Prosecution and Defense of Stock Option Backdating Cases

Did the Defendant Understand the Accounting Rules?

Whether the defendant understood the applicable accounting rules is a particularly vexing element of proof for both the government and defense. The accounting rules governing stock options are very muddy, and both public accounting boards and the SEC have repeatedly acknowledged that companies have had problems applying them in practice. The defense in Reyes argued both that the government failed to prove that Mr. Reyes was aware of the applicable rules and that the rules were complex, confusing, and had been misapplied by other companies.

Some 100-200 publicly traded companies have announced that they improperly accounted for backdated stock options and are under investigation. See 'Companies Responding to Stock Options Investigations' (Dow Jones & Co., Aug. 16, 2007, listing 140 publicly traded companies under investigation by the SEC). Either this country is facing its greatest corporate crime wave in history, or something else explains these startling numbers. The Reyes defense argued that the answer is found in the complex accounting rules that govern awards of stock options to corporate employees.

At the time relevant to most backdating cases, the governing accounting standards were issued by The Accounting Principles Board (APB), the predecessor to today's Financial Accounting Standards Board (FASB). APB Opinion No. 25 (1972), which sought to explain how companies should account for stock issued to employees, says that under 'traditional stock option ' plans an employer corporation grants options to purchase a fixed number of shares of stock of the corporation at a stated price during a specified period ' often at a discount from the market price of the stock at the date the rights are granted' (emphasis added). The murky last clause ' 'often at a discount from the market price of the stock at the date the rights are granted' ' suggests that corporations have flexibility in accounting for backdated options. As the defense in Reyes argued, this clause may well have contributed to the accounting confusion that has endured ever since.

In 1995, FASB issued a new accounting standard, FAS 123, entitled 'Accounting for Stock-Based Compensation.' FAS 123 purported to establish a new method for accounting for stock grants to 'mitigate deficiencies' in APB 25. Significantly, however, the FASB chose not to overrule or rescind Opinion 25, even though it acknowledged criticism that the Opinion produced anomalous results and offered little general guidance on how to account for new forms of stock-based employee compensation. Instead, FAS 123 provided an alternative to the APB 25 method for valuing stock grants while explicitly allowing companies to continue relying on APB 25. As has since become clear, many companies continued to employ APB 25's accounting methodology when issuing stock to employees and, unsurprisingly (as the Reyes team noted), continued to get the accounting wrong.

The uncertainty surrounding APB 25 led the FASB to issue yet another clarification in 2000. FASB Interpretation No. 44 (2000) ('FIN 44') was 'an interpretation of APB Opinion No. 25' issued because 'questions have been raised about [APB 25's] application' and because 'diversity in practice has developed.' The FASB went on to explain that when it issued FAS 123 in 1995, it 'decided not to address practice issues related to the application of Opinion 25. That decision was based on the Board's initial plan to supersede Opinion 25. However, Statement 123 permits entities to continue applying Opinion 25 to stock compensation involving employees. Consequently, questions remain about the application of Opinion 25.'

The FASB's attempt in FIN 44 to explain the persistent confusion surrounding APB 25 is unsatisfactory and startling in light of the criminal cases being brought today. In essence, the FASB admitted that: 1) APB 25 has created numerous practice problems; 2) the FASB intentionally disregarded those problems in 1995 because it planned to overrule APB 25; and 3) during its continued life, APB 25 fostered the very 'diversity in practice' that necessitated FAS 123 and FIN 44. It was not until December 2004, when the FASB revised FAS 123 in a publication known as FAS 123-R (2004), that the FASB finally overruled APB 25.

In Reyes, the defense argued that problems associated with accounting for stock options have persisted even with the overruling of APB 25. A September 2006 letter issued by the SEC's Office of the Chief Accountant (OCA) supports that contention. The OCA wrote the letter 'to discuss certain existing accounting guidance related to grants of stock options' in light of the fact that several companies 'have recently issued press releases announcing the restatement of their financial statements due to errors in their accounting' of stock options under APB 25.

Since an essential element of a charge of stock option backdating is proof that the defendant understood but violated applicable accounting rules, the tortured history of those rules significantly buttresses the potential defense that corporate officers were unaware of the accounting or disclosure consequences of backdating. That defense was unsuccessful in Reyes. Nevertheless, the issue is sure to be litigated in future cases, and the ground is fertile for future defense arguments.

Materiality in Backdating Cases

Materiality proved to be a hotly contested issue in the Reyes trial. The defense argued to the jury that stock option grants are non-cash costs that investors do not care about when making investment decisions. Indeed, the defense offered testimony from a fund manager who said that he omits those non-cash expenses when he reviews the financial performance of companies in which he is considering investing. In contrast, the government offered testimony from a mutual-fund employee who said that his firm disapproved of backdated options, and that such practices would have been of concern to the fund, which had as much as $2 billion invested in Brocade at one time. The government also presented testimony from a portfolio manager who said that backdating options inflated a company's net income and that, while backdating perhaps was not the most important factor in assessing a company's performance, it nevertheless was relevant to his investment decisions.

