus driving up the share price.
With the tech industry boom and rocketing stock prices of the late 1990s, options became the most coveted currency of Silicon Valley.
“The temper of the time was equity uber alles,” Kedrosky said. “The whole game was stock, which was totally motivated by the perception that stock had unlimited upside and the upside happened within six months.”
If the market price of a firm’s shares soared, an employee with vested options could immediately sell and haul in a handsome capital gain.
But from shareholders’ viewpoint, a crucial feature of options is that the exercise price normally is the stock’s final market price the day the option is granted by company directors. In other words, there is no built-in gain for the employee when options are awarded.
It now is clear that some companies in fact awarded options that already were profitable, or “in the money,” at least on paper.
“The whole point is to incentivize performance” via options, said Carol Bowie, director of governance at the Investor Responsibility Research Center, a Washington-based group that counsels institutional investors on governance issues. “If you’re giving in-the-money options, that defeats the purpose.”
Investigators are focusing largely on so-called backdating, which at its most extreme amounts to looking back on the calendar and cherry-picking the most favorable recent prices for option grants.
Backdating itself isn’t illegal, as long as it’s disclosed to shareholders. Over the last decade, however, most companies repeatedly assured shareholders that options were granted only at market prices, not at discounts, said Patrick McGurn, a corporate governance expert at investor advisory firm Institutional Shareholder Services.
For most of that period, he noted, the tech industry also fought aggressively to beat back proposals from accounting regulators and shareholder activists to require the formal expensing of stock options in corporate financial statements. The industry said such expensing would unfairly shrink companies’ reported profits.
Now, with dozens of firms acknowledging backdating, many have been forced to reduce previously reported earnings. That’s because the granting of discounted options understated expenses and overstated profit.
But was backdating premeditated fraud or something more akin to cutting corners?
Some tech veterans say there could be legitimate explanations for some of the pricing disparities that companies, and the government, are finding as they review past option grants.
John Duncan, a tax lawyer in Silicon Valley during the dot-com heyday, said option paperwork might have often languished on administrators’ desks, or corporate officers might have known they had decided to grant options sometime in the prior weeks but couldn’t remember exactly when.
So option program administrators may have just picked the most favorable recent date to price the awards, figuring it wouldn’t make much difference if their companies’ shares rose over the long run, said Duncan, now general counsel for Slide Inc., a San Francisco-based Internet company.
“Silicon Valley entrepreneurs dramatically undervalue the headaches and issues of paperwork and are so optimistic about the upward movement of stocks that they blind themselves as to whether these things really could hurt somebody,” he said. “My guess is the vast majority saw it as a gray area.”
Paperwork mistakes form the basis of Reyes’ defense in the case the Justice Department and SEC brought against him and another former Brocade executive, Stephanie Jensen, in late July.
“Any variance between the date Mr. Reyes granted stock options and company documentation is the result of paperwork processing delays and/or administrative errors,” said Richard Marmaro, his attorney.
The government accused Reyes and Jensen of routinely backdating option grants from 2000 through 2004. The two pleaded not guilty Aug. 30.
If proper accounting for options was gray to some companies, however, there was only black or white for Silicon Valley’s two most prominent companies: Chip giant Intel Corp. and computer networking titan Cisco Systems Inc. say unequivocally that they never engaged in option backdating.
That is a blow to attempts to defend the practice by contending that it was accepted throughout the tech industry.
Another defense offered by some in Silicon Valley -- although few will attach their names to it -- is that fudging option prices was good for shareholders because it kept valuable employees on board.
Mark Jaffe, president of executive recruiting firm Wyatt & Jaffe, said he believed that some tech executives who backdated options convinced themselves that “ ‘I didn’t do it for myself. I did it to hold my team together, I did it to maintain integrity and the continuity of executive staff, I did it so the employees didn’t lose morale,’ and so on.”
But in the Brocade case and a case filed against Comverse Technology Inc. of New York, the SEC alleges that top executives backdated not only employees’ options but their own -- belying the idea that personal enrichment wasn’t a motive.
“This was a fairly widespread situation of at best poor judgment and at worst unmitigated greed,” said Bowie of the Investor Responsibility Research Center.
chris.gaither@latimes.com
Petruno reported from Los Angeles and Gaither reported from San Francisco.
