The Securities and Exchange Commission has levied its first corporate penalties in cases of stock option backdating, portending bad news for other companies embroiled in the widespread scandal.
Brocade Communications and Mercury Interactive agreed to pay $7 million and $28 million, respectively, to settle civil charges brought by the SEC related to the backdated stock option awards. Neither company admitted or denied the SEC’s allegations.
SEC Chairman Christopher Cox said the $28 million corporate penalty in the Mercury case “should send a clear signal that fraudulent stock option backdating and other financial fraud will be severely punished.”
Indeed, observers say, the cases make it clear that, in egregious cases, the SEC will cast its net beyond the individuals involved. (Executives at both Brocade and Mercury were charged personally as well.)
Gorman
“Up until now, the SEC had limited its backdating cases to the individuals they claimed were involved in the backdating,” says Thomas Gorman, a partner in the law firm Porter, Wright Morris & Arthur. “These cases both named the companies, suggesting the expansion of the liability net.”
It has been widely reported that the SEC is investigating about 140 companies for backdating. Hundreds of other companies are evaluating their option issuance processes via internal investigations. “This bodes badly for those companies,” Gorman says. “The still outstanding question is, how far [is the SEC] going to go?”
So far, Gorman says, the SEC has focused “only on very intentional conduct and coverups and a small group of people directly involved in the process.” He notes that potentially dozens of people can be involved issuing options, including directors, committee members, outside lawyers, and consultants.
The settlements also resolve the question of whether the SEC would levy fines in such cases—in the affirmative, unfortunately for companies. “Until now, the Commission reportedly had been split as to use of these penalties,” Gorman says. “These settlements suggest the commissioners have come together on the idea of imposing penalties on companies where there was backdating.”
Thomsen
While backdating itself isn’t necessarily illegal, if not properly disclosed, it can violate accounting and tax rules. Linda Chatman Thomsen, director of the Division of Enforcement said falsifying compensation expense “is no less fraudulent than falsifying revenue, and we continue to be vigilant in policing fraudulent accounting practices.”
In April, the SEC announced the pilot project of a new procedure in cases where corporate penalties are involved, where its attorneys first consult with the commissioners about what fines might be imposed, before beginning settlement negotiations with the offending company (see related story, in box at right).
“In the immediate future, I think we can look to the SEC to bring a series of cases against companies that look a lot like these two,” Gorman says. “I think we’ll see a whole bunch of corporate penalties coming up. With the number of companies involved in this scandal, there could potentially be a lot of these cases.”
A statement by Cox announcing the Mercury settlement suggests as much. “In this case, as well as those that will follow, the SEC will do everything within our power to see to it that illegal options backdating is stamped out,” he said.
The charges against Mercury Interactive and four of its former senior officers allege that the officers schemed to award themselves and other employees secret compensation by backdating option grants and falsifying records and failed to record more than $258 million in compensation expenses from 1997 to 2005. Among other things, the SEC alleged that the company backdated all 45 of the option grants to executives and employees over that period.
The SEC also alleged that Mercury, through the executives, made fraudulent disclosures concerning its “backlog” of sales revenues to manage its reported earnings and structured fraudulent loans for option exercises by overseas employees to avoid recording expenses.
The Brocade settlement comes nearly a year after the SEC filed civil charges and the FBI and U.S. attorney in San Francisco filed criminal securities fraud charges last July against Brocade’s former chief executive Gregory Reyes and former human resources vice president Stephanie Jensen. The two allegedly hid $750 million in compensation costs by altering the dates of stock option grants. The SEC at that time also filed civil charges against Brocade’s former chief financial officer, Antonio Canova. The SEC said that action is ongoing.
The SEC civil action against Brocade alleges that the company falsified its reported income from 1999 to 2004 and committed fraud through its former CEO and other former executives who repeatedly granted backdated stock options, misstated compensation expenses, and falsified documents to cover it up.
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