US: Options Brought Riches and Now Big Trouble

Publisher Name: 
The New York Times

It was stock options that made Gregory L. Reyes, the former chief executive of Brocade Communications Systems, very rich, and now it is abuse of options that may send him to prison.

Mr. Reyes faces Justice Department charges that documents were forged as part of a scheme to issue backdated stock options, although the criminal charges do not cover options given to him.

But Brocade has since concluded that during the year Mr. Reyes made most of the half a billion dollars that he collected from cashing in options, the company was overstating its profit by more than $1 billion as a result of accounting errors connected to backdated options.

Regardless of whether Mr. Reyes is convicted of the charges, he and Brocade stand out as prime examples of how executives can enrich themselves even while many public shareholders - and the company itself - lose money.

Mr. Reyes arrived at Brocade in 1998, hired as chief executive to get the company ready to go public, which it did the next year. A maker of switches involved in the storage of data sent over the Internet, the company became a hot initial public offering.

It did not hurt that Brocade appeared to be profitable, in contrast to most Internet companies. In fiscal 2000, which ended in October of that year, Brocade reported earnings of $67.9 million.

But when the company got around to restating its earnings - taking into account the expenses it should have recorded because it did not comply with the rules on stock options - that "profit" turned into a loss of $951 million, a swing of more than $1 billion. That disclosure was made after Mr. Reyes left.

During his tenure at Brocade, which lasted six and a half years, the company ended up reporting net losses of $312 million. Mr. Reyes made profits of $556 million on his stock trades, his filings with the Securities and Exchange Commission indicate, with some of it going to family trusts, a family foundation and even his high school.
When Mr. Reyes joined Brocade, he took a salary and bonus that were not large by corporate American standards. But options were the key to the wealth that within a few years enabled him to buy his own jet - which he charged Brocade substantial sums to use - and to become a part owner of the San Jose Sharks, a National Hockey League team.

When he joined the company, he was granted options to buy 12.8 million shares at 28 cents each. (The figures, and all other per-share numbers in this column, are adjusted for three subsequent splits.) The company lent him the $3.5 million necessary to exercise the options, which he did a few months later.

The company went public in May 1999 at $2.38 a share, and soon took off. The stock leaped 138 percent the first day and it was at $133.72 when it peaked in October 2000.

By the time Mr. Reyes was ousted in early 2005, after word of the options issues spread, the shares were down to about $6. The price had fallen to around $4 in early 2003, and it was at those prices that Mr. Reyes became a heavy buyer of the shares. He ended up selling those shares for substantial profits after he stepped down as chief executive.

Mr. Reyes received large options grants during his tenure as chief executive, some of them dated on the same days that the government now says options given to other executives were wrongly dated. The criminal charges do not claim his grants violated the rules, but the S.E.C., in its related civil complaint, claims that "Reyes himself received backdated options."

None of the options he received after the company went public have been exercised, largely because of the stock's poorly performing price. But some of the options he still has are in the money, meaning profits could be made if they were exercised now, and others are close enough that they could become valuable if the stock rises only a moderate amount.

Many of the options that may yet prove valuable were granted to him as part of an options repricing tactic used by Brocade and a number of other companies. In December 2002, it announced that executives who wished to do so could turn in their high-price options and be issued a lesser number of new options the following July.

Mr. Reyes turned in 11 million options with exercise prices ranging from $12.90 to $76.88, and he received 1.1 million new options with a strike price of $6.54.
Some of the options that Mr. Reyes turned in were granted solely because the share price had fallen. In April 2001, the board later reported, it concluded that the 4.8 million options it granted him the previous November, at an exercise price of $76.88, "would no longer serve to adequately incentivize" Mr. Reyes. He was given another 3.97 million options with an exercise price of $20.70.

Evidently, the $442 million he had already taken in from selling stock did not provide enough incentive for him.

The decision to reprice options for executives - and other executives got a better deal than Mr. Reyes did - was made less than three weeks after the company announced a restructuring that called for cutting employment by 12 percent.

That decision also came months after Mr. Reyes had acquired a stake in the Sharks hockey team, and after he had bought his private jet and begun charging the company for his use of it on corporate business.

The pricing policy on that plane seems to have changed over time. During the first two years, the company said it paid less than what it would have cost to charter planes. But during the third year, it said it believed the rate was no better or worse than commercial rates.

Brocade spent almost $1 million on such payments. It also spent the same amount to obtain what it called "marketing and advertising services," as well as the use of facilities, from the Sharks.

The company has offered to settle expected S.E.C. options-related allegations against Brocade for $7 million, an offer it says the commission staff has recommended be accepted by the commission.

Richard Marmaro, a lawyer for Mr. Reyes, did not return telephone calls yesterday. Last week he issued a statement saying that he expected his client to be acquitted, adding that "financial gain is always a motive in securities fraud cases, and here, there was none." He said the government did not claim his client "made any money through the alleged option irregularities."

That is true of the Justice Department charges, but the companion civil case filed by the commission does make such a claim, saying he profited from selling stock while the company was concealing the options backdating.

AMP Section Name:Executive Compensation