• SEC and DOJ File First Civil and Criminal Charges Involving Stock Option Backdating
  • August 4, 2006 | Author: M. Duncan Grant
  • Law Firm: Pepper Hamilton LLP - Wilmington Office
  • On July 20, 2006, the Securities and Exchange Commission and federal prosecutors in San Francisco filed civil and criminal charges against the former CEO of Brocade Communications, Gregory Reyes, and Brocade’s former vice president for human resources, Stephanie Jensen, in one of the first cases involving the alleged backdating of stock option grants in violation of federal securities laws. The criminal charges carry a penalty of as much as 20 years in prison and a fine of up to $5 million. The SEC also filed a civil complaint against Antonia Canova, Brocade’s former CFO.

    The director of the SEC’s Enforcement Division, Linda Chatman Thomsen, stated that “this case will not be the last” involving the arguably widespread practice of backdating stock options.

    According to the SEC’s civil complaint, Reyes and Jensen routinely granted in-the-money stock options from 2000 to 2004 to enable Brocade to hire or retain certain employees, but in doing so, they modified documents to make it appear that the options had been granted on earlier dates with exercise prices equal to the closing market prices on such earlier dates.

    The SEC alleges that during that period, when Reyes, the sole member of the company’s compensation committee, distributed stock options to new or current employees, Jensen and others had previously supplied him with Brocade’s stock-price history, highlighting the lowest closing price during recent months. When the compensation committee granted options, according to the SEC, Reyes backdated offer letters and minutes of compensation committee meetings, so that the options would appear to have been granted on dates when the price of Brocade’s stock was low, with the exercise prices equal to the market prices at the close of trading on such dates. In certain instances, Reyes’ scheme allegedly resulted in options having been granted to certain persons before they had been hired by Brocade.

    Because Reyes and Jensen are charged with having created documentation that falsely represented that the options had been granted on an earlier date, which often corresponded with quarterly lows, Brocade is said to have violated generally accepted accounting principles by failing to properly record options-related expenses in its income statements.

    After discovering the backdating practice, Brocade was obligated to restate its prior financial statements by increasing its net loss from $2 million to $32 million in 2004, and by reducing net income by $304 million for the three-year period 1999 to 2001.

    According to various newspaper reports and statements from the SEC, numerous other companies are already under investigation for actions similar to those alleged to have occurred at Brocade. Federal prosecutors in California and New York have initiated investigations of at least several dozen companies that may have accounting problems associated with option backdating, and the SEC is investigating at least 80 companies.

    There are tax implications, as well, when an option is awarded at a price below the market price on the date of the grant. According to a press report, the Internal Revenue Service is now auditing the returns of several dozen companies and their top officers to determine whether there are additional income tax liabilities arising from the improper reporting of option grants.

    The interest that the SEC, federal prosecutors and the IRS are showing in the issue should be a strong warning to directors, officers and counsel to review their companies’ policies with regard to the granting and dating of stock options. It would appear to be nearly inevitable that stockholder class actions will follow soon.

    When handled properly, it is perfectly legal and appropriate to grant stock options to directors, officers and employees, but the intricate set of accounting and tax rules governing the granting of options must be followed very strictly. Backdating of option grants should be avoided in all circumstances. Moreover, the SEC voted on July 26 to adopt rules requiring that public companies disclose any executive compensation programs or practices that award stock options and set the exercise price based on the stock’s price on a date other than the actual grant date.

    The interest shown by federal prosecutors demonstrates that backdating and other improprieties involving the granting of options may create risks that are far greater than even having to restate the corporation’s prior years’ financial statements.