Brocade, Reyes, and Sonsini: Er, uh, never mind

July 17, 2007, 4:55 PM UTC
Fortune

Even before Brocade Communications System’s (BRCD) former CEO Gregory Reyes was indicted last summer for his role in that company’s stock options back-dating scandal, he seemed to be preparing to implicate Palo Alto superlawyer Larry Sonsini in the mess.

Sonsini’s firm, Wilson Sonsini Goodrich & Rosati, was Brocade’s outside counsel and Sonsini was a director on Brocade’s board. In an interview with Business Week in February 2006, available here, Reyes suggested that the company’s board was scapegoating him, and he seemed particularly incensed with Sonsini. Reyes argued that Sonsini — who had talked Reyes into resigning in January 2005, after an internal investigation at the firm confirmed backdating problems — had been the one who counseled him in 1999 to serve as a “committee of one” when granting stock options, rather than requiring the full board to approve each grant. This was a factor that had presumably made it easier for Reyes to backdate with impunity.

When I wrote a profile of Sonsini that ran in the November 17, 2006, issue of Fortune (available here), Reyes’s criminal defense attorney Richard Marmaro, of Skadden Arps Slate Meagher & Flom, also seemed to be linking Reyes’s plight to Sonsini, albeit more backhandedly: “Sonsini at all times acted totally above board and with the highest ethics of the profession,” Marmaro told me then, “and my client relied on his sage advice.”

But last Wednesday, the day Marmaro had told reporters he would be calling Sonsini as a witness , he didn’t, and it now appears likely that Sonsini won’t be called at all. (Marmaro did not respond to an email seeking comment.) The government had also put Sonsini on its witness list, but didn’t call him.

Reyes’s accusation against Sonsini — that he advised setting up the committee of one — was always a giant step removed from anything that would either truly exonerate Reyes of wrongdoing or truly implicate Sonsini in it. Notably, Reyes never accused Sonsini of telling him that it was okay to backdate, which is what the crime was. Committees of one were, and still are, commonly used for awarding options for lower level corporate executives, especially at companies like Silicon Valley startups for which options constitute a critical part of rank-and-file employees’ compensation. The law of Delaware, where Brocade was incorporated, authorizes their use for that purpose, and that’s the only use Brocade made of them. (Committees of one can’t be used for granting options to corporate officers, directors, or 10% shareholders — which would create a risk of self-dealing — and Brocade didn’t use them for that purpose.)

When I did my profile, Wilson Sonsini’s spokesperson also noted that, for what it was worth, the firm hadn’t even been the one that set up Brocade’s “committee of one” in any event. She said that committee had already been in place when Sonsini began advising Brocade, having been set up when a different law firm was advising Brocade, although she declined to name it. But in late May (as the Wall Street Journal reported here), after civil class action lawyers asked a judge to take judicial notice that Sonsini had set up Brocade’s committee of one (relying on press accounts of what Reyes told Business Week), the firm finally produced a copy of the February 1998 board minutes which do, indeed, show that the committee was created then, about 11 months before Sonsini began representing Brocade and joined its board. The firm’s outside attorneys in February 1998 had been Fenwick & West, another highly regarded Palo Alto firm, and the minutes were signed by its partner Dennis DeBroeck, as Brocade’s corporate secretary. (Wilson Sonsini’s filing, with the minutes attached as Exhibit A, is available here. DeBroeck, by the way — and I’m really just offering this in the spirit of “small world!” and not as an intimation of a vast conspiracy — is the husband of Nancy Heinen, the former general counsel of Apple (AAPL), who has been charged civilly by the SEC in connection with Apple’s backdating problems. (Calls and emails to DeBroeck and the firm’s chairman were returned by a spokesperson, who declined comment.)

Meanwhile, the pivotal issue in the Reyes trial has turned out to be what it so often is in white-collar trials: criminal intent. And though Marmaro has developed a rather complicated and interesting theory about why backdating involved no “material” misrepresentation (required to make out a fraud case), see earlier post on that, the crux of the case is proving to be much simpler and more basic: Did Reyes even realize he was doing anything wrong? In essence, it’s the Steve Jobs defense: Marmaro says Reyes didn’t understand the accounting repercussions of backdating. And just as the SEC evidently did not think it could prove Jobs knew that backdating was wrong (even by a less rigorous civil standard of proof), Judge Charles Breyer is now weighing seriously whether the government failed to meet its burden of proving beyond a reasonable doubt that Reyes knew he was doing something wrong. Breyer said he’d deliver his ruling on Thursday.

If Judge Breyer rules against Reyes and allows the trial to proceed, the moral for Reyes may be a hackneyed one: it’s not the crime, it’s the cover-up. The best evidence at the moment that Reyes knew he did anything wrong is that he allegedly lied to the attorney performing Brocade’s internal investigation in late 2004 when asked whether he used “look-backs” to price options at Brocade. The attorney, Craig Martin of Morrison & Foerster, testified that Reyes denied using look-backs — i.e., retrospectively looking for the lowest stock price of the previous quarter and then backdating options grants to that date — when in fact the company used them routinely and the evidence establishes that Reyes had to have known it did.

As bad as that looks, though, a crucial question remains as to when Reyes learned that there was something wrong with using look-backs. The backdating occurred from 2000 to 2002, so Reyes may have only learned that there was a problem much later. Much of the other evidence offered by the government as to Reyes’s state of mind suffers from the same problem. An email he authored, saying “IT IS ILLEGAL TO BACKDATE OPTIONS GRANTS,” was not written until October 2004. Similarly, a human resources officer who testified that Reyes told her, “It’s not illegal if you don’t get caught,” was uncertain as to precisely when the conversation occurred and even as to what Reyes meant by “it.”

The most likely outcome is that Judge Breyer will deny the motion for acquittal and let the jury grapple with the same questions itself. If he grants the acquittal motion now, the trial is over, the jury never gets to consider the case, and the acquittal order is unappealable, law professor Robert Weisberg of Stanford tells me, since double jeopardy attaches immediately. If, on the other hand, Breyer lets the jury decide the case, and the jury ultimately convicts, the judge could still enter a judgment of acquittal notwithstanding the verdict (called a judgment “NOV,” the acronym for the equivalent Latin phrase) at that point. In that event, the government could appeal the acquittal NOV and an appeals court, if it disagreed with Breyer, could reinstate the jury’s conviction.