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KB Home backdating case has high stakes for prosecutors

They seek to punish ex-CEO Bruce Karatz, but also to improve the record of a massive stock-options crackdown that so far has yielded few convictions.

March 08, 2010|By Stuart Pfeifer

Two months after the federal government's criminal cases against Broadcom Corp.'s top executives collapsed, the U.S. attorney's office is taking aim at another stock-options backdating target: former KB Home chief Bruce Karatz.

The stakes will be high for federal prosecutors when Karatz's trial starts Tuesday in Los Angeles.

Not only will they be seeking to punish a man they say flouted federal law while making millions of dollars for himself and his employees, they'll also be seeking to improve the record of a massive options crackdown that so far has yielded few convictions.

During the tech boom, no two words made American workers smile more than "stock options." Options turned thousands of ordinary people into millionaires and some millionaire executives into billionaires, while the tech-heavy Nasdaq stock index soared to a record high in March 2000.

In the years that followed, regulators and prosecutors began to investigate whether companies had broken the law by failing to disclose that they had backdated options to make them more valuable.

But several high-profile options trials have backfired on prosecutors -- most recently their cases against Henry Samueli and Henry T. Nicholas III, co-founders of Broadcom, the Irvine chip designer.

This time the government is targeting 64-year-old Karatz, who served as KB Home's chief executive from 1986 to 2006. During that time, Karatz won acclaim as a marketing genius. In 2006, Fortune magazine named KB Home the country's "most admired" home builder. The stock market value of the Westwood firm increased more than 1,200%from 1995 to 2005.

In this case, the government contends that Karatz handpicked dates when KB's stock price was low to inflate the value of his options, making millions in the process. That's a key difference between the Broadcom and KB cases: Samueli and Nicholas were not accused of wrongfully enriching themselves -- only their employees.

Options are a form of compensation. They give employees the option to buy a set amount of stock at a set price -- usually the closing price on the day they're granted. If the stock rises, employees can exercise their option to buy at the lower price and then sell at the current price for a profit.

Companies are allowed to backdate options to dates when the stock price was lower, making the options more valuable, as long as they account for it in Securities and Exchange Commission filings.

Prosecutors allege that Karatz directed KB officials to hide that the company had backdated options for many years.

In 2007, KB restated its earnings to disclose $70 million in liabilities related to the backdating of options from 1999 to 2005, according to the indictment.

The indictment does not say exactly how much Karatz may have gained as a result. But when he left the company in 2006, KB required Karatz to pay back $13 million the company said he personally gained as a result of backdating. Karatz also paid $7.2 million to settle a lawsuit filed by the SEC. As part of the settlement, he admitted no wrongdoing.

Defense lawyers contend that Karatz and other company executives played by the rules as they understood them and that many other publicly traded companies handled options the same way KB did.

"The evidence will show that no one at KB Home, including the defendant . . . thought they were committing a crime when they set the grant dates for stock options," defense lawyer John Keker wrote in a trial brief.

It's the same defense that William J. Ruehle, the former chief financial officer for Broadcom, used at his options-fraud trial last year in Santa Ana.

U.S. District Judge Cormac J. Carney dismissed that case before jurors began deliberations, saying that prosecutors had improperly intimidated witnesses. He also questioned whether Ruehle and others at Broadcom had intended to commit any crimes.

"The accounting standards and guidelines were not clear, and there was considerable debate in the high-tech industry as to the proper accounting treatment for stock option grants," Carney said. "Indeed, Apple and Microsoft were engaging in the exact same practices as those of Broadcom."

Keker, Karatz's lawyer, said he was expecting a similar outcome for his client.

"The recent decisions in the backdating trials," he said, "show just how misguided the criminal prosecution of these option-pricing cases is."

stuart.pfeifer@latimes.com

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