The stunning dismissals of criminal cases against three former Broadcom Corp. executives in the last week focused on what the judge called “shameful” misconduct by prosecutors. But at the core, he had something more telling to say: Prosecutors couldn’t prove the defendants did anything wrong.
The Broadcom cases, among others, illustrate the struggles the U.S. attorney’s office has encountered in prosecuting corporate executives for backdating stock options, a practice that makes it appear that their companies had fewer expenses and greater income than they really had.
Among the most elusive elements in such cases, lawyers said, is proof that executives intended to commit a crime by backdating the options and conceal their actions.
“I think the problem with the cases is the intent element. It’s hard to prove the key parties intended to overstate income, which is the crux of the charged offenses,” said Fernando L. Aenlle-Rocha of Los Angeles, a former federal prosecutor who now advises clients on backdating issues as a white-collar defense lawyer.
Nathan J. Hochman, a former assistant attorney general, said prosecutors are always looking for the “most provable lies.” But those are hard to find in options backdating cases, he said, because the explanation behind the action can be very complicated. “It’s one thing to say that I approved a stock option that got backdated. It’s another thing to say that’s a crime,” said Hochman, now a Santa Monica litigator.
Thom Mrozek, a spokesman for the U.S. attorney’s office in Los Angeles, defended the prosecutors’ efforts.
“We will only bring cases when we are convinced that there is criminal wrongdoing and that we have the evidence to prove the case beyond a reasonable doubt to a jury,” Mrozek said.
With much fanfare, federal authorities began investigating options practices in 2006 after academic studies showed that scores of companies, many of them technology firms, had dated options grants retroactively to make them more valuable to employees and, in some cases, to the executives who granted them.
By February 2007, the FBI reported that it had 61 active options backdating investigations, and the Securities and Exchange Commission was looking at more than 100 companies for possible civil enforcement actions.
The prosecutions that followed the FBI investigations grew to include executives at some major corporations.
In addition to Irvine chip designer Broadcom, cases were brought against Brocade Communications Systems Inc. of San Jose, Comverse Technologies Inc. in New York and builder KB Home in Westwood.
Then the cases began to fall apart. Last year, the former general counsel for computer security company McAfee Inc. was acquitted of options-backdating charges. Prosecutors won a conviction in the case of former Brocade Chief Executive Gregory Reyes -- only to see the conviction overturned on appeal.
Last week, U.S. District Judge Cormac J. Carney tossed out a guilty plea that Broadcom co-founder Henry Samueli had entered to a charge of lying to securities regulators who were investigating the company’s backdated options.
Carney described Samueli as “a brilliant engineer and a man of incredible integrity” and said he believed he pleaded guilty to a crime he didn’t commit because of a “shameful” campaign by prosecutors to intimidate him and tarnish his reputation.
On Tuesday, Carney dismissed backdating charges against Broadcom co-founder Henry T. Nicholas III and the company’s former chief financial officer, William J. Ruehle, accusing federal prosecutors of intimidating witnesses and preventing the defendants from receiving a fair trial. He also said he had significant questions about the strength of the evidence presented during two months of testimony in Ruehle’s trial.
One problem has been the murky accounting rules for stock options. Companies can legally backdate options, as long as the practice is accounted for as an expense in regulatory filings. In 2007, Broadcom added $2.2 billion in options-related expenses it had failed to disclose in previous years. More than 200 other companies also have restated options expenses.
Stock options are a form of compensation, allowing employees to buy stock at a particular price -- usually the closing price on the date they’re granted. If the stock price increases over time, employees can buy the stock at the lower price and sell it for a profit. An earlier grant date, when the stock was lower, enables employees to get bigger profits.
Ruehle’s attorney, Richard Marmaro, argued at trial that Broadcom had made a simple accounting mistake -- and Carney seemed to agree.
“The accounting standards and guidelines were not clear, and there was considerable debate in the high-tech industry as to the proper accounting treatment for stock option grants,” the judge said. “Indeed, Apple and Microsoft were engaging in the exact same practices as those of Broadcom.”
Defense lawyers argued that it was unfair to expect engineers such as Samueli and Nicholas to understand rules that accountants themselves didn’t.
Erik Lie, a University of Iowa business professor whose research helped expose the backdating scandal, has calculated that 13.6% of all option grants to top executives from 1996 through 2005 were backdated or otherwise manipulated. Despite that, he said, “it’s not always clear what happened inside the companies. I think in most cases it was illegal, but it’s very difficult to prove.”
There was some genuine confusion about rules for accounting for options, he said, and executives at many companies used that as a cover to manipulate stock option grants aggressively.
One pending options-related prosecution involves Bruce Karatz, former chief executive of KB Home. He faces 20 counts of fraud and making false statements in backdating stock option grants for himself and employees without disclosing the practice. He has pleaded not guilty.
Karatz’s attorney, John Keker of San Francisco, said he believes prosecutors will encounter the same problems as they have in previous options cases. “The recent decisions in the backdating trials show just how misguided the criminal prosecution of these option pricing cases is,” he said. “The accounting rules made little sense. Company after company applied those rules in good faith, in a way the government now says was wrong.”
Without addressing the Karatz case specifically, Mrozek, the U.S. attorney’s spokesman in Los Angeles, said: “A setback in one case will not dissuade us from our pursuit of justice in a similar case.”
One difference between the Karatz and the Broadcom cases: Karatz is accused of improperly manipulating his own stock options; the Broadcom cases were focused on misdated options for the rank-and-file engineers and other employees of the company.
That could have a bearing in court, said litigator Hochman: “Personal greed is a tried-and-true motivation the government has used to prove why someone commits a crime.”