Court throws out conviction of ex-CEO in options-backdating case

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In a blow to the government, the first chief executive found guilty by a jury of backdating stock option grants has had his conviction overturned.

Gregory Reyes, former CEO of San Jose-based Brocade Communications Systems, will get a new trial after a federal appeals court in San Francisco ruled that his case was tainted by prosecutorial misconduct in statements to jurors.

Reyes, 46, was convicted in 2007 of conspiracy and fraud for backdating employee option grants in 2001 and 2002. The practice, widespread particularly in the technology industry, was a way to cherry-pick favorable exercise prices for the options, boosting their value to employees.

But backdating also had the effect of understating corporate expenses, and prosecutors said it amounted to fraud because shareholders weren’t told of the practice. Brocade and many other companies had to restate previous earnings reports to properly account for option expenses.

The government saw the Reyes trial as a showcase that would send a strong message to other executives.

Arguing in January 2008 for a tough sentence for Reyes, Assistant U.S. Atty. Tim Crudo said in a court filing that the case ‘had far less to do with accounting than it did with the willingness of a powerful CEO to flout the law.’ He said a harsh sentence would deter other executives from being tempted to falsify corporate records.

Reyes was sentenced to 21 months in prison and assessed a $15-million fine. But he has been free since his trial, pending his appeal.

The appeals court did not dispute that the government met the burden of showing that Reyes’ backdating of options falsified records and thus withheld information that Brocade’s investors should have been given.

But in overturning the conviction, the court noted that Reyes had argued that ‘he relied in good faith on the accuracy of the [Brocade] Finance Department’s documentation . . . to make sure that the corporate books were accurate, and that he was not responsible for the false records.

‘Reyes’ counsel, in closing argument, therefore told the jury that the Finance Department knew about the backdating, thus supporting the defense position,’ the court said.

Yet one of the government’s prosecutors, the court said, ‘told the jury that the employees in the Finance Department ‘don’t have any idea’ that the backdating was occurring. The prosecutor thereby asserted to the jury facts that he knew were belied by the statements to the FBI from responsible Finance Department officers.’

‘In representing the United States, a federal prosecutor has a special duty not to impede the truth,’ the court reminded the Justice Department.

The appeals panel also affirmed the backdating-related conviction of Stephanie Jensen, Brocade’s former human resource director, but ordered a new sentencing for her. Despite the government’s seemingly intense interest in prosecuting option-backdating cases when the scandal broke open in 2006, the Wall Street Journal today cites a new academic study that found that the majority of firms that engaged in backdating never were caught or even admitted to the practice.

The highest-profile case still pending: Former KB Home CEO Bruce Karatz, 63, is facing trial in Los Angeles on charges that he backdated options for himself and other executives, defrauding shareholders. Karatz reaped $233 million in compensation from 2003 to 2005, largely via options.

Options-backdating trials also are pending for former Broadcom Corp. officers Henry T. Nicholas III and William Ruehle.

-- Tom Petruno