The SEC and the U.S. Attorney for the Northern District of California held a joint news conference today to announce the filing of the first enforcement actions based on the back dating of stock options. Following a year long investigation, the SEC filed civil fraud charges against three former officers of Brocade Communications – the former CEO, CFO and vice president of human resources. The U.S. Attorney’s office filed a single count criminal complaint alleging securities fraud against the former Brocade CEO and vice president of human resources.


Both cases are based several instances of backdating options and the claimed falsification of company records to conceal those actions from auditors, shareholders and the public. These actions turned the financial reporting of the company into “hash” according to SEC Chairman Cox. As a result Brocade has been required to restate its financial statements.


Criminal and civil investigations relating to the practice of backdating stock options are continuing. The SEC’s enforcement director noted that the agency has dozens of open investigations looking into the issue.

The backdating of stock options raises a number of complex issues as previously discussed in this blog. While not all such action violates the law as SEC Commissioner Paul Atkins made clear in his speech on July 6, 2006, the actions filed today, coupled with the complexity of the issues, makes it clear that every issuer should carefully review its practices surrounding the issuance of options.

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Last week, in United States v. Stein, Judge Kaplan found a portion of the DOJ guidelines, followed to assess cooperation contained in the Thompson Memorandum, unconstitutional. No. S1 05 Crim. 0888 (LAK) (S.D.N.Y. June 26, 2006), Specifically, the court found that “so much of the Thompson Memorandum and the activities of the USAO as threatened to take into account, in deciding whether to indict KPMG, whether KPMG would advance attorneys’ fees to present or former employees in the event they were indicted for activities undertaken in the course of their employment interfered with the rights of such employees to a fair trial and to the effective assistance of counsel and therefore violated the Fifth and Sixth Amendments to the Constitution.” Id. at *82-83.

While the court declined the defendants’ request to dismiss the case, it directed the government to adhere to its representation to not consider KPMG’s payment of defense fees in assessing compliance with the deferred prosecution agreement (DPA). The court also directed the clerk of the court to open a civil docket number for the filing of appropriate claims against KPMG. This ruling follows the recent action of the United States Sentencing Commission, which amended its guidelines to delete comments that had previously permitted courts to consider whether a corporate defendant had waived the attorney-client privilege in assessing cooperation and acceptance of responsibility for assessing whether a downward departure should be made.

The ruling by Judge Kaplan and the action of the Sentencing Commission are welcome and long overdue steps in reforming the standards on cooperation. The actions of the SEC and DOJ have put extreme pressure on companies to waive the attorney-client privilege to try and build up “cooperation points” to avoid harsh sanctions. This has caused serious erosion to the attorney-client privilege and, in the long run, can only serve to undermine the quality of the legal advice given to companies, thereby undermining the goals of law enforcement. Similarly, government review of whether defense fees are paid has placed companies under extreme pressure to breach long-standing arrangements as Judge Kaplan found in his ruling. Again, such action by the government can only erode effective enforcement of the law — the government cannot enforce the law by trampling on people’s rights. When that type of action is taken, there can be no doubt that we all lose.

Hopefully, in light of Judge Kaplan’s ruling and the Sentencing Commission’s recent amendment of its guidelines, both the SEC and DOJ will rethink their approach to cooperation and refashion it in a manner that will foster good law enforcement and respect for the rights of those under investigation.

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