A jury has found former Brocade Systems chief executive Gregory Reyes guilty of felony fraud relating to stock options backdating.
The verdict will likely strengthen the US government’s resolve to prosecute more tech executives involved in similar accounting scandals.
A California jury delivered the verdict yesterday, after hearing over five weeks of testimony and spending six days in deliberations. Reyes now faces large fines and/or a jail sentence of up to 20 years.
He was prosecuted on ten counts of securities fraud after Brocade disclosed accounting problems, and then asked Reyes to resign, in 2005. The jury yesterday found him guilty on all ten counts.
Judge Charles Breyer revealed that he had denied a defense motion to dismiss the case, which he decline to do publicly two weeks ago. The absence of a ruling on the motion had been considered an indication the judge was not convinced of the strength of the prosecution’s case.
Reyes is expected to appeal the conviction.
The case was the first to go to trial in the ongoing Securities and Exchange Commission investigation into how hundreds of public companies accounted for stock options grants.
Backdating is the practice of using 20-20 hindsight to pre-date in-the-money executive stock grants, making them more valuable. It has been used by companies hoping to attract and retain executives by offering them large cash sums out of shareholders’ pockets rather than the company’s own coffers.
The legality of backdating per se continues to be debated, but in practice it usually appears to involve the forging of documents and the misreporting of expenses for tax and earnings purposes, obfuscating a company’s true financial health, which would make it firmly illegal.
The Reyes jury clearly agreed, in delivering yesterday’s verdict, although deliberations may not have been clear-cut. Two or three of the jurors, along with Reyes’ wife Penny, could be heard weeping as the verdict was read, according to reports out of the courtroom.
Prosecutors had alleged that Reyes had routinely executed backdated documents and evaded rules that required Brocade to publicly report these compensation expenses, with the help of vice president of human resources Stephanie Jensen, between 2000 and 2004.
The tactic was often used to tempt executives to join Brocade, by offering them options with strike prices tied to dates months before they actually joined the company, the SEC alleged.
Jensen will be tried separately at a yet-to-be-announced date.
During the period in question, accounting rules required companies to expense in-the-money options grants on their earnings statements, which Brocade did not, thereby boosting its bottom line, according to the SEC’s complaint.
Reyes himself did not directly financially benefit from backdated grants, prosecutors admitted.
He left Brocade in January 2005, the same day that the company announced millions of dollars in earnings restatements. In June 2005, the SEC began its formal investigation into the company’s accounts. In July 2006, Reyes was prosecuted. He pleaded not guilty the following month.
A key challenge for prosecutors was proving that Reyes acted with intent to break the law, which meant demonstrating he knew what he was doing was wrong.
One particularly damning piece of evidence was a 2004 email sent by Reyes to Jim Bidzos, a fellow director of the security company VeriSign, in which he explicitly, and in upper-case letters, said that backdating options grants was illegal.
A former human resources executive from Brocade also testified for the prosecution that Reyes had once said backdating was not illegal if you don’t get caught.
Backdating scandals have shaken the tech industry over the last couple of years.
Kent Roberts, former general counsel at McAfee, is expected to stand trial next year on backdating fraud charges, having been fired from the company last year.
The SEC has also filed civil fraud charges against former executives from Mercury Interactive relating to allegedly improper backdating.
Apple’s former CFO settled the SEC’s civil fraud charges against him, relating to backdating, in April.
Other companies, including VeriSign (where Reyes once held a seat on the board) and Research in Motion, have restated earnings after internal reviews, but found no evidence of misconduct.
Scores of other public companies, many of them in the tech sector, are in various stages of SEC investigations.
The SEC recently promised an increase in the amount of enforcement actions it will announce. Securing the conviction of Reyes can only strengthen its hand.