Brocade's ex-CEO: Options backdating not 'material,' so can't be fraud
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
Posted by Roger Parloff 3:11 PM 10 Comments comment | Add a Comment

Sounds immaterial to me...let's give the guys a break if they can show immateriality, get it signed off by auditors, and move on. I would think that would be a more economically beneficial way of dealing with this than the endless court cases we are currently faced with. However, if it turns out to be material for some, then court is the place for them.
Posted By Chris, Tulsa OK : 10:37 AM  

This is a sound argument. In reality, the whole issue of what it costs to give a stock option is immaterial of whether or not backdating has occurred. The cost of the option is the cost of the shares when they are purchased, not when they are granted, either in reality or on paper. Most companies hold their own stock (hence the flurry of stock by-backs currently). If a company want to give someone this stock, the cost to the company is what it paid to acquire that stock initially. Yes, it affects shares outstanding, but the date of the grant has no real impact on the companies expenses. Hence this arguement against backdating being fraud is a sound one. Immoral, well that is another discussion...
Posted By Jay, Houston, TX : 11:05 AM  

Mr. Parloff,

Your contorted logic misses three points: (1) fraud, (2) looting, and the(3) tax consequences to cash flow. The fraud, they lyed about the date of the options grants misleading shareholders as to the gain the executive would receive from execution of the option. The looting, through the treasury stock method, a higher cash charge will now be taken by the company and larger hit to shareholders' equity, because the executive antis up less for his grant strike price, when the company goes out to the market to buy the amount of shares exercised in the grant. The exeuctive pays less to the company, so the company must spend more cash to buy back the shares in the open market. The company and its shareholders are hurt because cash and shareholders' equity decline more than if the grant dates were properly accounted for. Shareholders' equity or book value shrinks dramatically, destroying shareholder value.

Third, the cash flow must be adjusted, which was completely distorted, to take out the cash shield previously garnered from the tax savings from the option exercise. The company must now adjust its tax books to negate the affects of that tax shield.

These executives are looters, criminals, and bottom-feeders that committed fraud and criminal conspiracy by stealing from shareholders and the government by taking more cash from the companies they represent than was disclosed. They must be punished, banned from the executive ranks of any corporation, including Steve Jobs, shareholder enemy #1.
Posted By Andrew H. Dral, Sacramento, CA : 11:42 AM  

It's a pretty lame excuse and furthermore assumes that the only issue investors look at a pluses and minuses. Fact: if I know a company's CEO is a fraud and a liar, I'm probably NOT going to invest. As the old adage goes: "Where there's smoke there's fire". Why invest is a possibly fraudulent operation when there are so many other, well-run outfits to choose from?
Posted By Paul Blanch - Alachua, FL : 12:34 PM  

Andrew, chill out buddy. The bolsheviks are out this season.....
Posted By Vent U.R. Kapitalist : 12:49 PM  

When company executives break the law (and that is what they were doing) then as an investor I want to know about it before hand. This "it doesn't matter" defense doesnt fly with me. When these little option schemes comes to light it effects the share price of the company and as a share holder and part owner of the company I am negatively effected. Therefore it does matter. I hope all three are properly punished.
Posted By Joseph Brown, Wichita Kansas : 12:50 PM  

"Steve Jobs", shareholder enemy #1? Are you kidding?

I've been an AAPL investor for years, and it is the opposite. Steve Jobs, as CEO of Apple, has done more to -benefit- its shareholders than any other CEO. Can you cite any long-term Apple shareholder who shares your opinion?

Regarding any purported "benefit" to Steve Jobs, as commonly cited, in terms of those options being cancelled and, instead, restricted stock being granted:

What's amazing is that none of these news articles mentions the simple FACT that Steve Jobs' salary at Apple was, and has been, $1 year.

This was his ONLY financial compensation for that year.

Anyone who complains that Steve Jobs "benefited financially" from those backdated options (even though they were cancelled and instead he was issued restricted stock) completely ignores this issue. Whatever amounts were involved, this was his entire/only pay package for that year.

