New Stock Option Fears in the Valley

The feds' big win in the options backdating case against ex-Brocade CEO Greg Reyes has many wondering if this is only the start for prosecutors

Attention, executives at the 200 or so companies that have been involved in the options backdating scandal that dominated many boardrooms last year. You may not be as safe as you thought you were from criminal indictments.

That is the most likely takeaway from the Department of Justice's surprisingly lopsided victory in its case against former Brocade Communications Systems (BRCD) Chief Executive Officer Greg Reyes, who was found guilty Aug. 7 on all 10 of the charges levied against him. Reyes, who spent roughly $30 million on his defense, faces up to 20 years in prison and millions of dollars in fines, not to mention possible civil judgments from the shareholder suits that could be sparked by his conviction.

Reyes will appeal the verdict, says his lawyer. "Today, we are disappointed. Tomorrow, we will continue the fight," said Rich Marmaro, of Skadden, Arps, Slate, Meagher & Flom, in a statement.

No Smoking Gun

It's not just the 10-0 victory (one that was belied by the emotion on display when the verdict was read, as more than one juror cried) that is putting lawyers for other technology executives on notice. It's that the facts in the case against Reyes set a low bar for prosecutors to clear, should they choose to bring more cases.

For starters, Reyes—unlike executives such as Apple (AAPL) CEO Steve Jobs and former United Healthcare (UNH) CEO Bill McGuire—did not receive backdated options himself. "This will set a tone that an executive can have mens rea—"a guilty mind"—even if he didn't personally line his own pockets," says George Stamboulidis, head of Baker Hostetler's white-collar defense practice. That's important, as an element of the securities fraud, false statement and records falsification charges on which Reyes was convicted requires that the defendant understand that his or her actions were illegal.

What's more, the case against Reyes included no blockbuster smoking guns to prove that he knowingly broke the law. For example, the government had no overheard conversations or e-mails in which Reyes admitted his involvement in the alleged scheme with former Brocade human resources chief Stephanie Jensen. The pair, prosecutors say, routinely falsified paperwork so that Brocade's finance department would process it without incurring accounting charges required for options grants given at below the market price.

Rather, the government made the most of Brocade's clear pattern of granting options on days when the stock was low, together with a smattering of damaging but not definitive testimony. One former HR staffer said Reyes once told her "it's not illegal if you don't get caught," but couldn't remember if they were talking about backdating at the time. On another occasion, in 2004, Reyes sent an e-mail to a fellow board member of VeriSign (VRSN) in which he declared, "IT IS ILLEGAL TO BACKDATE OPTIONS GRANTS."

While the government argued this was proof of his knowledge of accounting rules, Reyes' lawyers argued that Reyes was referring solely to a new reporting clause in the Sarbanes Oxley Act of 2002 that involves only grants to top executives—not the broader grants to rank-and-file employees that provided the basis for Reyes' conviction.

Key Discrepancy Emerged

The most damaging evidence against Reyes may have come from Craig Martin, a lawyer with Morrison & Foerster, who led the internal investigation Brocade's board launched in late 2004. In his interviews with Reyes, Martin testified that Reyes denied that any grants had been backdated. Instead, he argued that he'd actually made the grants properly and that the reason it looked suspicious was that he only signed the paperwork days or weeks later, on forms carrying the date when he claims to have made the granting decision.

But in the trial, when numerous former Brocade HR staffers testified to picking low prices off of Yahoo Finance (YHOO), Reyes' lawyers did not contest that backdating had occurred. Instead, they argued that Reyes had no knowledge that any of it was illegal, or that any grants had not been properly accounted for. On Aug. 2, jurors requested transcripts of Martin's testimony.

That's a damning discrepancy, to be sure—but nothing like the e-mails found in other cases. For example, Gary Fischer, a former top executive with chipmaker Integrated Silicon Solution (ISSI), who recently settled with the Securities and Exchange Commission, admitted in an e-mail that he chose to grant options one day off a quarterly low in ISS stock. That way, auditors wouldn't suspect that the company was backdating. "[It] implies we tried to take advantage of the drop by quickly locking in on the following Monday," Fischer wrote. "Obviously the advantage is no P&L impact plus the person gets the upside of the remaining vesting."

In other cases, companies admit top executives' involvement. Apple disclosed last December that it had backdated 6,428 grants during Jobs' tenure, including two massive grants to Jobs. While it admitted that Jobs knew about the backdating and on some occasions even recommended the dates, the board "found no misconduct" in part because Jobs "did not appreciate the accounting implications," according to its filing.

Emboldened Prosecutors?

So will the Reyes decision once again put Jobs and other executives at risk? Scott Schools, the U.S. Attorney in the San Francisco office that won the conviction, downplayed any larger significance of the verdict. "A single jury, limited to the evidence in a single case, determined that a single defendant has violated the law," he said, according to press reports. And Jobs is most likely out of the woods. Two sources say it's highly unlikely that the Justice Dept. will come after Jobs or anyone currently at Apple.

But others say the Reyes decision could embolden federal prosecutors nationwide to go on the attack. That alone will surely lead many defense attorneys to think harder about settling with the government to avoid prosecution. Stamboulidis predicts that, "prosecutors and regulators will be able to extract larger penalties and settlements" from executives. Several sources suggest this could theoretically include former Apple chief counsel Nancy Heinen. Under her watch someone at Apple created minutes of a fictitious board meeting to grant Jobs options—just the sort of falsification that lies at the heart of the Reyes case. But Heinen's lawyer, Cris Arguedas, doesn't think the Reyes verdict will prompt prosecutors to seek more convictions. "Every case is different, with different evidence," she wrote in an e-mail to BusinessWeek.

Other observers agree that it's hard to jump to conclusions about DOJ's next steps, but for different reasons. That's in part because Justice is dealing with the turmoil surrounding Attorney General Alberto Gonzales and the personnel changes in many offices. "A lot of criminal defense lawyers are having a very difficult time trying to understand what the U.S. Attorneys are up to," says one defense lawyer involved in multiple backdating cases.

In any case, the Reyes conviction could lead lawyers to rethink what constitutes a great case for the government. Until now, it was thought that the best cases would involve a continued pattern of options shenanigans, even after the Sarbanes Oxley Act clarified and emphasized the need for careful options accounting rules.

Weighing Damage to Shareholders

But Brocade tightened its processes at the time, just as most tech firms did. Then there's the lack of direct evidence that Reyes knew he was breaking the law. That's considered to be critical, to counter defense lawyers' arguments that their clients had only followed the advice of the finance staffers, lawyers and accountants who created and approved the books. Lastly, prosecutors look for cases where there was substantial damage to shareholders—again, a hard case to make in the Brocade case.

Much of the trial involved discussion of whether investors cared when the company restated earnings to properly account for the backdated options. While the government argued that the company's shares did in fact fall on the two occasions when the company disclosed options-related restatements, the stock quickly bounced back. Unlike Enron, WorldCom and other cases of massive fraud, Brocade shares have remained roughly flat, dropping from $7 at the time of the first options-related restatement to $6.19 on Aug. 7. "If you've got investors losing their shirts like they did with Enron, you may need someone to blame. But there's nothing like that happening here," says University of Illinois law professor Larry Ribstein.

Ribstein is among those who fear that the Reyes decision will open the floodgates for criminal indictments on crimes they feel are best punished via the checkbook, as a result of civil penalties and settlements with the SEC. "This will clearly embolden the government to seek more criminal prosecutions—and criminal prosecutions are a very blunt instrument with which to go after conduct that involves a lot of nuance and detail," Ribstein says.

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