Option Backdating: A Flawed SEC Complaint Raises Questions About the Enforcement Program And Its Direction

Last week, the court granted in part a motion to dismiss portions of the claims brought against Lisa Berry, former General Counsel of Juniper Networks, Inc. and KLA-Tencor. The motion was based on the statute of limitations and the failure to plead fraud with particularity as required by Federal Civil Rule 9(b). SEC v. Berry, Civil Action No. C-07-04431 slip op. (N.D. Cal. May 7, 2008).

The Commission filed a complaint against Ms. Berry based on option backdating claims for the time period 1997-2002. That complaint alleged that Ms. Berry routinely used hindsight to identify dates with historically low stock prices, facilitating the backdating of option grants by KLA’s stock option committee. After moving to Juniper, Ms. Berry established a similar backdating process at that company, creating minutes of fictitious stock option committee meetings to document false grant dates. This resulted in materially false disclosures and overstated net income at KLA and Juniper. The complaint alleges violations of Sections 10(b) and 17(a), as well as the books and records and proxy provisions. It seeks a permanent injunction, disgorgement of ill-gotten gains, monetary penalties and an officer director bar.

Ms. Berry’s motion to dismiss was granted in part and denied in part. First, Ms. Berry sought dismissal based on the statute of limitations. In this regard, the Court noted that under 28 U.S.C. § 2462, there is a five year statute limitations. This applies to any relief that is a penalty but not to the equitable relief. The request for a penalty is barred. In contrast, a request for disgorgement is not a penalty. Since the SEC argues that the statute is subject to equitable tolling, the court granted an opportunity to amend the complaint.

Second, the court held that under Section 9(b) the SEC must plead fraud with particularity. While this does not apply to allegations regarding state of mind, it does apply to other facts relating to the fraud. The court ruled that the SEC failed to meet this standard for most of the allegations in the complaint:

The SEC’s entire complaint against Ms. Berry regarding KLA focuses on her role in backdating stock options to employees. The complaint makes cursory references to option grants to executives, and at one point uses a discussion regarding executive stock options grants to suggest Ms. Berry possessed scienter. But, at no point does the SEC clearly allege with particularity that KLA backdated stock options to executives. Absent such an allegation, there is no basis for concluding that the discussion regarding executive stock option grants in the proxy statements was false. On the contrary, the option discussion in the proxy statements could be true. To recap, Ms. Berry has carried her burden of demonstrating the SEC has failed to allege with particularity any securities fraud based on misstatements, other than the SEC’s allegations arising from Ms. Berry signing KLA’s two Form S-8. With respect to the Forms S-8, the SEC’s allegations are sufficient.

Slip Op. May 5, 2008.

This is not the first time the SEC has filed a case based on years-old conduct or that part of its claims have been held time barred. Undoubtedly it is not the first time that it has failed to meet the pleading standards. But, it should be the last. There is no excuse for the SEC to file cases based on conduct which on its face appears to be time barred without at least pleading facts sufficient to establish tolling. Likewise, there is no excuse for the SEC to file a complaint which lacks specificity, particularly in view of the Commission’s vast investigative powers. Bringing enforcement actions is not a game where one hopes to slide by. Bringing enforcement actions is a deadly serious business which scars those named as defendants for life, whether the SEC ultimately prevails in the litigation or not. Regardless of whether the SEC prevails in this case, more is required of a good prosecutor than filing actions which are time barred on their face and lack the basic facts. It is time to conduct a complete review of enforcement policies and procedures to re-energize the program.