A top Securities and Exchange Commission enforcement official tells Compliance Week the regulator will likely close out a large number of its options backdating cases in the near future without taking any enforcement action.

And in a break from its recent practice, the official, Walter Ricciardi, deputy director of the Division of Enforcement, said the SEC will send a letter to all of its targets informing them they are no longer being probed.

“It’s a new policy,” Ricciardi confirms.

Sure enough, just the last week alone, two semiconductor companies—Nvidia and PMC-Sierra—announced that the SEC notified them by letter that the staff’s investigation into their company’s stock option practices has been terminated and that no enforcement action against the company has been recommended.

Ricciardi confirmed to Compliance Week that the SEC has investigated about 130 companies. That number—which mirrors the figure Ricciardi recently mentioned to a group of attorneys in Washington, D.C.—is much higher than the widely held count of 105 companies that had previously disclosed that they were targets. That’s according to Randall Fons, partner with Morrison Foerster in Denver, who discussed Ricciardi's speech during a luncheon that the firm recently hosted in New York City.

Brodsky

Ricciardi’s comments regarding the status of the enforcement actions and the policy of notice letters was a surprise to some, as the Commission is typically silent about such matters. “I am surprised they are so open and public about disclosing this,” asserts Richard Brodsky, former staff attorney in SEC enforcement division and counsel with Squire Sanders & Dempsey in its Miami office.

Most experts, however, including attorneys who formerly worked in the SEC’s enforcement division, are not surprised that many of the probes will end without charges. For one thing, they note that the SEC does not have the manpower to bring 130 options backdating cases.

Others note that the Commission’s efforts in this realm have been successful—companies are now duly informed regarding the SEC’s position on backdating, so draconian punishments for more than 100 companies are simply not necessary. “I think the SEC accomplished what it set out to do,” adds University of Iowa Professor Erik Lie, who first alerted SEC investigators to the backdating issue after conducting a study in 2004. “They must maximize their resources.”

In addition, he adds, many companies have already been penalized by the markets and private lawsuits.

Ricciardi says there are a number of factors that the SEC might consider when deciding not to bring charges against a particular company. For example, the company might have had paperwork mistakes, as opposed to committing intentional and recurring fraud. Other considered factors as cited by Ricciardi: the magnitude of falsification of financial statements, the number of improper grants, the period of time during which the practices occurred, the amount of investor harm, and the level of cooperation.

Fons

Randall Fons at MoFo speculates that Ricciardi’s first factor, above—that the company was involved in an isolated one-time incident, and now simply needs to tighten controls to get the financial statements right—was probably the most common. “It may not be an ongoing problem,” Fons theorizes. “Quite a few fall into that category.”

NO ENFORCEMENT

Below are announcements from two companies stating that the SEC had closed backdating investigations with no enforcement action:

PMC-Sierra Announcement

The staff of the Securities and Exchange Commission notified PMC-Sierra, Inc. (the “Company”) by letter dated October 26, 2007 that the staff’s informal investigation into the Company’s stock option practices has been terminated and that no enforcement action against the Company has been recommended to the Securities and Exchange Commission.

NVIDIA Announces Termination of SEC Investigation Regarding Historical Stock Option Grant Practices:

Tuesday October 30, 5:30 pm ET

SANTA CLARA, Calif., Oct. 30 /PRNewswire-FirstCall/ -- NVIDIA Corporation (Nasdaq: NVDA - News) today announced that the Securities and Exchange Commission (SEC) has formally notified NVIDIA that the SEC investigation related to NVIDIA’s historical stock option grant practices has been terminated. No enforcement action has been recommended.

Sources:

PMC-Sierra, Inc. Form 8-K From the SEC (Oct. 26, 2007);

Nvidia Form 8-K From the SEC (Oct. 26, 2007).

“Backdating itself is not a violation of securities laws,” adds Thomas Gorman, partner at Porter & Wright. “So, it must take place in conjunction with something else,” such as accounting or disclosure violations.

Gorman

Gorman also theorizes the SEC may have hammered out some sort of settlement with a potential target. In other cases, the conduct may have not been egregious, or the company may be negligent but the illegal conduct was not willful, Gorman theorizes. Rather, Gorman asserts that in most cases where the SEC has charged companies or individuals, there either was significant scienter, falsified documents, or self-dealing. “They must prove an individual conspired or did it on their own to change the stock price,” Brodsky concurs.

