A federal jury in San Francisco recently returned guilty verdicts on all counts in the first criminal trial involving backdated stock options. Gregory Reyes, former CEO of Brocade Communications Systems, Inc., was charged with securities fraud, mail fraud, making false SEC filings, false statements to auditors, and falsifying books and records. Separately from this criminal prosecution, the SEC has targeted more than 100 companies for backdating. Many other companies have conducted internal investigations.
A stock option is the right to purchase stock at a set price. Options have been used for many years as a compensation incentive to reward employees for enhancing shareholder values. The term "backdating" refers to setting the grant date of an option to a prior date when the value of the company's stock was lower. Employees receive awards with built-in gains. Backdating can also happen unintentionally through failure to follow corporate formalities. Under the law, an option is not granted until all required corporate action has occurred to create an enforceable right to buy stock. This normally requires action by the board of directors or compensation committee specifying the key terms of the option, including the option recipient, the number of shares, the vesting schedule, the exercise price and the type of award. If the board ratifies the grant of an option at a prior date, the ratification date becomes the actual grant date. While some backdating has occurred intentionally, it can occur inadvertently if corporate records are incomplete on the actions taken to show when options were granted.
Regardless of intent, the effect on corporate earnings is the same under accounting rules that governed stock options prior to 2006. Companies could issue stock options without recording a compensation expense as long as the exercise price of the option was no less than the market value on the true grant date. If the exercise price was less than the market value on the true grant date, the company would be required to reduce earnings by the amount of the discount. In backdating cases, companies have been charged with over-stating earnings to investors due to failure to recognize the discounts between the market value on the true grant date and the option exercise price. In the Reyes case, Brocade was required to restate its earnings over a five-year period to show a decline of more than $300 million in corporate earnings during the period.
Obviously, these accounting and tax rules governing equity compensation are extremely complex. Legal commentators have expressed skepticism about the government's ability to prove criminal intent in these cases - did the defendant understand the accounting implications of the backdating practice and know that the company's financial statements would be misstated as a result? The successful prosecution of Reyes will likely encourage prosecutors to file criminal charges in other cases involving backdated stock options.
At trial, Reyes' defense attorney argued that Reyes had no accounting background and offered stock grants as a way to attract talented employees and increase shareholder value. In an attempt to contrast Reyes with Enron's Ken Lay and other executives who personally profited from other types of corporate wrongdoing, Reyes' attorney also made much of the fact that Reyes himself did not receive any backdated options. Prosecutors, however, introduced evidence that Reyes and others backdated compensation committee minutes, employment agreements and other documents in order to make it appear that the stock options were granted on dates when the value of Brocade's stock was relatively low. Prosecutors also had "smoking gun" testimony from a former Brocade human resources manager, who testified about a conversation regarding stock options in which Reyes said, "It's not illegal if you don't get caught." The jury obviously found this evidence sufficient to convict Reyes notwithstanding the defense's argument that Reyes lacked criminal intent. The jury's willingness to convict Reyes after a lengthy trial in the highly technical arena of stock option accounting is likely to embolden prosecutors to pursue criminal charges in other pending backdating investigations.
The backdating issue may be of less concern for prospective option awards. Since August 2002, all directors and senior officers have been required to report the receipt of an option within two business days on SEC Form 4. Before that rule change, Form 4 reporting could be done at the end of a calendar quarter or, sometimes, at the end of the year. The newer two-day rule eliminates the practical opportunity to backdate options for directors or officers. Since 2006, accounting rules governing stock options have eliminated the ability to grant options for zero cost. All equity based compensation awards are treated as compensation and charged to earnings, just like cash.
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