A federal appeals court yesterday tossed out the very first backdating conviction ever. Greg Reyes, the former CEO of Brocade, had been convicted during the height of backdating hysteria in 2007. The Ninth Circuit cited prosecutorial misconduct and ordered a new trial. Basically, the court said the prosecutors lied about the state of the evidence in their closing arguments.
The case turned on whether or not Reyes had a “criminal state of mind.” More particularly, the prosecution had to show that Reyes knew his company was materially misstaing its financial condition when it didn’t report expenses related to the back dated options. As the court notes, this became a rather complex and technical deliberation when it reached the jury.
Why all this attention to expensing the options? Recall that companies are required to expense in-the-money options but not out-of-the-money options. When a company backdates an option, it makes it look like it granted an out of the money option when it is actually in the money.
Let’s give an example to make this clearer. If Brocade awarded a stock options on September 1st with a strike price at $40 per share on September 1st, whether or not it needs to expense the option grant depends on where the stock price is that day. If the stock price is at $41, the option grant must be expensed. If it is at $39, it need not.
Let’s say that the stock price was $39 on September 1st, and subsequently climbed to $45 by December 31st. Now that same $40 option grant would have to be expensed because its strike price is under the share price. What backdating companies did was pretend that they granted the stock option on the earlier date, when it would have been out of the money and didn’t need to be expensed. So you grant the option on December 31st at the September 1 stock price and date it on September 1st, saving the company from taking an accounting expense.
When spelled out, it really doesn’t sound all that nefarious. Indeed, prosecutors at first had to stretch to find how this was anything but a technical accounting issue that should be resolved with a fine against the company. What they came up with was this: because the options were actually in the money when granted, they should have been expensed. By not expensing them, the company was misstating its financial condition in its SEC filings.
The case probably should have been thrown out on the grounds of materiality. And, if it goes back to trial, it may be. The amount of the misstatement of expenses was rather minor compared to Brocade’s balance sheet. And since the expenses were just accounting expenses, rather than real money going out the door, it’s unlikely shareholders would have given a damn.
But the appeals court didn’t even have to get that far, thanks to the excessive zeal of the prosecution. Part of Reyes defence was that he had relied on the finance department of Brocade to OK the options. Reyes said that as CEO he thought if his company’s finance guys greenlighted the backdated options, the move must be within the rules. The government argued that the finance department didn’t know anything about the backdating, claiming that Reyes was a rogue CEO.
In the government’s closing argument it said that it could call every member of the finance department and they’d all testify they didn’t know about the backdating. But that just wasn’t true, and the prosecution knew it wasn’t true.
The court wound up scolding the federal prosecutors.
“Deliberate false statements by those privileged to represent the United States harm the trial process and the integrity of our prosecutorial system. We do not lightly tolerate a prosecutor asserting as a fact to the jury something known to be untrue or, at the very least, that the prosecution had very strong reason to doubt,” the court said.
Given this level of misconduct and the thinness of the initial case, we hope the government decides not to retry Reyes. While it would be clarifying to have further rulings explaining why the entire enterprise of criminalizing backdating is wrongheaded, Reyes has been through enough. He shouldn’t be made a martyr to test legal theories.
Law professor Larry Ribstein puts it best:
The court nevertheless refused to dismiss the indictment. Now the government has to decide whether to spend millions more to retry this case. Doing so would be incredibly irresponsible. How could the government justify a retrial of a case that, in the court’s view, rested so fundamentally on the prosecutor’s lie to the jury?
This case illustrates not only a central legal ambiguity in backdating cases, but the extent to which corporate crime cases have been marred by excessive prosecutorial zeal. This botched case crowns the illegitimacy of the whole fiasco of criminalizing backdating.
The embarrassment of backdating panic in journalism has now become an embarrassment for the federal government. It’s time to move on.
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