Federal prosecutors on Thursday filed the first criminal charges against executives in a mushrooming investigation into the possible manipulation of stock options.
Gregory L. Reyes, the chief executive of Brocade Communications until January 2005, and Stephanie Jensen, the vice president for human resources until 2004, were each charged in a criminal complaint with one count of securities fraud. Prosecutors said the two doctored the minutes of board meetings, job-offer letters and other documents to make it appear that employees were granted stock options at an earlier date, when the share price of Brocade was lower.
The Securities and Exchange Commission also filed a civil complaint, which named Brocade’s former chief financial officer, Antonio Canova, as well as the other two executives. (Mr. Canova, who resigned in December 2005, was not named in the criminal case.)
The criminal complaint is the most significant step yet by investigators in what is shaping up to be a large-scale scandal in the corporate world. Corporations — from small technology companies like Altera and Mercury Interactive to industry giants like UnitedHealth — have been ensnared in investigations into whether their executives or boards improperly granted stock options at attractive prices.
Now that prosecutors in San Francisco have fired the first volley, many lawyers said they expected a flurry of indictments to follow.
“I think we’re going to see a quick succession of cases,” said Scott S. Balber, a lawyer with Chadbourne & Parke who would not say whether any of his corporate clients had been contacted by regulators regarding the backdating of options.
So far, federal prosecutors in San Francisco, Manhattan and Brooklyn have opened more than 33 cases looking at potential accounting problems or fraud; the Securities and Exchange Commission is examining at least 80 companies. More than a dozen senior executives have been dismissed. Nearly every company has been reviewing its practices.
“This case will not be the last,’’ said Linda Chatman Thomsen, the director of the S.E.C. enforcement division.
An option gives the holder the right to buy shares of stock at a predetermined price in the future, commonly the market price on the date they were granted. Instead of offering higher salaries, companies sometimes prefer to lure potential hires with stock options, conserving company cash.
According to the criminal and civil complaints filed Thursday in Federal District Court in San Jose, Calif., Mr. Reyes routinely backdated documents to provide new employees with a larger compensation package. Brocade, a maker of data storage networking products, is based in San Jose.
The Department of Justice criminal complaint does not contend that any of the three company officials directly made financial gains from the backdating. But Kevin V. Ryan, the United States attorney for Northern California, said the government was not obligated to prove personal financial gain in this case.
Instead, prosecutors are building a case that suggests that the intent was to hire highly qualified employees that other companies had wanted.
The S.E.C.’s civil complaint does contend that Mr. Reyes was motivated by personal gain and did receive backdated options himself. “He was thus motivated to continue the scheme, in part, to enrich himself and his fellow officers,” the S.E.C. complaint says.
Although Brocade’s board approved those grants, the government did not name any directors as defendants. Ms. Thomsen and Mr. Ryan did not rule out the possibility that others at Brocade might be charged. Mr. Ryan also declined to discuss whether any employees or former employees had been granted immunity to testify or help the government build its criminal case.
At a news conference in San Francisco, Christopher Cox, the chairman of the S.E.C., called the backdating practice “poisonous” and said “the S.E.C. is committed to bringing it to an end nationwide.”
The criminal charge carries a penalty of as much as 20 years in prison and a fine of $5 million.
Lawyers for Mr. Reyes and Ms. Jensen denied the charges. “Financial gain is always the motive in securities fraud cases, and here there was none,’’ Mr. Reyes’s lawyer, Richard Marmaro, said in a statement. A call to Mr. Canova’s lawyer was not returned.
Options are a powerful incentive for executives to try to get the stock price higher so that the option becomes “in the money,’’ meaning the shares can be bought at a price below the current market price.
Handing out in-the-money options is not illegal as long as the grants are disclosed to shareholders. At the time in question in this case, in-the-money options had to be counted as an expense on the company’s books. (New rules now require companies to deduct options as an expense.) Failure to disclose or to deduct in-the-money options from income could lead to securities fraud charges. And because such options do not qualify for tax breaks once they are exercised, such grants raise tax fraud issues, too.
Yet what remains unclear is where regulators and prosecutors will draw the line when it comes to backdating. Brocade’s case may be different because it involves allegations of doctoring documents.
But other companies will argue that the rules establishing a stock option’s grant date were not always clear, or at least open to interpretation. For a period during the 1990’s, for example, several companies including Microsoft granted stock options for rank-and-file employees at monthly lows, often with the blessing of auditors.
Other companies may suggest the backdated options were caused by legitimate paperwork delays; there was sloppiness but no criminal wrongdoing. And even among top S.E.C. regulators, there is a significant debate brewing over another common but disturbing options practice: at what point does the opportunistic granting of stock options at attractive prices ahead of good news become illegal?
Defense lawyers are struggling to get a sense how far investigators will pursue cases and where the line should be drawn between aggressive grant practices and fraud.
Brocade “is a good case to start with because it involves allegations of falsified documents,’’ said Kenneth A. Raskin, head of the global executive compensation, benefits and employment law practice at White & Case. “Other cases are not going to be as black and white."
The Brocade case illustrates how one company granted stock options in a frenzied Silicon Valley culture.
Technology start-ups were sprouting throughout the Bay Area and beyond and desperately needed to fill jobs. Stock prices often swung wildly from day to day. And instead of offering higher salaries, companies preferred to offer stock options.
At the same time, few outsiders scrutinized the practice. Accounting and law firms sought to please their clients; misinformation, intentional or not, was abundant.
Indeed, backdating stock options was so common among Silicon Valley firms, several West Coast lawyers and compensation experts said, that it was viewed at the time as the equivalent of running a stop sign in the desert. Executives were often willing to push the boundaries or in some cases simply ignore the rules.
“It was a high-risk, high-reward time,” said Tom G. LaWer, a partner at Greenberg Traurig’s Silicon Valley practice. “You had people who were entrepreneurs. They often started with small companies where every day is a bet-your-company decision. In this case, a lot of them concluded the risk was small and the reward was great.”
From 2000 to 2004, Mr. Reyes and Ms. Jensen falsified company records, including minutes of directors’ meetings, and employment-offer letters and understated Brocade’s expenses and overstated its income, according to the S.E.C.
Ms. Jensen reported directly to Mr. Reyes. The S.E.C. contends he backdated options grants on at least nine occasions in 2001 and 2002 and on six occasions in 2003 and 2004.
Mr. Reyes was given sole authority to grant stock options by Brocade’s board, in essence, making him the company’s compensation committee, the government contends. Mr. Reyes and Ms. Jensen often waited until the end of a fiscal quarter before granting options at the lowest price for that quarter.
In fact, the practice became so routine that by June 2003, “an HR employee prepared a memorandum describing the practice,” the S.E.C. complaint says.
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