The Reyes jury was instructed as follows on materiality: '[I]nformation is material if there is a substantial likelihood that a reasonable investor would ' find it significant in deciding whether to buy, sell or hold a security ' [T]o find that a particular misrepresentation or omission is material, you must find that reasonable investors would have viewed [it] as having significantly altered the total mix of information made available to them.' It is clear that the materiality of backdating is an issue over which the government and defendants will continue to clash in future cases.

Motive to Backdate

Reyes was notable because there was no proof that the defendant had received any backdated options himself, so his motive to engage in backdating was less than clear. Motive is not an element of the offense of backdating, but proof of motive nevertheless has a powerful effect on juries. The government could not argue that Reyes backdated to line his own pockets with in-the-money options and instead argued that he acted to attract or retain corporate talent in order to improve the company's performance and thereby benefit his own professional standing and reputation.

While this is not as powerful a motive as in cases where the government argues that the defendant was motivated by greed, Reyes shows that, at least where there is evidence that the defendant understood the applicable accounting rules, the government can obtain a guilty verdict even where there is no proof that the CEO himself received backdated options.

Conclusion

The law in this area will continue to develop. The four issues examined here, and tested to some extent on the unique facts of the Reyes case, illustrate the likely flash points in future stock option prosecutions.

Steven F. Reich, a member of this newsletter's Board of Editors, is chair of the Criminal Defense and Investigations practice group at Manatt, Phelps & Phillips, LLP. Andrew C. DeVore is a principal in DeVore & DeMarco LLP and a former federal prosecutor in the Southern District of New York. Both Mr. Reich and Mr. DeVore, and their respective firms, represent individuals in stock option backdating matters.

After Michael E. Clark reviewed then-emerging issues in the area of stock option backdating in last December's issue of Business Crimes Bulletin, former Brocade Communications Systems, Inc. CEO Gregory Reyes was found guilty of backdating-related crimes despite what most observers agree was a vigorous and well-funded defense. United States v. Reyes, No. 06-0556 (N.D. Cal., jury verdict, Aug. 7, 2007). This article discusses four critical issues likely to influence future backdating cases.

Backdating Is Not a Garden Variety Stock Fraud

Backdating is different from conduct typically alleged as stock fraud because it is not in itself illegal. So long as the backdating of options is accompanied by proper accounting treatment and public disclosure, there is no securities law violation. Backdating cases thus have come to be thought of largely as accounting cases. As a result, a potent potential defense has emerged for corporate officers who may have known backdating was occurring but, because they did not have hands-on responsibility for their company's financial or accounting practices, were unaware of the accounting or disclosure consequences of that practice. This defense does not exist with more common forms of alleged stock fraud where, for example, a defendant would be unlikely to claim that he or she was aware of revenue manipulation but didn't understand that such manipulation had accounting consequences or had to be disclosed.

Did the Defendant Understand the Accounting Rules?

Whether the defendant understood the applicable accounting rules is a particularly vexing element of proof for both the government and defense. The accounting rules governing stock options are very muddy, and both public accounting boards and the SEC have repeatedly acknowledged that companies have had problems applying them in practice. The defense in Reyes argued both that the government failed to prove that Mr. Reyes was aware of the applicable rules and that the rules were complex, confusing, and had been misapplied by other companies.

Some 100-200 publicly traded companies have announced that they improperly accounted for backdated stock options and are under investigation. See 'Companies Responding to Stock Options Investigations' (Dow Jones & Co., Aug. 16, 2007, listing 140 publicly traded companies under investigation by the SEC). Either this country is facing its greatest corporate crime wave in history, or something else explains these startling numbers. The Reyes defense argued that the answer is found in the complex accounting rules that govern awards of stock options to corporate employees.

At the time relevant to most backdating cases, the governing accounting standards were issued by The Accounting Principles Board (APB), the predecessor to today's Financial Accounting Standards Board (FASB). APB Opinion No. 25 (1972), which sought to explain how companies should account for stock issued to employees, says that under 'traditional stock option ' plans an employer corporation grants options to purchase a fixed number of shares of stock of the corporation at a stated price during a specified period ' often at a discount from the market price of the stock at the date the rights are granted' (emphasis added). The murky last clause ' 'often at a discount from the market price of the stock at the date the rights are granted' ' suggests that corporations have flexibility in accounting for backdated options. As the defense in Reyes argued, this clause may well have contributed to the accounting confusion that has endured ever since.

