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Backdating Is Seen as Option in Tech Realm

Silicon Valley probes are targeting practices that many consider legitimate means to advance firms' goals.

September 10, 2006|Tom Petruno and Chris Gaither | Times Staff Writers

SAN FRANCISCO — Gregory Reyes was facing a personnel crisis. The executive he had just hired for a top sales job at his Silicon Valley company suddenly was threatening to jump to a competitor.

So Reyes, then chief executive of computer networking firm Brocade Communications Systems Inc., decided to offer the recruit a much bigger pay package. Instead of options to buy 285,000 Brocade shares -- the initial offer -- Reyes anted up 500,000.

He didn't stop there, according to federal prosecutors. They say Reyes dangled a sweetener: The purchase price of the options would be fudged -- "backdated" -- so that the employee would have an immediate paper profit of $2.5 million on the shares.

The government says that was a crime, one that could put Reyes behind bars for 20 years if the charges stick. And more executives could find themselves joining Reyes in court dockets, as prosecutors and securities regulators examine past option grants at more than 100 companies nationwide, most of them technology firms.

The widening probe is of particular concern in the nation's tech center -- Silicon Valley and the San Francisco Bay Area -- where options have long been the coin of the realm. At least 30 firms in the area have disclosed federal inquiries.

But even as the Justice Department and the Securities and Exchange Commission bear down in their investigations, there is a sense of disbelief among many in the tech sector that companies' option practices of the last decade have literally become a federal case.

"Clearly, they did something wrong, but it's very different from a WorldCom or Enron situation, where it appeared the fraud was just to fleece investors," said Tom LaWer, an executive compensation lawyer in East Palo Alto. "It seems as if there was a bit of laziness and stupidity involved."

In the hard-charging entrepreneurial culture of Silicon Valley, the creative use of stock options to reward favored employees is seen by many as a reasonable means to further a company's goals -- not the basis of a criminal conspiracy.

"I'm reluctant to read a gigantic morality tale into this," said Paul Kedrosky, a former tech stock analyst who now runs the von Liebig Center for Entrepreneurism and Technology Advancement at UC San Diego. "It's more like speeding on the highway. Everyone saw other people doing it and thought it was OK."

That doesn't wash with many big investors and corporate governance experts, who note that the crux of the government's concern is that executives flat-out lied to shareholders and handed out unauthorized stock wealth to colleagues and to themselves.

To some critics, it's no surprise that the tech industry is playing a starring role in the option scandal. Silicon Valley has long had a reputation for being disdainful of outside shareholders' demands for accountability.

"They thought they lived by different rules," said Jeffrey Sonnenfeld, a professor of management at Yale and founder of the Chief Executive Leadership Institute in Atlanta. "They said e-governance was different."

A stock option is the right to buy shares for a set amount -- the exercise price -- within a certain period of time. For the tech industry, options were a favored compensation tool beginning in the 1980s because many up-and-coming firms couldn't afford to pay big salaries to workers. Stock was the logical alternative.

A key argument for using options as a carrot has been that they aligned workers' interests with those of shareholders. With skin in the game, employees would have a greater incentive to work hard and boost sales and earnings, thus driving up the share price.

With the tech industry boom and rocketing stock prices of the late 1990s, options became the most coveted currency of Silicon Valley.

"The temper of the time was equity uber alles," Kedrosky said. "The whole game was stock, which was totally motivated by the perception that stock had unlimited upside and the upside happened within six months."

If the market price of a firm's shares soared, an employee with vested options could immediately sell and haul in a handsome capital gain.

But from shareholders' viewpoint, a crucial feature of options is that the exercise price normally is the stock's final market price the day the option is granted by company directors. In other words, there is no built-in gain for the employee when options are awarded.

It now is clear that some companies in fact awarded options that already were profitable, or "in the money," at least on paper.

"The whole point is to incentivize performance" via options, said Carol Bowie, director of governance at the Investor Responsibility Research Center, a Washington-based group that counsels institutional investors on governance issues. "If you're giving in-the-money options, that defeats the purpose."

Investigators are focusing largely on so-called backdating, which at its most extreme amounts to looking back on the calendar and cherry-picking the most favorable recent prices for option grants.

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