Backdating: Why Penalties Are Puny

The SEC considers options violations less serious than other kinds of financial fraud

The more than yearlong probe into options backdating, which has left executives quaking at roughly 140 companies, is nearing completion. The surprising upshot: much smaller fines than anyone expected. On May 31 the Securities & Exchange Commission announced that Hewlett-Packard (HPQ ) unit Mercury Interactive and Brocade Communications Systems (BRCCD ) would be the first to settle civil fraud charges related to backdating. Mercury agreed to a fine of $28 million, while Brocade will pay just $7 million.

Those totals were much lower than the fines handed out in a series of recent high-profile financial fraud cases. To settle with the SEC, Qwest Communications International (Q ) paid $250 million in 2004, America Online (TWX ) ponied up $300 million in 2005, and Fannie Mae (FNM ) forked over $400 million in 2006.

So what accounts for the smaller penalties? For all the vehement criticism of backdating, the fines largely reflect the SEC's recognition that options backdating is a much less serious offense than accounting fraud aimed at deliberately misleading investors about a company's financial results. The cost to shareholders is much lower, as is the impact on earnings. "This is a different type of offense than we've seen in other areas," says Peter J. Henning, a former SEC enforcement attorney and securities law professor at Wayne State University Law School. "There is mismanagement [in the options timing cases], but it doesn't go to the core operation of the company."


The skimpier fines also appear to reflect a compromise after an intense debate within the SEC over how severely to punish companies that participate in wrongdoing. In sharp contrast to predecessor William H. Donaldson, Cox has resisted issuing large corporate penalties in financial fraud cases. Instead he favors stepped-up penalties against individual wrongdoers and increased cooperation with prosecutors to bring criminal charges when warranted. He and the other two Republican commissioners argue that shareholders, already victimized by the fraud, ultimately bear the costs of such fines, while the two Democratic commissioners and many lawyers in the SEC's Enforcement Div. generally lean toward larger fines to deter abuse. In a rare move, the commissionactually lopped 20% off the $35 million fine Mercury originally agreed to pay in negotiations with the SEC's enforcement staff to settle its backdating charges last September.

Cox also insisted that the SEC weigh the monetary damage and any ill-gotten gains that stem from wrongdoing much more heavily in the setting of fines. In early 2006 the agency issued new penalty guidelines outlining the factors it will consider; the first criterion is now the economic impact of any misbehavior on the company and the shareholders. And over the past year, the SEC has increasingly required the Office of Economic Analysis to estimate those costs as the starting point of any discussion over penalties in backdating cases. In the past, enforcement officials had more leeway to negotiate fines on their own with an eye toward deterrence. The result: Situations in which the company or shareholders benefited from a fraudulent scheme are the most likely to result in large fines, while those in which shareholders have already suffered damages will be met with more leniency.

In the backdating cases now before the SEC, those changes mean officials will take into account a variety of factors in determining whether a corporate penalty is warranted. First, they will look at the number of backdated grants, how much money was at stake, how many executives were involved, and who they were. Then they will consider whether executives knew they were violating the rules and whether they doctored records or otherwise tried to cover up. The SEC also substantially reduces the penalties for companies that cooperate in uncovering fraud and turning over the responsible executives.

Overall, though, the tab for backdating is likely to remain low. "Most people will view this as a considerable rollback from the kinds of penalties that we've seen in recent years," says Jacob S. Frenkel, a former SEC enforcement lawyer now in private practice. But the SEC will still have considerable discretion. Officials say Apple Inc.'s (AAPL ) extensive cooperation in the recently ended probe of the timing of its options grants between 1997 to 2002 was a key reason the SEC took no action against the company, even as it filed backdating-related suits against two former executives (see, 05/1/07, "Apple CEO Bit into Temptation"). Meanwhile, allegations that Mercury falsified records extensively and used fraudulent loans to avoid disclosing the true cost of its option grants help explain why its fine was four times that of Brocade's; in addition, Mercury avoided recording $258 million in expenses from backdated options, almost four times the $72.3 million that Brocade concealed. With the pace of settlements expected to pick up in the coming months, plenty of other companies will soon find out how much such differences are worth.

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By Dawn Kopecki

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