On August 7, 2007, a jury in the United States District Court for the Northern District of California found Gregory L. Reyes, the former CEO of Brocade Communications Systems, Inc. ("Brocade"), guilty of securities fraud and conspiracy for backdating stock options granted to Brocade employees. The trial was the first in an options backdating case and commentators are predicting the verdict may embolden prosecutors to pursue similar cases.
"Backdating" stock options occurs when a company grants options to employees with an exercise or strike price lower than where the stock is actually trading at the time, typically because the options are misdated to take advantage of an earlier price that is more favorable to the executive. Backdating itself is not a crime. However, a company must account for the difference between the exercise price of the option granted and the actual price of the stock on the grant date as a compensation expense, reducing its net income. When a company knowingly and intentionally fails to do so, backdating may be viewed by regulatory authorities and prosecutors as an inappropriate manipulation of the company’s earnings.
According to a press release issued by the United States Attorney’s Office for the Northern District of California, evidence in the trial showed that Reyes "schemed to price option grants to Brocade employees by using historical stock performance data to pick low prices while backdating the grant minutes to hide when the options were actually granted," which allowed "Brocade to improperly avoid recognizing compensation expenses that would have reduced the company’s reported net income." In the twenty-three page indictment issued in the Reyes case, providing top value for stock options to attract employees was listed as Reyes’ motive for backdating the Brocade stock options. Reyes will be sentenced on November 21, 2007. He faces possible imprisonment for up to twenty years and fines of up to $5 million. Reyes’ attorney says he will appeal the jury’s verdict.
The stock options backdating scandal swept the country in 2006, but the August 7th verdict was the first of its kind, as no options case had previously made it to trial. Commentators had speculated that criminal convictions for options backdating would be difficult, if not impossible, due to the complexity of the accounting rules involved and the perceived inability of prosecutors to prove that executives knew that differences in prices existed and that they intentionally and deliberately changed them to manipulate earnings. The Reyes conviction sends a loud and clear message that criminal convictions in options backdating cases are possible. Notably, the facts in Reyes were not particularly egregious, as Reyes himself did not even receive any of the improperly dated options at issue. The verdict further demonstrates that jurors can understand the issues presented in backdating cases and that they are willing to convict – even where the defendant himself did not directly benefit from the misconduct.
The SEC, which has civil and regulatory authority, and the Justice Department, which has the authority to pursue criminal cases, have launched investigations into the options practices of nearly 150 companies. Despite the government’s widespread investigation of options backdating, so far it has brought only a handful of criminal cases. Commentators are already predicting, however, that the Reyes verdict may embolden prosecutors to seek more indictments. Following the verdict, Scott N. Schools, United States Attorney for the Northern District of California, stated that prosecuting options backdating, where it results in overstating earnings and misleads investors, is "one of [his] office’s top priorities… ."
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