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Karatz stock-options case may resonate with an angry public.

For an American public seething over the housing market crash and the financial and economic crises it triggered, Bruce Karatz’s conviction Wednesday may offer some small hope that justice can and will be done in the business world.

Karatz, the former chief executive of Los Angeles builder KB Home, wasn’t on trial for crimes related directly to the housing market bubble. Rather, he was found guilty of fraud tied to the manipulation of stock option grants beginning more than a decade ago.

But so-called option-backdating abuses — which mushroomed into a national corporate scandal in 2005 and have since been uncovered at hundreds of U.S. companies — involve some of the same basic issues that would be at the heart of any government prosecution of crime related to the financial crisis: disclosure (or lack thereof) of pertinent facts to investors, self-enrichment, and serious conflicts of interest.

The breadth of the government’s attack in the option-backdating scandal also provided a reminder that “everybody was doing it” doesn’t constitute a viable defense of fraud charges.

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What’s more, the 64-year-old Karatz is a big fish in the corporate world, exactly the kind of headline name that people want to see held accountable for financial crimes.

Last week, arguably the biggest fish of all on Wall Street — Goldman, Sachs & Co. — became the target of a civil lawsuit by the Securities and Exchange Commission, alleging that the firm defrauded institutional investors in an investment tied to subprime mortgages.

Yet at the criminal level, the effort the Justice Department has expended in prosecuting backdating cases in recent years also is a cautionary tale of sorts: It shows that even when the federal government throws its full weight to ferret out perpetrators of financial fraud, the number of go-to-jail convictions it wins may be far smaller than what a frustrated public might be expecting.

In December, the government lost a high-profile backdating case when a federal judge in Orange County threw out criminal charges against Broadcom Corp. co-founders Henry T. Nicholas III and Henry Samueli. Prosecutors, the judge said, had resorted to “shameful” tactics, including witness intimidation.

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As financial scandals go, stock option backdating never was likely to set most Americans’ blood to boil.

Backdating essentially involved rewriting history for the benefit of stock option recipients.

Generally, the purchase, or exercise, price of an option is supposed to be the stock price on the day of the grant. By backdating option awards — in effect, cherry-picking prices after the fact — companies could turn options into guaranteed income for company officers and other employees on the receiving end.

The practice became widespread in the late-1990s in Silicon Valley, where stock options long have been the preferred type of compensation for tech company executives.

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After a widely publicized academic study in 2005 pointed up the apparent prevalence of backdating, the government launched an all-out legal attack, primarily via dozens of civil cases brought by the SEC. In the wake of the shocking corporate accounting scandals epitomized by Enron Corp. in the early part of the decade, regulators had little choice but to show zero tolerance for number-fudging.

Perhaps the great irony of the backdating, however, is that it isn’t necessarily illegal. Had companies simply disclosed to investors that option-grant prices had been cherry-picked — and if the accounting had been proper — there might have been no legal recourse for regulators.

In the Karatz case, the jury said it didn’t believe that the CEO had set out to defraud shareholders by backdating options, including some of his own. But it agreed with the government on four of 20 charges, including that Karatz had lied to accountants and in a financial filing by denying that he had engaged in backdating.

The SEC’s case against Goldman Sachs also centers on disclosure, specifically about the involvement of hedge fund manager John Paulson in designing a mortgage investment that Paulson then bet (via derivative securities) would go bad.

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With any major government investigation and prosecution of financial fraud, the question inevitably asked is whether the results — in terms of identifying the guilty and bringing them to justice — turned out to be worth the resources expended.

That still is a matter of considerable debate in the options-backdating scandal.

The government’s focus on backdating beginning in 2006 caused hundreds of companies to spend huge sums chronicling their own option-pricing practices, and whether shareholders had been harmed.

“There were a lot of companies that expended substantial expenses over ... not much,” said Fernando Aenlle-Rocha, a partner at White & Case in Los Angeles.

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What’s more, settlement of class-action suits tied to backdating probes have cost companies more than $2 billion, according to a tally by RiskMetrics Group.

As usual, the lawyers got richer because of the backdating scandal.

But if that’s the price to pay to expose whatever fraud helped to nearly bring down the financial system, most Americans would probably say it’s worth it.

We can only hope that the SEC and federal prosecutors show the same level of exuberance in going after Wall Street that they have in pursuing companies for backdating stock options.

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tom.petruno@latimes.com


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