Evolving Standards of Prosecution in the Options Backdating Scandal

Last week, the SEC brought its latest case in the seemingly never-ending stock option backdating scandal.  In SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. July 12, 2007), the agency charged the founder and former Chairman and CEO of Engineering Support, Michael F. Shanahan, Sr., and his son, a former board member at the company, with violations of the antifraud, proxy, and reporting provisions in connection with an option backdating scheme.  This is the most recent case to trickle out of the SEC of the reported 140 companies under investigation.  Two points make this case somewhat noteworthy.  First, the options involved immediately vested, according to the SEC complaint.  Thus, if the options were improperly backdated as the SEC claims the defendants immediately profited from the scheme.  Typically, option grants do not vest at least in part until some point in the future.  Under those circumstances, it is not always clear that backdating will result in a profit. Likewise, the huge numbers about how much people profited are somewhat questionable when the options do not vest immediately.  

Second, and perhaps of more importance, are the kind of claims brought here.  With dozens of companies still under investigation, the continuing question is what standards the agency will use in determining whether to bring enforcement actions.  The initial cases all involved aggravated fact patters with falsified documents, cover-ups, false claimants and similar activities.  While Shanahan involves claims of fraud based on what, if established, is intentional conduct, it lacks the kind of egregious conduct seen in many earlier cases.  To be sure, Shanahan contains allegations of false backdated options, large profits and false filings.  The claims however, are based on violating a stock option plan that directed options be priced at the market, allegations that various filings represented that the options were properly priced according to the plan and the failure to disclosure the fact that the options had been backdated.  If established by the SEC, this conduct of course violates the securities laws.  At the same time, it is clear that the case is based on allegations which materially differ from many of the earlier cases.  This may represent a significant evolving step in the scandal, signaling that the SEC is expanding it loop of liability.  

That loop may receive further definition later this week.  On Thursday, the Court in U.S. v. Reyes, the criminal trial involving the former Brocade CEO is due to rule on the defense’s Criminal Rule 29 motions for acquittal made at the conclusion of the government’s case-in-chief.  Whatever the ruling, it is significant that the Court delayed the decision on the motions for a significant period of time.  All too often courts, deny these motions from the bench following the oral argument.  In Reyes however, the Court significantly delayed ruling on the motions to consider the papers.  This action, at a minimum, suggests that there is a very significant question as to whether the government has established its case.  If granted, the ruling would be a huge blow to the government’s prosecution of options backdating cases.  Indeed, such a ruling could redefine the standards used by the government in evaluating cases, particularly in view of the repeated allegations of intentional conduct made by both government prosecutors and SEC officials when the cases involving Brocade were brought.  Even if the motions are denied in Reyes (as is typical), the long delay in ruling on them raises significant questions about the kinds of cases the government is selecting for prosecution.  As the scandal continues to evolve, the question of standards of prosecution and case selection will continue to be key not only for the dozens of companies and individuals still under investigation, but also others because of what it says about SEC and DOJ enforcement of the securities law.