By Roger Parloff
July 31, 2007

While the jury continues to deliberate over whether to convict former Brocade (BRCD) CEO Gregory Reyes of felony fraud in connection with that company’s options backdating practices, it is already clear that proving criminal wrongdoing in such cases is much harder than many experts originally predicted. It seems most unlikely that government will be attempting to prosecute many more pure backdating cases criminally in the future. (Cases of backdating plus self-dealing, forgery, and other shenanigans — like the alleged creation at Comverse Technology (CMVT) of a phony account in the name of “I.M. Fanton” (“I am Phantom”) — are another matter, of course.)

For the U.S. Attorney’s Office in San Francisco to come away with a conviction after this six-week trial — which involved a clear-cut, repeated, and long-term pattern of backdating plus evidence of after-the-fact lying by the CEO — it will have to win two arduous victories: one with the jury and, even if successful there, a second with the judge, who has already expressed concern about whether the government has proven Reyes’s criminal intent to even the bare minimum level legally required to sustain a jury verdict. Already one has to wonder whether prosecutors will proceed with their scheduled criminal trial of Reyes’s human resources subordinate, Stephanie Jensen, in light of how difficult it has proven to land the much bigger fish. (Though Jensen and Reyes were indicted together, Jensen’s lawyers won a severance, allowing her to be tried separately.)

Tellingly, on July 25, when the government charged KLA-Tencor’s (KLAC) former CEO Kenneth Schroeder in connection with that company’s options backdating, it brought only civil charges, even though the evidence of Schroeder’s guilty state of mind was arguably stronger than anything presented in the Reyes case. At KLA-Tencor the SEC alleges that in March 2001 the company’s general counsel e-mailed Schroeder a memo explaining why it was illegal to backdate, only to have Schroeder e-mail back: “Please don’t take away some of my best tools for attracting and retaining people. We need those people to win the battle. Help me, don’t just tell me how to follow a strict interpretation of rules. I need a ‘war time counselor,’ not someone who can recite page and verse.”

Nevertheless, even with this sort of powerful evidence about Schroeder’s state of mind, the SEC charges only that Schroeder “knew or was reckless in not knowing” (emphasis added) that his company was not properly accounting for the options it was granting — a mindset warranting only civil, not criminal penalties. (Schroeder’s counsel told the Wall Street Journal that, subsequent to this e-mail exchange, Schroeder spoke to the company’s finance chief and received assurances that the company was handling the options properly. See here.)

Even Apple’s (AAPL) former general counsel Nancy Heinen, whom the SEC charges with having ordered the creation of phony documents to conceal the backdating going on at that company, has only been charged civilly. And, of course, neither Apple nor its CEO were ever charged with anything.

Reyes may have been unfortunate in that Brocade happened to be the first company where backdating came to light. Its problems were not among those exposed by the famous Wall Street Journal Perfect Payday article of March 2006 (see here), but rather came to light more than a year earlier, when a disgruntled employee blew the whistle in late 2004.

On a tangential note, in their desperation to win their challenging case against Reyes, the prosecutors seem to have engaged in some unbecomingly fancy footwork, judging from both the motion to dismiss the indictment that Reyes’s counsel Richard Marmaro filed this past weekend and, to an even greater degree, the government’s legalistic response to it. It appears from the papers that the prosecutors bringing the criminal case have, at the very least, tried to present to the jury a much cleaner and more simplistic picture of what was happening at Brocade than was really the case. The prosecutors have argued to the jury, for instance, that officials in Brocade’s finance and accounting department “didn’t know a thing” of Reyes’s backdating and were deceived by him, but they’ve failed to call many of the key finance officials in question, several of whom have given statements to the FBI and SEC, according to Marmaro’s motion, suggesting considerable knowledge of and acquiescence in at least certain backdating transactions. Indeed, the SEC has charged Brocade’s former CFO Antonio Canova in a civil case, alleging that “he knew, or was reckless in not knowing,” that Brocade was backdating options and not accounting for them properly.

The government’s response to Marmaro’s motion fell far short of the outraged denial that one ordinarily expects in these Kabuki dances. Instead, it begins with the sort of fine, tortured, scholastic distinction that one doesn’t like to see used by public prosecutors: “The defendant [Reyes] contends that the allegations of the SEC’s complaint . . . are actually facts and that the United States’ attorneys erred by making arguments contradicted by those allegations qua ‘facts.’ . . . He cites no authority for that proposition.”

The hair-splitting then continues: “The United States Attorney’s Office . . . and the SEC are independent litigating entities. . . . Indeed, the SEC has on occasion taken positions in litigation opposed to that of the USAO.” Before it’s done, the government admits that it did, during rebuttal summation, “inadvertently” mischaracterize an exhibit related to this issue, but that the harm could be cured by having the jury instructed to disregard the prosecutor’s remark.

Maybe I’m being unfair, so I’ll let you judge for yourself. Here is Marmaro’s motion, here’s the Government’s response, and here’s Marmaro’s reply. Judge Charles Breyer has not yet ruled on the motion, which could, of course, be mooted out by an acquittal.

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