Lie agrees, noting that these are not easy cases. “We find it hard to prove backdating took place,” Lie concedes.

Brodsky at Sanders & Dempsey adds that it is generally a good sign that the SEC would not try to justify cases or bully companies or individuals into settlements if it does not think it has a good case simply to justify its large commitment and expense to the investigations.

Hiding Improprieties, Filing False Documents

The cases in which the SEC has brought charges provide keen insight into what moves the regulator to take action.

Altogether, 105 companies have announced SEC investigations, according to Morrison Foerster. At least 19 companies have settled with the regulator. Of that number, 15 investigations were concluded with no punitive action. Four companies agreed to permanent injunctions—Brocade, KLA-Tencor, Juniper, and Mercury Interactive. Two companies paid civil fines—Brocade ($7 million) and Mercury ($28 million). KLA and Juniper agreed to permanent injunctions.

In addition, individuals from nine companies have been sued by the SEC. In most cases, those individuals were charged with hiding improprieties and filing false documents.

For example, when the SEC charged Gregory Reyes, the former CEO, president, and chairman of Brocade, Stephanie Jensen, the company’s former vice president of human resources, and Antonio Canova, Brocade’s former CFO, Canova was charged with not taking action after learning of the alleged backdating scheme and later certifying false and misleading financial statements. The complaint also alleged that Canova was aware that options grants were being backdated and not disclosed, yet failed to alert Brocade’s audit committee and auditors. (In a related criminal case, Reyes has since been found guilty on all 10 counts; sentencing is scheduled for later this month).

When the SEC subsequently charged another one-time chief financial officer Michael Byrd, they alleged he repeatedly disregarded evidence that other senior executives—including Reyes—were improperly backdating stock option awards as far back as 2000. The commission also alleged that Byrd falsified documents to hide the backdating improprieties and failed to account for the options correctly in an attempt to avoid the related balance-sheet expenses.

Thomsen

Similarly, in July 2007, when the SEC settled backdating charges against KLA-Tencor, Linda Chatman Thomsen, the SEC’s Director of Enforcement, asserted that KLA “dramatically overstated its reported financial results, depriving investors of accurate information about the company’s compensation costs and financial performance.”

The SEC also said that although pricing the options below current prices required the company to report a compensation charge under “well-settled” accounting principles, former KLA officials avoided reporting the charges by falsely documenting that the options had been granted on an earlier date, according to the complaint. The SEC claimed that the company overstated net earnings in fiscal years 1998 through 2005 by as much as 156 percent.

And when the SEC charged Lisa Berry, former in-house corporate attorney of KLA-Tencor Corp. and Juniper Networks, with backdating option grants from 1997 to 2003, it alleged that these grants were given without proper disclosures, thus hiding true compensation numbers from investors. Moreover, Berry acknowledged in a 1998 memorandum that repricing executive stock options with an earlier grant date’s lower price would result in KLA having to take “a charge to its P&L,” the SEC said.

The SEC also noted that after Berry went to Juniper, just before its 1999 initial public offering, she allegedly created minutes of compensation committee meetings that had not occurred in order to justify misdated option grants. Her alleged scheme resulted in more than $300 million in expenses not being disclosed by Juniper, according to the SEC.

Notification a Touchy Subject

Attorneys generally applaud Ricciardi’s pledge to notify each target when the SEC terminates a probe. This is a touchy issue among many former targets of SEC probes.

The SEC does not have a policy for notifying subjects of informal probes that they are no longer being investigated. And even when it comes to formal investigations—which provide the SEC subpoena power—there is no notification requirement. What the SEC rule says is, “the staff, in its discretion, may advise the party” that the probe has been terminated. This underscores the significance of Ricciardi’s pledge. “I’m not surprised Walter did this,” says Brodsky of Sanders & Dempsey. “He is a very open guy. He is not one to hide cards. It’s a good thing.”

Morgan

Attorneys stress that SEC probes are financially and psychologically costly to companies and individuals. If they are found to have done nothing wrong, they deserve to move on without suspicion weighing over them, the attorneys say. “The Staff knows when they are at the ends of an investigation,” asserts Nick Morgan, a partner with DLA Piper. Adds Gorman: “If they get a closing letter, they can get closure. It is also good for the company’s stock price.”

The Commission would not provide Compliance Week with a list of companies that had received (or might receive) letters informing those companies that their backdating investigations had closed with no enforcement action.

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