Is Backdating Criminal?
In a January 10, 2007 Wall Street Journal op-ed piece provocatively entitled "Should Steve Jobs Go to Jail?" (here, subscription required) the attorneys for Gregory Reyes, the former CEO Brocade Communications who faces criminal charges in connection with stock option activity at Brocade, present their view that "most options backdating cases" are "not fraud, but books and records errors." They recite that Steve Jobs, the CEO of Apple who faces his own set of questions about options grants at his company, like their client, is a "non- accountant who didn’t personally benefit one cent from the options grants at issue." They go on to state that the "problem with the government’s theory is that it "conflates books and records violations with criminal securities fraud." The government thus "untethers securities fraud from the legal elements that safeguard executives from conviction from inadvertent accounting violations resulting in little or no harm to companies or investors." The authors go on to assert that "there is no proof of deceit or concealment in alleged backdating cases," and that the backdating was "actually undertaken in good faith" arising from the high volume of options grants that led to "paperwork errors."
While the authors' essay is most directly intended to exonerate their client, their arguments join a chorus of other voices that have contending that options backdating in general is not illegal and the current proecutorial zeal to prosecute backdating is a combination of government (and media) overreaction and failure to understand the practical and legal ramifications of backdating. This view is most persuasively presented on Professor Larry Ribstein’s Ideoblog (here) and in Holman Jenkins columns in the Wall Street Journal (most recently, here).
There is absolutely no doubt that what has happened with the options backdating story is what usually happens when there is a contagion event across many companies. The media has jumped on the story, looking for scapegoats and all too eager to see this story as one more example of "greedy" corporate executives enriching themselves (supposedly) at shareholder expense. There is no doubt that some of the media coverage has swept with too broad a brush, and lumped together many companies and many kinds of activities as if the activity and the companies were all equivalent and equally culpable. But while not every company executive whose name has been associated with the backdating story is criminally culpable, neither is every one of them completely innocent, as the authors of the Journal op-ed piece seem to come close to suggesting.
It is undoubtedly the case, as the op-ed authors contend, that a number of different things have gotten "conflated" in the whole options backdating scandal. First and foremost, there is an unfortunate tendency for too many commentators to sweep together a whole range of conduct under the heading "options backdating." As The D & O Diary has taken great pains to emphasize in discussing the options backdating scandal, what is commonly referred to as options backdating actually includes a wide variety of options related activities, including not just backdating itself, but options springloading (here and here), employee related options backdating (here), bullet-dodging (here), and even options exercise backdating (here). Each of these kinds of activities is different, each involves different actions, and each arguably involves varying levels of culpability, both potential, and in some cases, actual. More to the point, there varying aspects of each of these different sorts of activities that make the activities more or less arguably criminal.
The variables that potentially might make options related activities more arguably criminal can be seen best in an extreme example. As chance would have it, the same day as the op-ed piece appeared in the Journal, an extreme example arose in the case of William Savin, the ex-General Counsel of Comverse Technology. On January 10, 2007, Sorin settled the enforcement proceeding that had been brought against him by the SEC in connection with options backdating allegations. The SEC’s press release about the settlement can be found here. The SEC had charged Sorin, along with former Comverse CEO Kobi Alexander and David Kreinberg, Comverse’s former CFO, of engaging in a scheme to backdate Comverse options grants from 1991 to 2001. The SEC’s complaint against the three former officials can be found here. Their scheme is alleged to have resulted in the restatement of income because of the understatement of Comverse’s compensation expense. Sorin himself was alleged to have realized more than $14 million from the sale of stock underlying the exercises of backdated option that were granted during the 1991 to 2001 period. Sorin was specifically alleged to have played a critical role in the scheme by drafting grand documents with false grant dates. Sorin is also alleged to have facilitated a similar backdating scheme at Ulticom, a Comverse subsidiary, by creating false company records.
In settling the fraud charges, Sorin neither admitted or denied the allegations. (However, on November 2, 2006, Sorin pled guilty to a single count of conspiracy to commit securities fraud, mail fraud, and wire fraud.) As part of the SEC settlement, Sorin consented to be enjoined from further securities laws violations; to pay $1.6 million in dosgorgement, of which $1 million "represented the ‘in-the-money" benefit from the exercises of backdated options grants; $800,000 in prejudgment interest; and a civil fine of $600,000. The total value of the amounts Sorin agreed to pay is more than $3 million.
Even though Sorin neither admitted or denied the allegations against him, the allegations provide an interesting context to assess the op-ed authors’ assertion that backdating is no more than a mere scrivener’s error. By contrast to the benign picture the op-ed authors conjure, Sorin was alleged to have personally benefited; he was alledged to have falsified documents, both at Comverse and at Ulticom; and Comverse investors were alleged to have been deceived because income was overstated by the understatement of expense.