So... the alternative would have been: what? Cancel the backdated options, and... then what? Don't issue the restricted stock? Who do you know who would have worked for $1 for the year?
Posted By David Miller, Yorktown Heights, NY : 3:32 PM  

This Apple stockholder was and is happy to see Steve Jobs and his brilliant crew get paid. These people have benefited me financially and cheered me by their accomplishments.
Posted By C. Byles, Denver, Colorado : 3:36 PM  

To Mssrs. Blanch and Dral:

Though my occupation is data analysis, I've been to law school. You need to apply legal principles and a bit of logic to this situation, instead of what appears to be mostly sour grapes. As an Apple investor for the last 5 years, I've seen a 1200% return on my investment. Steve Jobs is the sole driving factor behind that performance. Stock options are a form of compensation, like salaries and bonuses. It's extremely difficult to value stock options that 95% of the time don't get exercised. Does it make sense not to pay Mr. Jobs and his management team for the job they were doing? Again, as a stockholder with half my portfolio (wish that it had been 100%) in AAPL, I don't think Jobs has been compensated enough for the work he's done for me. Your view of the situation puts zero value on the work done on your behalf as an investor, and whines that you lost out on an additional .05% profit...or is the real problem thatg you missed out on the original 1200%?
Posted By Zeke, Portland, Oregon : 1:22 PM  

Dr. Peter Drucker called stock options, �encouragement to loot the corporation.� He knew that the damage done by stock options remained concealed to most investors, until it was too late.

The following chart shows the damage done by using shareholder equity to buy-back stock options. In 2005 stock buy-backs rose 60% over 2004 for a record $315B. Three out of the four heavy stock option distributor companies, listed below, witnessed absolute declines in shareholders� equity or book value. Book value is the difference between assets and liabilities. When a company is profitable book value will increase, not decrease. But these four companies had their book value per share, since 2003, decline by 10.9%, 9.8%, 2.5%, and 29.6% for Intel, Cisco, Sun, and Dell, respectively. Book value was destroyed by stock options. If your 401K or IRA owned these stocks directly or had them in an index your wealth was transferred to executives selling off their stock options. The total compensation of the top-5 best paid executives at publicly held companies, from 2000 to 2003, amounted to 10% of all corporate earnings.

A March 19, 2006 article in the NY Times by Gretchen Morgenson put it nicely, a comment about the transfer of wealth from shareholders to managers from Fred Hickey editor of the High-Tech Strategist, �Stock options are the biggest force behind this trend, Mr. Hickey said. First, they dilute per-share earnings at the companies that dispense them, hurting existing shareholders. Then, to try to reduce the burgeoning growth in stock outstanding that results from option grants, companies spend their owners� cash to buy back shares in the open market. This cuts into the amount of earnings that can be retained by the company and that contribute to shareholder equity.�

End of Fiscal Year
Fiscal $s in Millions $s per Share % Percent
Year Shareholder Equity Book Value Per Share 1 Year 3 Year 5 Year
Company End 2003 2004 2005 2003 2004 2005 Return Return Return
Intel Corp. DEC 37,846 38,579 36,182 $6.13 $5.94 $5.46 23.5% -22.9% -14.8%
Cisco Systems JUL 28,029 25,826 23,174 $3.88 $3.66 $3.50 21.1% 67.0% 37.1%
Sun Micro JUN 6,491 6,483 6,674 $2.03 $1.98 $1.98 27.0% 57.4% -66.6%
Dell Computer JAN 6,280 6,485 4,129 $2.40 $2.52 $1.69 -22.5% 9.0% 15.8%

Note that returns for the S&P 500 were 11.9%, 58.9%, and 17.6% for 1 year, 3 year, and 5 year returns, as of March 31, 2006, respectively. All the companies, except for Dell, beat the 1 year S&P 500 11.9% return, only Cisco exceeded the 3 year and 5 year S&P 500 returns. In 2005 Intel spent $10.6B and Dell spent $7.2B buying back shares. For the first three quarters of fiscal year 2006 Cisco has spent $5.5B, while Sun Microsystems has spent about ~$1.8B since February 2001, but nothing in fiscal year 2005 or in three quarters in 2006. The damage was done to Sun in the first half of 2001 with a ~$1B stock buy-back.

The recent back-dating scandal makes this situation worse, because more shareholder equity is removed, than would otherwise be the case if legitimate grant dates were used.
Posted By Andy, Sacramento, CA : 10:43 AM  

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About this blog
This blog is about legal issues that matter to business people, and it's geared for nonlawyers and lawyers alike. Roger Parloff is Fortune magazine's senior editor (legal affairs). He practiced law for five years in Manhattan before becoming a full-time journalist. To join in the discussion or suggest topics, please email rparloff@fortunemail.com.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.