Backdating and an Increasingly Tough SEC

We continue to follow developments in the backdating area, particularly noting the difference in the treatment at the state and federal level. Federal authorities (criminal and civil) have aggressively pursued allegations of backdating, with the most recent development the conviction of Gregory Reyes, the former CEO of Brockade. In contrast, at least some on the Delaware Chancery Court have stretched to validate the practice, viewing backdating as little more than another form of executive compensation.

The SEC has been aggressive with respect to backdating. This can be seen from thecomplaint filed against Michael J. Byrd, a former CFO, COO and president of Brockade. The complaint emphasized the role played by Reyes at the backdating scheme and the use of falsified documentation. As the complaint notes:

• "In contravention of Brocade's disclosed practice, CEO Reyes and others systematically created false and misleading 'minutes' of purported 'meetings,' or similar documentation, that represented that options had been granted to employees and executives on particular dates and used the closing price of Brocade's stock on those dates as the options exercise price, although the options had actually be granted and the paperwork prepared days, weeks, or months afterward, when the market price for Brocade's stock was higher. The employees and executives were thereby provided extra, undisclosed compensation in the form of in-the-money options, while Brocade failed to record the necessary expense for the extra compensation."

In contrast, the complaint does not allege that Byrd issued any backdated options or falsified any documents. Indeed, on at least one occasion, he "sought assurances" from Reyes about whether a grant had in fact been determined several months earlier.

It was Byrd who advised that those receiving options had to be at least part time employees (defined as working at least four hours per week), something he described as a "silly solution" to the problem of issuing options at earlier dates but not something characterized by the complaint as inaccurate or inappropriate. Instead, his fault seemed to be the awareness of facts suggesting that employees were given options even before they were hired on a full or part time basis.  

Thus, for example, in one instance alleged in the complaint, Reyes and Byrd were informed on August 7, 2000 that an "ideal candidate" had been identified for the director of software. The email sought authority to issue options at $160, when the share price was trading somewhere around $200.  Reyes replied to Byrd that: "The great news is that I approved his stock some time ago when he agreed to become a part time employee."  In effect, Reyes was claiming that the "ideal candidate" had been hired at an earlier date when the option exercise price was lower. 

The complaint took the position that it was obvious that Reyes was claiming to have approved options at a date "before the candidate had even been offered or accepted the position".  In other words, Byrd should have known that the employee was receiving backdated options.  In response, Byrd sent an email to someone identified as working "closely" with Reyes and asked that he "make sure that we made [the candidate] a part time employee when his stock option was granted and all of the documentation is in agreement with this fact."

The scenario did raise questions about how someone identified as an "ideal candidate" could have been hired as a part time employee at an earlier date.  And Byrd did not question the odd circumstances.  Moreover, his email indicated that the Reyes hiring decision needed to be backed up by adequate documentation, perhaps suggesting that he had reservations about the Reyes claim.  In any event, the charges against him are mostly for failing to be cognizant of odd circumstances and for failing to challenge his boss.  These factors may well suggest that Byrd knew what was going on but they fall short of the smoking guns that exist in most other cases and reflect and aggressive effort on the part of the Commission to pursue backdating.