Using these elements as a framework to assess potential culpability, it seems to me that the op-ed authors' theme that backdating is essentially innocent gets weaker the more a particular set of circumstances involves personal benefit, document falsification, and the greater the impact the activity had on the company’s reported financial condition. As they correctly contend, cases without these elements lack indicia of securities fraud. But as the allegations against Sorin suggest, there may be cases where these allegations of personal benefit and deception are present and where the shareholder harm was great.
Whether any particular case involved culpable behavior depends on what actually happened, and this is where the distinction between the different kinds of options grant activity matters most. As The D & O Diary pointed out when the criminal complaint was first filed against Gregory Reyes (here), the employee related options grant activity of which Reyes is accused seems to be different in kind and character from other alleged options backdating activity, precisely because it lacked the element of self-interest and self-benefit that may be involved in other kinds of options grant activities. So the differences between the kinds of activity matter. (A copy of the criminal complaint against Reyes may be found here.)
What these kinds of distinctions may mean for Steven Jobs is still an open question. As I have pointed out (here), the grant related practices under scrutiny at Apple involve both options springloading as well as options backdating. Moreover, one critical element – whether or not Jobs personally benefited from the options practices—is the subject of heated debate. For example, a January 11, 2007 Washington Post article entitled "Apple Chief Benefited From Options Dating, Records Indicate" (here, registration required) presents a perspective that the options he was granted in December 2001 and that were backdated to October 2001 personally benefited him when he later traded the options for registered shares he subsequently sold at a profit. By contrast, Professor Ribstein contends (here) that the same options grant involved no culpable activity and that the grant date was reasonably fixed at a date certain so that the exercise price could be fixed while Jobs continued his negotiations with the company over the size of the grant.
Without having the benefit of complete information, it is hard to tell what the government ultimately may do in connection with the options backdating at Apple, or for that matter at any of the other companies that are under investigation. But just as the op-ed authors argue that prosecutors ought not to conflate books and records violations with securities fraud, so too should distinctions be carefully drawn about the specific kind of activity involved, because different activities will involve different degrees of the elements that potentially could support allegations of culpability: self-benefiting activity, deceit, and shareholder harm. As the Comverse allegations illustrate, there are going to be at least some cases where these elements arguably support allegations of criminality. It seems to me that by "conflating" conduct that might be sufficiently self-interested and deceptive to constitute fraud with mere good faith paperwork errors, the op-ed authors seek to extend the justifiable excuse of the innocent to cover even the conduct of the culpable. Ironically, I happen to think that the lack of self-interest involved in the employee-related options backdating allegations against their client puts his client at the less culpable end of the spectrum.
While the authors' essay is most directly intended to exonerate their client, their arguments join a chorus of other voices that have contending that options backdating in general is not illegal and the current proecutorial zeal to prosecute backdating is a combination of government (and media) overreaction and failure to understand the practical and legal ramifications of backdating. This view is most persuasively presented on Professor Larry Ribstein’s Ideoblog (here) and in Holman Jenkins columns in the Wall Street Journal (most recently, here).
There is absolutely no doubt that what has happened with the options backdating story is what usually happens when there is a contagion event across many companies. The media has jumped on the story, looking for scapegoats and all too eager to see this story as one more example of "greedy" corporate executives enriching themselves (supposedly) at shareholder expense. There is no doubt that some of the media coverage has swept with too broad a brush, and lumped together many companies and many kinds of activities as if the activity and the companies were all equivalent and equally culpable. But while not every company executive whose name has been associated with the backdating story is criminally culpable, neither is every one of them completely innocent, as the authors of the Journal op-ed piece seem to come close to suggesting.
It is undoubtedly the case, as the op-ed authors contend, that a number of different things have gotten "conflated" in the whole options backdating scandal. First and foremost, there is an unfortunate tendency for too many commentators to sweep together a whole range of conduct under the heading "options backdating." As The D & O Diary has taken great pains to emphasize in discussing the options backdating scandal, what is commonly referred to as options backdating actually includes a wide variety of options related activities, including not just backdating itself, but options springloading (here and here), employee related options backdating (here), bullet-dodging (here), and even options exercise backdating (here). Each of these kinds of activities is different, each involves different actions, and each arguably involves varying levels of culpability, both potential, and in some cases, actual. More to the point, there varying aspects of each of these different sorts of activities that make the activities more or less arguably criminal.
