The Plot Thickens at Brocade

Peter Burrows

There's some very over at Brocade Communications, the once high-flying storage networking company. And I'm not talking about its promising financial performance, announced on Feb. 17. Rather, I'm thinking of the fourth paragraph of the earnings release, which reads:

During the quarter the Company began active settlement discussions with the staff of the SEC regarding its restatements related to stock option accounting. As a result of these discussions, in Q1 06, the Company booked a $5.0 million provision for an estimated settlement expense. This amount is the Company's best estimate at this time and is subject to change as discussions with the staff of the SEC continue.

Depending on who you talk to, a $5 million penalty, if that is what ends up happening, is either a fairly painful slap on the wrist or just a token gesture. That could mean one of two things, suggest my sources. Option 1: that the SEC hasn't found anything too over-the-top egregious after its eight-month investigation into options accounting irregularities announced by Brocade over the past year. This would uphold the view of former CEO Greg Reyes, who was ousted as a result of the probe. His take: that while there were paperwork errors made in how options were granted, there was no intentional effort to defraud investors. Then there's option 2: that the SEC has decided not to punish Brocade and its investors, but still plans on pursuing a case against Reyes. At least among my Silicon Valley sources, most figure Option 2 is more likely. Says one CEO: "The SEC wants to make an example of someone, but what's the best way to do that and serve the public interest? By going after a company that's cleaned up its act? If anything, I think they’d go after Greg Reyes.”

But that's not the end of the intrigue. Turns out that, according to a Feb. 8 government filing, two of Brocade's boardmembers will not stand for reelection at the company's annual meeting on April 17.

One of those directors is Seth Neiman, a managing partner at Crosspoint Venture Partners. He's considered a father of the company, given that he provided initial funding and management aid even before there was a business plan. My sources suggest his departure is no big surprise, as Nieman has talked about wanting to step off the board for the last few years.

More interesting is the departure of former 3Com Corp. chief financial officer Chris Paisley. As head of the board's audit committee, he's had a central role in the saga of the past year. He launched the sweeping internal investigation into the company's books that began in late 2004, after a disgruntled former sales manager threatened to bring a whistleblower suit to the SEC alleging options accounting naughtiness, if the company didn't renege on a threat to foreclose on his house to get repayment of a loan granted to him when he was hired. The investigation led to massive restatements, a public acknowledgement of accounting problems and possibly "improprieties", and the ouster of Reyes, a larger-than-life personality in this niche of the networking market who was seen as the driving force behind the company.

Paisley, who sits on various boards and is a professor of accounting at Santa Clara University, hasn't returned calls to comment on his deceision to leave the board. Some sources figure he simply wants a break after a year of putting in an inordinate amount of work. One source tells me the audit committee held something like fifty meetings in the past year.

But if it turns out nothing truly dastardly occurred at Brocade, it might be hard for Paisley to distance himself from the company. That's because if the SEC settles with Brocade for $5 million or so and doesn't go after Reyes, the former CEO would likely to press his case--possibly in court--that he was wrongfully pushed out, and that Paisley's investigation did more to hurt investors than to help them. For example, Reyes rails at the $14 million the company has spent on the investigation, and says Paisley overplayed the powers vested in the audit committee chair by the Sarbanes Oxley Act. "This was SOX run amok," asserts Reyes.

While on the topic of Brocade, there's one more recent item of note, also announced in that 8-K filing from Feb. 8. The company announced it was paying boardmember Dave House, a former executive at Intel and Nortel, a one-time $100,000 bonus for his work over the past year. That's interesting because, according to multiple sources, House was originally picked to replace Reyes. Only after many top executives protested that House lacked sufficient knowledge of the close-knit storage networking business did the board decide to give the job to company executive Mike Klayko, who was running sales at the time.

Brocade, House and Klayko all declined to comment, citing the SEC investigation.

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