(cross-posted at Deny My Freedom and Daily Kos)
Last weekend, I wrote about the brewing corporate scandal regarding backdated stock options. For a quick refresher, the SEC has been investigating companies that have irregularities with regards to the time when stock options were given to corporate executives and employees. The ongoing investigations were thought to have involved about 50-60 companies and the question of whether or not there has been ‘backdating’ of stock options given as compensation to executives – essentially changing the date at which these options were given to periodic lows of the company’s stock. This in and of itself is not illegal, as the US Attorney Kevin Ryan pointed out, despite the questionable ethics.
Backdating is not necessarily illegal if it is properly disclosed and accounted for, he said. But “fraudulent intent to take advantage of insider information or accounting malfeasance” as well as “an effort to hide from the market and keep others not fully informed” potentially could be deemed securities fraud, accounting fraud or wire fraud.
Essentially, there has to be intent or a lack of full disclosure to investors in order to have a crime. One might think that this high bar would have the effect of diluting the amount of wrongdoing found. However, the first charges were filed yesterday, and if it’s any indication of what’s to come, the Justice Department and the SEC are going to be taking a very hard line:
Federal authorities issued civil and criminal securities-fraud charges against a former Silicon Valley chief executive and two other executives in a stock-options backdating scheme, signaling they will take a hard line in the widening scandal.
Prosecutors accused 43-year-old Gregory Reyes, the CEO of Brocade Communications Systems Inc. until January 2005, of backdating options he doled out as a “committee of one” to hundreds of employees, boosting the potential value of the options and concealing millions of dollars of compensation expenses from shareholders.
Officials underscored how seriously they view options manipulation by charging not just Mr. Reyes — who isn’t directly accused of backdating his own grants, and who made no profit from them — but also a former chief financial officer and former vice president for human resources at the firm.
It’s stunning, to say the least, to see the former CEO of Brocade (a communications company) to be charged for a crime that he did not, at least on the surface, personally appear to benefit from. Additionally, the CFO of the company did not even directly participate in the effort:
In addition, the SEC has filed civil charges against Antonio Canova, Brocade’s former chief financial officer, saying he learned about the scheme in writing but failed to alert Brocade’s auditors or audit committee.
The issue at hand may be markedly different, but it bears a striking resemblance to what happened at Enron. Top executives colluded in a manner that manipulated the value of the firm and its earnings, while other executives turned a blind eye to the problem. An argument one will hear often from corporate defenders when it comes to regulation is that corporations will be able to police themselves and be able to distinguish what is right and wrong. However, as I learned in my corporate ethics class, corporations often get into trouble because they figure out how to try and get around the law – instead of trying to do what is the ethically correct course of action to take.
More from the Wall Street Journal:
The civil and criminal complaints allege broad backdating at Brocade from 2000 to 2004. The SEC alleged that Mr. Reyes was trying to attract employees to the company with particularly valuable options grants. Brocade’s stock price was rising rapidly for part of the period, meaning that every day that passed before employees received their grants decreased potential gains. The complaints allege that Mr. Reyes looked at the stock-price history and picked prior days when the stock was particularly low to date option grants.
[…]
Brocade restated results in 2005 after an internal probe into options matters. The biggest impact was in the year ended Oct. 28, 2000, which swung from a $67.9 million profit to a $951.2 million loss. The restatement lowered net income in some periods, and raised it in others. In all, Brocade shaved a total of $303 million in net income between fiscal 1999 and fiscal 2001, the SEC noted in its complaint.
In yesterday’s filings and at the news conference, officials described in some detail how the alleged scheme worked. In one instance, according to the SEC complaint, Mr. Reyes interviewed a job candidate on Feb. 1, 2002, and told Ms. Jensen that day that the candidate would be hired and should be included in an options grant being backdated to Nov. 28, 2001. Ms. Jensen included the person and signed a backdated offer letter to the candidate, who was hired. When Brocade shares fell, according to the SEC, Mr. Reyes changed the grant date again, and Ms. Jensen directed preparation of a new, backdated offer letter.
The article makes a good point in that backdating options does not necessarily mean that restated earnings will be lower than before – indeed, it may sometimes be higher, particularly if the stock’s price continues to sink for a given period of time. However, for one fiscal year, there was a restatement of over one billion dollars. Imagine if other companies are discovered to have consistently backdated options to the point where it means that there were actually billions of dollars of losses instead of profits. It could easily destroy a company’s share value and cause investors to sell off the stock.
Although it was originally thought that the investigation of backdated stock options was largely relegated to tech companies, which tend to compensate their executives and employees with stock options when they started up in the 1990s and had very little cash with which to pay them, the SEC revealed that the investigation is much broader than anyone had previously anticipated:
Linda Thomsen, the SEC’s enforcement chief, said: “The scheme was blatant. Undisclosed options backdating is an assault on the integrity of public companies.”
She revealed that the SEC was investigating 80 companies across the US, far more than the combined 60 originally thought to be under investigation by both the SEC and the justice department.
Such companies included members of the S&P 500 stock index, and not just technology companies.
Just recently, the Cheesecake Factory – a far cry from a technology company – announced it was checking into its practice of granting stock options. Barnes and Noble said today that the SEC is investigating the company for backdated stock options. If the indictment of Brocade’s top managing executives is any indicator, there is going to be a lot of hurt coming down the road on this. Unlike previous SEC chairman Harvey Pitt, who believes that firms should still be the ones doing the enforcement on themselves (even though he was chairman when the Enron, Tyco, and Worldcom scandals came to light), current chairman Christopher Cox is using fighting words:
The SEC’s Mr. Cox warned that backdating “deceives investors and the market as a whole about the financial health of companies that cheat in this way.” He added, “It is poisonous to an efficient marketplace.”
The punishment for the Brocade executives, should they be found guilty, is a 20-year jail sentence and a $5 million fine.
This is going to be much uglier than originally thought. Apparently, the Sarbanes-Oxley Act wasn’t too much regulation, as corporations have previously complained. The problem was that it was not enough.