Federal investigators leveled civil and criminal securities fraud charges against former Brocade Communications Systems Inc. (BRCD) CEO Gregory Reyes Thursday, the first of what promises to be many indictments related to the backdating of employee stock options.
The United States Attorney’s Office in San Francisco charged Reyes, 43, and former Brocade VP of Human Relations Stephanie Jensen, 48, of one count each of securities fraud for allegedly falsifying the dates that stock options were issued to employees, and then further falsifying documents to cover up the original fraud. The federal Securities and Exchange Commission filed a civil suit against the pair and against former Brocade CFO Antonio Canova, who allegedly was complicit in the cover-up.
The alleged fraud between 2000 and 2004 “resulted in the inflation of Brocade’s net income by $1 billion in the year 2000 alone,” concealing millions of expenses from investors, SEC Chairman Chris Cox said in a press conference in The City. Brocade, a San Jose company with about $600 million in annual sales, makes switches and software for computer networks.
Cox said the agency is investigating more than 80 companies nationally for similar practices: “The full weight of the federal government is being put behind this effort,” he said.
Backdating stems from the custom of granting employees stock options as part of their compensation package, a common practice in technology firms. Accounting and tax rules stipulate that such stock options are issued on the datethe decision is made to grant the stocks. But in backdating, the stock-issue date is pegged to an earlier time when the stock was worth less, so the recipients receive stock options already increased in value.
Reyes and Jensen used backdated options to make Brocade’s compensation more attractive in a competitive technology job market, Federal Bureau of Investigation agent Joseph Schadler said in the criminal complaint.
The company said in a statement it has already restated its earnings and that “none of the charges affected its historical revenues, cash positions, or non-stock option related operating expenses.” The company has offered the SEC a $7 million settlement.
Reyes’ attorney Richard Marmaro said his client is innocent.
“Mr. Reyes is not even alleged to have granted himself any of the options at issue in the case, nor is there even an allegation that he made any money through the alleged option irregularities. All he did was what his board authorized him to do,” Marmaro said.
Before accounting reforms in 2002, backdating could be legal if disclosed to shareholders and the federal Internal Revenue Service, but in many cases that did not happen, according to University of Iowa Professor Eric Lie, whose work brought the scandal to light. When backdating occurs without reporting, money that should have been either paid in dividends to shareholders or reinvested in the company becomes unacknowledged compensation, meaning that earnings reports can be inaccurate — and that the IRS may not have been told of the extra income for the recipients.
FBI Acting Special Agent in Charge Arthur Balizan said backdating erodes confidence in the entire publicly-traded market.
Nearly a third of the companies that have acknowledged internal or federal inquiries possible backdated options are headquartered in Bay Area.
As regulatory agencies investigate, the question remains whether beneficiaries will have to pay the piper. That is likelier for executives that had knowledge of the wrongdoing than for line workers, analysts said, but both may face income-tax consequences. The IRS is not yet partnering with the FBI, U.S. Attorney’s Office and SEC, but can be brought in if the tax issue is shown to be major, U.S. Attorney Kevin Ryan said.
“There are probably plenty of cases where there is no criminal liability whatsoever. It depends on the facts of each case,” U.S. Attorney Eumi Choi said.