The variables that potentially might make options related activities more arguably criminal can be seen best in an extreme example. As chance would have it, the same day as the op-ed piece appeared in the Journal, an extreme example arose in the case of William Savin, the ex-General Counsel of Comverse Technology. On January 10, 2007, Sorin settled the enforcement proceeding that had been brought against him by the SEC in connection with options backdating allegations. The SEC’s press release about the settlement can be found here. The SEC had charged Sorin, along with former Comverse CEO Kobi Alexander and David Kreinberg, Comverse’s former CFO, of engaging in a scheme to backdate Comverse options grants from 1991 to 2001. The SEC’s complaint against the three former officials can be found here. Their scheme is alleged to have resulted in the restatement of income because of the understatement of Comverse’s compensation expense. Sorin himself was alleged to have realized more than $14 million from the sale of stock underlying the exercises of backdated option that were granted during the 1991 to 2001 period. Sorin was specifically alleged to have played a critical role in the scheme by drafting grand documents with false grant dates. Sorin is also alleged to have facilitated a similar backdating scheme at Ulticom, a Comverse subsidiary, by creating false company records.
In settling the fraud charges, Sorin neither admitted or denied the allegations. (However, on November 2, 2006, Sorin pled guilty to a single count of conspiracy to commit securities fraud, mail fraud, and wire fraud.) As part of the SEC settlement, Sorin consented to be enjoined from further securities laws violations; to pay $1.6 million in dosgorgement, of which $1 million "represented the ‘in-the-money" benefit from the exercises of backdated options grants; $800,000 in prejudgment interest; and a civil fine of $600,000. The total value of the amounts Sorin agreed to pay is more than $3 million.
Even though Sorin neither admitted or denied the allegations against him, the allegations provide an interesting context to assess the op-ed authors’ assertion that backdating is no more than a mere scrivener’s error. By contrast to the benign picture the op-ed authors conjure, Sorin was alleged to have personally benefited; he was alledged to have falsified documents, both at Comverse and at Ulticom; and Comverse investors were alleged to have been deceived because income was overstated by the understatement of expense.
Using these elements as a framework to assess potential culpability, it seems to me that the op-ed authors' theme that backdating is essentially innocent gets weaker the more a particular set of circumstances involves personal benefit, document falsification, and the greater the impact the activity had on the company’s reported financial condition. As they correctly contend, cases without these elements lack indicia of securities fraud. But as the allegations against Sorin suggest, there may be cases where these allegations of personal benefit and deception are present and where the shareholder harm was great.
Whether any particular case involved culpable behavior depends on what actually happened, and this is where the distinction between the different kinds of options grant activity matters most. As The D & O Diary pointed out when the criminal complaint was first filed against Gregory Reyes (here), the employee related options grant activity of which Reyes is accused seems to be different in kind and character from other alleged options backdating activity, precisely because it lacked the element of self-interest and self-benefit that may be involved in other kinds of options grant activities. So the differences between the kinds of activity matter. (A copy of the criminal complaint against Reyes may be found here.)
What these kinds of distinctions may mean for Steven Jobs is still an open question. As I have pointed out (here), the grant related practices under scrutiny at Apple involve both options springloading as well as options backdating. Moreover, one critical element – whether or not Jobs personally benefited from the options practices—is the subject of heated debate. For example, a January 11, 2007 Washington Post article entitled "Apple Chief Benefited From Options Dating, Records Indicate" (here, registration required) presents a perspective that the options he was granted in December 2001 and that were backdated to October 2001 personally benefited him when he later traded the options for registered shares he subsequently sold at a profit. By contrast, Professor Ribstein contends (here) that the same options grant involved no culpable activity and that the grant date was reasonably fixed at a date certain so that the exercise price could be fixed while Jobs continued his negotiations with the company over the size of the grant.
Without having the benefit of complete information, it is hard to tell what the government ultimately may do in connection with the options backdating at Apple, or for that matter at any of the other companies that are under investigation. But just as the op-ed authors argue that prosecutors ought not to conflate books and records violations with securities fraud, so too should distinctions be carefully drawn about the specific kind of activity involved, because different activities will involve different degrees of the elements that potentially could support allegations of culpability: self-benefiting activity, deceit, and shareholder harm. As the Comverse allegations illustrate, there are going to be at least some cases where these elements arguably support allegations of criminality. It seems to me that by "conflating" conduct that might be sufficiently self-interested and deceptive to constitute fraud with mere good faith paperwork errors, the op-ed authors seek to extend the justifiable excuse of the innocent to cover even the conduct of the culpable. Ironically, I happen to think that the lack of self-interest involved in the employee-related options backdating allegations against their client puts his client at the less culpable end of the spectrum.
posted by Kevin LaCroix at 3:25 PM
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