Brocade’s ex-CEO: Options backdating not ‘material,’ so can’t be fraud

February 9, 2007, 12:11 AM UTC
Fortune

Brocade’s indicted ex-CEO Greg Reyes filed a nervy motion in federal court Monday whose fate could have an enormous impact on the 200 or so other public companies now under scrutiny for options backdating.

In it, Reyes asks that the fraud charges against him be dropped on the grounds that the backdating of which he stands accused had such a trivial impact on Brocade’s financial statements that no reasonable investor would have paid it any mind when deciding whether to buy or sell a share of Brocade (BRCD) stock. The argument–that the backdating was not legally “material” to investors–is more persuasive than you might expect. You Apple (AAPL) investors out there, desperate to keep Steve Jobs out of harm’s way from options-timing issues at Apple and Pixar, should certainly be cheering the motion on.

Written by Richard Marmaro of Skadden Arps Slate Meagher & Flom, Reyes’s motion may be the most skillful formulation to date of the point-of-view–popular in Silicon Valley–which regards most options backdating as having been a victimless pecadillo that’s been demonized by ex post facto moral indignation. It’s unfair, we’ve been told, to look back at bubble-era conduct through our contemporary, SOX-colored glasses. But Marmaro goes beyond these mushy generalities, and scores some hard-headed points.

Marmaro is defending Reyes against both a federal criminal indictment and a civil SEC enforcement action. The motion was filed in the civil case, but its logic should impact the fraud charges in the criminal case, too, and the same judge is hearing both. (He’s U.S. District Judge Charles Breyer in San Francisco; his brother Stephen sits on the U.S. Supreme Court.)

Of course, it’s important to remember that even if the motion were have the greatest success conceivable–knocking out both the criminal and civil fraud charges–Reyes would still face remaining criminal and civil charges stemming from alleged books and records violations. Still, the most serious charges he faces are securities fraud counts (and mail fraud counts, too, on the criminal side), and those are what the motion takes aim at.

Reyes and Brocade’s former human resources chief, Stephanie Jensen, have been charged with systematically backdating the options granted to scores of Brocade’s employees and new hires from 2000 to 2004, and with falsifying board minutes, job offer letters, and other employment documents to make everything look copacetic. (Former CFO Antonio Canova is also charged in the SEC case.)

Marmaro’s bold argument is this: Assuming, for the sake of argument, that Reyes did all that, investors could not have been defrauded because no reasonable investor at that time was paying any attention to the non-cash expenses the government claims Brocade should have been recording on its income statements.

“Investors deciding whether to purchase a technology growth stock like Brocade . . . analyzed revenues and revenue growth, cash flows, and cash operating expenses,” Marmaro writes, all of which Brocade correctly reported. In fact, Wall Street analysts who covered these stocks routinely drew up “pro forma” income statements that intentionally excluded non-cash expenses because they were regarded as obscuring true operating performance, Marmaro continues. “The backdrop,” he writes, was “a marketplace in which [employee stock option] expenses were widely regarded as having little or no relation to the economic value to employees of the [options] issued or the costs incurred by the companies issuing them.” That was so, in part, because of the multiple uncertainties surrounding whether the options would ever vest and be exercised. In Brocade’s case, for instance, 95% of the options at issue never vested, or were never exercised, or were cancelled, or expired underwater.

In a more unexpected argument-and a bit of a serpentine one-Marmaro also argues that, in essence, Brocade actually did disclose (in the notes to its financial statements) the impact options expensing would have had on its income statements, in case there were any investors out there who really cared. Here’s what he means.

Prior to 2005, companies did not have to expense at-the-money options at all. However, since 1995 they were required, under Statement of Financial Accounting Standards No. 123, to lay out in the notes to the financials what the impact on revenues would have been if such options had been expensed. Most companies, including Brocade, used Black-Scholes calculations to comply with that rule. So if you go to Brocade’s 10-Qs and 10-Ks for the relevant years, you’ll see the impact options expensing would have had on its income statements.

Wait a minute, the reader may be saying. The Black-Scholes calculations of the at-the-money options Brocade claimed to be granting would not have generated the same numbers as Brocade should have been reporting had it properly expensed the in-the-money options it was really awarding. That’s true. But, ironically, because the rules for expensing in-the-money options employed a different valuation technique (not Black-Scholes), the options expenses Brocade actually reported in the notes to its financial statements always showed a higher charge against earnings than the proper calculation would have! (I.e., a higher charge against earnings than the one that ultimately appeared in the restated financials after the backdating was discovered.)

Interesting. But will it fly legally?

I think Marmaro’s motion goes far toward explaining what people in Silicon Valley have been trying to tell us when they’ve protested that there’s something trumped up and ex post facto about the furor over backdating. At the same time, it’s hard to believe Marmaro’s arguments will really get anyone off the civil or criminal hook. Seems like reasonable investors might have attached material significance, for instance, to knowing that Brocade was routinely granting in-the-money options to its employees, if for no other reason that such options don’t serve the incentivizing purposes that at-the-money options are supposed to. It’s also just hard to believe that top corporate executives would have jumped through so many hoops to avoid having to disclose something, if they’d truly regarded it as immaterial to investors.

Sometimes legal arguments just seem too clever to win. I’m doubtful of this one.

What do people think?

COMMENT FROM RICHARD MARMARO: The only thing with which I disagree is your conclusion which I think trivializes a substantial argument supported by 3 expert opinions. Obviously you are entitled to your opinion, but your position did not seem to refute any of our experts’ opinions. Thanks. Rich