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Scrutiny of Options Expected to Grow

The first case alleging backdating of awards signals that prosecutors have a low threshold for what constitutes a crime.

July 22, 2006|James S. Granelli | Times Staff Writer

The government's first charges in a stock-option backdating scandal have put corporate America on notice: It's time to 'fess up, if you haven't already.

What's more, prosecutors are signaling that they have a low threshold for what qualifies as a crime in corporate pay abuses, some legal experts said.

The criminal and civil charges filed Thursday against former Brocade Communications Systems Inc. Chief Executive Gregory L. Reyes and former Human Resources Vice President Stephanie Jensen did not allege that they manipulated stock option awards to enrich themselves.

Rather, prosecutors said, Reyes and Jensen sought to make options more lucrative for other employees as a way to recruit and keep staff from 2000 to 2004.

The crime, the Justice Department and the Securities and Exchange Commission said, was in falsifying documents and thus lying to shareholders about the cost to the company of the option awards. Options give employees the right to buy shares at a set price, called the exercise price, within a certain time period.

"This is a very strong signal that, notwithstanding the fact that the chief executive didn't profit from it, the government is aggressively going after falsifications," said David Brodsky, a New York partner at law firm Latham & Watkins.

Other cases expected to be brought by prosecutors will probably involve top executives who themselves benefited by backdating options -- cherry-picking favorable exercise prices for the options.

But with San Jose-based Brocade, the message is that authorities have cast a wide dragnet in this scandal, lawyers said.

"Before, people weren't sure where the SEC was heading," said lawyer Scott Meyers, head of the litigation group at law firm Levenfeld Pearlstein in Chicago. "Now it's pretty clear where the government is going."

Dozens of companies -- many in Silicon Valley -- in recent months have publicly acknowledged that they are being investigated for how they doled out stock options as part of employee pay packages in the late 1990s and early 2000s.

The Brocade case, experts said, is a warning that companies should be bringing in independent investigators to review their option awards, and that if they find suspect practices, they should go to regulators with the information.

With the first charges now filed, scrutiny of other companies "is only going to get worse" said Steve Barth, a partner at law firm Foley & Lardner in Milwaukee.

SEC Chairman Christopher Cox said Thursday that the SEC was investigating more than 80 companies.

The advice to companies Friday from SEC enforcement chief Linda C. Thomsen: "Call me."

Thomsen said the agency had long pushed companies to report problems and to cooperate in any investigations. That practice, lawyers say, usually leads to leniency toward the companies themselves, if not to the executives who may be responsible for misconduct.

Thomsen conceded, however, that the SEC was dealing with a lot of gray areas in terms of what constitutes misconduct in option practices.

"The fact that we have 80 investigations doesn't mean that we have 80 cases," she said. "Our focus is going to be on fraud.... We're looking at intentional acts."

Normally, the exercise price of an option is the market price of the stock on the day the option is awarded. If an employee eventually exercises the option and then sells the stock, the employee's profit is the difference between the exercise price and the sale price.

The SEC doesn't prohibit backdating of options -- or picking an exercise price that is below the stock's market price -- as long as the company discloses it and correctly accounts for the difference between the lower exercise price and the market price as an expense.

Wayne Smith, co-chair of law firm Gibson Dunn & Crutcher's litigation section, said he believed that what is alleged in the Brocade case -- including falsifying of board meeting minutes and backdating employment records for new hires to get them a better stock option price -- "was at the far end of what most companies did."

Attorneys for Reyes and Jensen on Thursday said their clients were innocent.

Some experts said the Brocade case could strengthen the hand of SEC Chairman Cox in pushing for greater disclosure of executive pay and benefits.

The SEC is set to take up Wednesday the chairman's proposal for more clarity in how companies explain their compensation policies to investors.

The Brocade case "helps put the focus on compensation," said Timothy J. Coleman, a Washington, D.C., white-collar crime defense lawyer and former Justice Department lawyer who supervised the Enron Task Force.

One certain consequence of the option investigations is that outside auditors will be taking a harder look at whether companies followed the rules in awarding options, Brodsky said.

"You think this would be the kind of issue that chief financial officers would be aware of, that auditors would be aware of," he said. "But the evidence is that very few people were paying attention to the requisites for stock option grants."

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