A Smaller Options Scandal?

The campaign to lock up accused backdaters is moving slowly. Here's how a key case is playing out

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When federal prosecutor Kevin Ryan stepped up to a podium in San Francisco on July 20 to announce the first criminal charges for options backdating, the issue seemed poised to become America's next great corporate scandal. The U.S. Attorney for Northern California's heavily covered case targeted Greg Reyes and Stephanie Jensen, the former CEO and human resources chief, respectively, of storage-gear maker Brocade Communications Systems Inc. (BRCD ) in San Jose, Calif. They were just 2 of more than 100 executives under investigation for backdating at the time--and new names were being added to the list almost every day.

Since then the campaign to lock up accused backdaters seems to have lost some momentum. Only one other criminal case has been filed, against executives from Comverse Technology Inc. (CMVT ). Ryan has resigned, as have two of the original four prosecutors on a backdating task force created at the time. That includes Chris Steskal, the original lead attorney on the Brocade case. Although about 140 companies are under investigation by the government for backdating, few observers expect anywhere near that number of indictments. "This scandal is a mile wide and an inch deep," says Mark E. Beck, a criminal defense attorney in Los Angeles.

As legal experts take a closer look at the backdating issue, some are questioning how well it will play in court. Recent history illustrates why. Plenty of business practices that were roundly condemned by government lawyers, academics, and columnists--including allocating hot IPO shares to favored investors and trading mutual funds after market close--failed to produce the expected jail sentences. And plenty of executives whom the pundits expected to see in orange jumpsuits, such as former HealthSouth (HLS ) CEO Richard M. Scrushy, are walking free. "My prediction is that a lot of these cases are going to prove to be a lot murkier in terms of criminality than the seemingly stark allegations as they initially emerged," says Larry E. Ribstein, a law professor at the University of Illinois. "There will be difficulties finding out who did what and whether they knew it was wrong."

That view is affirming to many executives in Silicon Valley who view the options backdating issue as a media-driven witch hunt. Many privately argue that the guidelines for setting option prices provided wide discretion to senior management and boards pre-Sarbanes-Oxley. The practice was widespread and often authorized by lawyers and accountants. And in many cases the backdating had little impact on the company's shareholders.

So far, local and federal prosecutors have managed to win a few backdating plea bargains without going to court. In recent days former Take-Two Interactive Software CEO Ryan Ashley Brant, inventor of the game Grand Theft Auto, pleaded guilty in New York state court to falsifying financial records, and former Monster Worldwide general counsel Myron F. Olesnyckyj pleaded guilty to federal securities fraud and conspiracy.


But Reyes, whose case is set to go to trial in June, has vowed to fight. As one of the wealthiest and most competitive men in Silicon Valley, he is paying more than $1 million a month to a 20-person legal team from Skadden, Arps, Slate, Meagher & Flom to keep him out of jail. He is facing 12 criminal counts, including 4 related to securities and mail fraud and 8 based on falsifying Brocade's books and making false filings to the Securities & Exchange Commission and the company's accountants. All told, the charges carry a maximum sentence of 105 years and $20.5 million in fines. "I'm going to win," says the 44-year-old Reyes, who says he's worth about $400 million. "I know I didn't do anything wrong. I was just doing my job as I understood it." Jensen has also pleaded not guilty.

This type of bluster is typical of former corporate hotshots accused of breaking the law. But dig a little deeper, and it's clear that the Reyes prosecution is hardly an ideal launchpad for the government's effort to put accused backdaters behind bars.

The toughest part of the case for Reyes appears to be the eight counts alleging that he committed "books and records" violations. According to the Justice Dept., Reyes and Jensen routinely falsified board minutes and other internal documents to hide the fact that they were pegging employees' stock options to days in the past when Brocade shares were low. Backdating is not illegal, but hiding the practice and failing to expense the backdated options is. An internal document prepared for the board's investigators indicated that 25% of grants made from Brocade's 1999 IPO to 2004 were made at monthly lows. The mathematical odds of such luck are minuscule, says Erik Lie, the University of Iowa business school professor who first raised questions about backdating. "It just can't happen" without benefit of hindsight, he says.

Prosecutors have accumulated quite a bit of circumstantial evidence to support these charges. For example, Brocade's audit committee uncovered internal records that suggest one high-ranking former manager began receiving options in November, 2001, even though Reyes didn't interview him about coming aboard until Feb. 1, 2002. Richard Marmaro, Reyes' attorney, says all of this employee's options were priced on Feb. 28 and that paperwork suggesting otherwise is incorrect. Then there's an operations manual specifying that options clerks pick the lowest stock price since the previous option grant when bringing Reyes new paperwork to sign. Marmaro insists Reyes didn't know of the manual's existence.

Powerful stuff--and there may be more like it that has not come out in public yet. But it's nothing next to some of the smoking guns that have emerged in other cases in which executives seeking to keep their backdating under wraps participate in the deliberate falsification of internal documents. And the rules surrounding record-keeping "are highly technical," says Peter J. Henning, a professor of law at Wayne State University who is co-editor of the blog White Collar Crime Prof. "It will be very easy for jurors to get lost," he says. "These are not the type of issues they find appealing."


That may be particularly true in the Reyes case, Henning says, because the former Brocade chief did not receive any backdated options himself. That puts him in distinct contrast with Apple's (AAPL ) Steve Jobs and former CEOs such as United HealthCare's (UNH ) William W. McGuire, who agreed to pay back millions in ill-gotten gains. From a prosecutorial standpoint, "the best cases are ones that involve self-dealing," says Columbia University law school securities professor John Coffee.

Another key factor absent in the Brocade case is much shareholder harm. Even if jurors believe Reyes intentionally backdated options grants to other employees, the vast majority of the allegedly backdated options were never exercised. What's more, Marmaro says, Brocade's investors didn't care a whit about backdating. The stock fell only slightly when the company announced its $304 million restatement in early 2005, then soared 17% when Brocade issued its final report on the scandal.

Given the trivial impact on Brocade investors and the lack of any personal profit on Reyes' part, prosecutors may find it hard to make the securities-fraud charges stick. In court, Reyes' lawyers plan to argue that he sought only to help shareholders by making it easier for Brocade to attract and retain talent. That argument may not be enough to keep him out of jail. But, thanks to Brocade's stock performance, he is going to have a much easier time making it with a straight face than many of the other executives facing backdating charges.

By Peter Burrows, with Lorraine Woellert in Washington

— With assistance by Lorraine Woellert

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