In 1995, FASB issued a new accounting standard, FAS 123, entitled 'Accounting for Stock-Based Compensation.' FAS 123 purported to establish a new method for accounting for stock grants to 'mitigate deficiencies' in APB 25. Significantly, however, the FASB chose not to overrule or rescind Opinion 25, even though it acknowledged criticism that the Opinion produced anomalous results and offered little general guidance on how to account for new forms of stock-based employee compensation. Instead, FAS 123 provided an alternative to the APB 25 method for valuing stock grants while explicitly allowing companies to continue relying on APB 25. As has since become clear, many companies continued to employ APB 25's accounting methodology when issuing stock to employees and, unsurprisingly (as the Reyes team noted), continued to get the accounting wrong.

The uncertainty surrounding APB 25 led the FASB to issue yet another clarification in 2000. FASB Interpretation No. 44 (2000) ('FIN 44') was 'an interpretation of APB Opinion No. 25' issued because 'questions have been raised about [APB 25's] application' and because 'diversity in practice has developed.' The FASB went on to explain that when it issued FAS 123 in 1995, it 'decided not to address practice issues related to the application of Opinion 25. That decision was based on the Board's initial plan to supersede Opinion 25. However, Statement 123 permits entities to continue applying Opinion 25 to stock compensation involving employees. Consequently, questions remain about the application of Opinion 25.'

The FASB's attempt in FIN 44 to explain the persistent confusion surrounding APB 25 is unsatisfactory and startling in light of the criminal cases being brought today. In essence, the FASB admitted that: 1) APB 25 has created numerous practice problems; 2) the FASB intentionally disregarded those problems in 1995 because it planned to overrule APB 25; and 3) during its continued life, APB 25 fostered the very 'diversity in practice' that necessitated FAS 123 and FIN 44. It was not until December 2004, when the FASB revised FAS 123 in a publication known as FAS 123-R (2004), that the FASB finally overruled APB 25.

In Reyes, the defense argued that problems associated with accounting for stock options have persisted even with the overruling of APB 25. A September 2006 letter issued by the SEC's Office of the Chief Accountant (OCA) supports that contention. The OCA wrote the letter 'to discuss certain existing accounting guidance related to grants of stock options' in light of the fact that several companies 'have recently issued press releases announcing the restatement of their financial statements due to errors in their accounting' of stock options under APB 25.

Since an essential element of a charge of stock option backdating is proof that the defendant understood but violated applicable accounting rules, the tortured history of those rules significantly buttresses the potential defense that corporate officers were unaware of the accounting or disclosure consequences of backdating. That defense was unsuccessful in Reyes. Nevertheless, the issue is sure to be litigated in future cases, and the ground is fertile for future defense arguments.

Materiality in Backdating Cases

Materiality proved to be a hotly contested issue in the Reyes trial. The defense argued to the jury that stock option grants are non-cash costs that investors do not care about when making investment decisions. Indeed, the defense offered testimony from a fund manager who said that he omits those non-cash expenses when he reviews the financial performance of companies in which he is considering investing. In contrast, the government offered testimony from a mutual-fund employee who said that his firm disapproved of backdated options, and that such practices would have been of concern to the fund, which had as much as $2 billion invested in Brocade at one time. The government also presented testimony from a portfolio manager who said that backdating options inflated a company's net income and that, while backdating perhaps was not the most important factor in assessing a company's performance, it nevertheless was relevant to his investment decisions.

The Reyes jury was instructed as follows on materiality: '[I]nformation is material if there is a substantial likelihood that a reasonable investor would ' find it significant in deciding whether to buy, sell or hold a security ' [T]o find that a particular misrepresentation or omission is material, you must find that reasonable investors would have viewed [it] as having significantly altered the total mix of information made available to them.' It is clear that the materiality of backdating is an issue over which the government and defendants will continue to clash in future cases.

Motive to Backdate

Reyes was notable because there was no proof that the defendant had received any backdated options himself, so his motive to engage in backdating was less than clear. Motive is not an element of the offense of backdating, but proof of motive nevertheless has a powerful effect on juries. The government could not argue that Reyes backdated to line his own pockets with in-the-money options and instead argued that he acted to attract or retain corporate talent in order to improve the company's performance and thereby benefit his own professional standing and reputation.

While this is not as powerful a motive as in cases where the government argues that the defendant was motivated by greed, Reyes shows that, at least where there is evidence that the defendant understood the applicable accounting rules, the government can obtain a guilty verdict even where there is no proof that the CEO himself received backdated options.

Conclusion

The law in this area will continue to develop. The four issues examined here, and tested to some extent on the unique facts of the Reyes case, illustrate the likely flash points in future stock option prosecutions.

Steven F. Reich, a member of this newsletter's Board of Editors, is chair of the Criminal Defense and Investigations practice group at Manatt, Phelps & Phillips, LLP. Andrew C. DeVore is a principal in DeVore & DeMarco LLP and a former federal prosecutor in the Southern District of New York. Both Mr. Reich and Mr. DeVore, and their respective firms, represent individuals in stock option backdating matters.