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Thomas O. Gorman,
Dorsey and Whitney LLP
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Gorman.tom@Dorsey.com

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    THE LINE BETWEEN CRIMINAL AND CIVIL SECURITIES CASES

    The government obtained a conviction against Bruce Karatz, former Chief Executive Officer of KB Home, in its criminal option backdating case. The verdict, however, raises more questions than it resolves. U.S. v. Karatz, Case No. 09-203 (C.D. Cal.).

    The jury returned guilty verdicts on just four of twenty counts in the case against Mr. Karatz. The convictions were on two counts of mail fraud and two counts of making a false statement. At the same time, the jury returned not guilty verdicts on sixteen counts which include mail and wire fraud, securities fraud and filing false proxy statements. The acquittals came on all charges based on option backdating claims.

    The indictment stems from option backdating issues at KB Home. Those charges, as well as an earlier SEC case, center on claims of fraudulent stock option practices alleged to have been used to improperly increase the compensation of Mr. Karatz. According to the SEC, Mr. Karatz used hindsight to select stock option grant dates from at least 1999 through 2005. As a result of those practices, KB Home filed periodic reports and proxy statements with the SEC which did not correctly report the stock option grant practices at the company. Mr. Karatz was alleged by the SEC to have received backdated annual stock option awards amounting to 2,860,000 shares, giving him profits of more than $6 million from the exercise of backdated options. SEC v. Karatz, Civil Action No. CV 09-06012 (C.D. Cal. Sept. 15, 2008).

    The SEC case against Mr. Karatz was settled with a consent to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. Mr. Karatz also agreed to pay about $6.7 million in disgorgement and prejudgment interest and a civil penalty of $480,000. See also Litig. Rel. 20717 (Sept. 15, 2008).

    In criminal cases, government prosecutors typically prevail either by obtaining guilty pleas or convictions at trial. In the handful of high profile criminal option backdating actions however, this has not always been the case. Previously, the General Counsel of McAfee, Kent Roberts, was acquitted of criminal option backdating charges as discussed here. Similar charges brought against former Broadcom Corp. co-founders Henry Samueli and Henry Nicholas III were dismissed for prosecutorial misconduct. Likewise, the charges brought against Broadcom CFO William Ruehle based on option backdating claims were dismissed because of prosecutorial misconduct, as discussed here.

    In contrast, the government prevailed in actions against James Treacy, former president of Monster Worldwide Inc., as discussed here, and former Brocade Communications Systems Inc. Chief Executive Gregory Reyes. Mr. Treacy’s case is on appeal to the second circuit court of appeals. The government only prevailed against Mr. Reyes after an earlier conviction was reversed by the ninth circuit court of appeals for prosecutorial misconduct. Mr. Reyes is expected to appeal the most recent conviction.

    The mixed results in these cases, tinged by prosecutorial overreaching and misconduct, reflect in part the blurred line between civil and criminal securities fraud. Criminal securities fraud charges brought by DOJ were intended by Congress to be differentiated from civil SEC charges through the added element of “willfulness.” With the increasing criminalization of the securities laws, however, the distinction between willfulness in criminal cases and scienter in civil fraud actions has all but disappeared. Stated differently, little divides criminal securities fraud cases which can result in years of imprisonment from civil fraud actions where the consequences are an injunction and other remedial relief along with civil penalties.

    The blurred line between criminal and civil securities fraud also places a premium on the judicious exercise of prosecutorial discretion. While the government prevailed on four counts against Mr. Karatz – and post trial motions and an appeal have yet to be filed – it lost sixteen counts. That is hardly a “win” for the government. That result, coupled with repeated prosecutorial misconduct in litigating option backdating cases and the loss in the case against Mr. Roberts, raises serious questions about the quality of these actions. The appeals in the Reyes and Treacy cases may only compound those questions. The resolution of these issues begins with revisiting the dividing line between civil and criminal securities fraud and the standards which govern the exercise of prosecutorial discretion.

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