Of course, backdating is bad. But is it always crooked?

Posted by: Peter Burrows on February 23, 2007

OK, Rob, thanks for the invite to dig farther into this backdating issue (see the next post). The question underlying my story this week isn’t whether backdating is bad. Of course it is. It’s whether, and in what cases, it is criminal.

No doubt, companies and people that backdated need to be held accountable, and they are. Already, dozens of firms have restated earnings (although this is usually a pain-free formality, since investors often don’t seem to care that much). And there’s clearly a huge role for the Securities & Exchange Commission, via civil suits, to get back ill-gained profits and punish those that made them possible. And for the IRS, for that matter, to recover taxes on those ill-gotten gains.

Indicted former Brocade execs Greg Reyes and Stephanie Jensen (as well as former CFO Tony Canova, who was not criminally indicted) already face SEC charges, and the seriousness of this for them and others in the same situation should not be minimized. If found liable, they’ll face big penalties and disgorgement of profits on backdated shares. And the class action lawyers—guilty verdict in hand—would have a field day going after what’s left of their money. (By the way, losing the SEC case would also probably mean that Reyes would not be able to pass on those million-a-month legal fees to Brocade. As I understand it, Brocade’s Directors & Officers insurance plan would likely pay only if he’s cleared of all charges). Also, Reyes and Jensen would likely never get another job at a public company—though that may be already the case.

More after the break…

But the question is whether a jury will find that they should go to jail. Certainly, that's where a few executives caught up in the scandal will end up. One possibility is Monster.com general counsel Myron Olesnyckyj, who plead guilty to securities fraud the other day. He's surely regretting an e-mail that in just a few lines gave the government what it needed to prove that a) he knew Monster was backdating, b) that he knew it was hiding this fact from the company's auditors and c) that the reason for the scheme was so that the company could understate expenses to pump up earnings. It was a white collar crime prosecutors' "Thank you, God" piece of evidence.

But I'd bet the government isn't going to get too many such gifts. On the contrary, in most cases the explanations for backdating will be less clear. Take the Reyes case. It appears he didn't receive any backdated options himself. And while Apple and others have pointed fingers at some former executives, Brocade has never implicated Reyes of wrongdoing.

At trial, look for Reyes' lawyer, Skadden Arps' Rich Marmaro, to try to reinterpret what at first glance looks like an impossibly fortuitous pattern of low-priced grants. At Brocade, 25% of the grants given between 1999 and 2004 were at monthly lows. Do the math, and there's a 50 trillion-to-one possibility of that happening randomly. But Marmaro will argue that random isn't the right comparison--and that many of Brocade's well-timed grants were due not to illegal hindsight, but to smart foresight. On one occasion, he says, Reyes saw the market over-react to a negative analyst report, and decided to quickly grant options. In another case, it was a rumor that Reyes knew was false. Marmaro's goal: to recast Reyes not as a self-enriching slimeball, but as a boss who was vigilant about trying to lock in the most lucrative paydays for employees. As Reyes told me, “Everyone on the jury is going to want to work for me by the time this is done.”

That's a stretch goal if there ever was one. The government, which has brought only two criminal cases and says it is only going after the most egregious instances, may have damning evidence yet to come. And Marmaro will be earning his keep if he can explain away a few dozen low-priced grants, and other circumstantial evidence.

But whatever happens in this particular case, I think we in the media need to be careful about applying the term "criminal" with regards to backdating. We're talking about dozens--probably hundreds--of Valley companies that have had some backdating occur. Do we really think that there are hundreds or even thousands of outright crooks from these firms running around Silicon Valley? These are mostly affluent, well-educated techie professionals--in other words, people with a lot to lose. And they're smart people, to boot. I just don't buy the idea that hordes of our khacki-wearing, Starbucks-sipping tech brethren were scheming to rob investors--to risk it all, by actually breaking the law.

Instead, I think we'll find lots of less nefarious reasons why backdating became so common. A lot of companies lacked proper accounting controls, for starters. I've heard of lots of stories of companies that sought the advice of their lawyers and accountants, but were told that backdating was no big deal or was within legal limits. I think we'll also find instances in which people succumbed to pressure from new hires or employees who wanted to get their options at a lower price--say, because the stock had risen 20% since they'd had their interview, or got that big promotion.

Is any of this right? No. All of these folks should have listened to the ethical codes their mammas taught them, and avoided this mess. Now, they're paying the price. But except for those that backdated to expressly pad their own wallets and/or knowingly cook the books to bilk investors, I say let's make them pay off their debt to society in dollars, not in jail time.

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Bloomberg Businessweek writers Peter Burrows, Cliff Edwards, Olga Kharif, Aaron Ricadela, and Douglas MacMillan, dig behind the headlines to analyze what’s really happening throughout the world of technology. Tech Beat covers everything from tech bellwethers like Apple, Google, and Intel and emerging new leaders such as Facebook to new technologies, trends, and controversies.

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