Part VII: SEC Enforcement Trends, 2009 — Option Backdating
Option backdating cases have been a focus of enforcement in recent years. Essentially, they involve fraudulently backdating stock option grants so that they are in the money and then not recording the related expenses of those options properly in financial statements. In many instances, these cases also involve disclosure violations.
The SEC is reportedly working its way through what was once a large inventory of option backdating cases. Most of these cases have been based on allegations of scienter and fraud. Frequently, the actions include allegations of cover-ups. In some instances, criminal charges have been brought. See, e.g. U.S. v. Reyes, No. 06-cr-0556 (N.D. Cal. Aug. 27, 2007) (former CEO of Brocade Communications convicted on criminal backdating charges); but see U.S. v. Roberts, Case No. 3:07-cr-00100 (N.D. Cal. filed Feb. 27, 2007) (former general counsel of MacAfee acquitted of fraud charges based on option backdating, but jury hung on charges regarding falsification of books and records which judge recommended government drop). In some cases however, the Commission has brought actions based on negligence, using Securities Act Section 17(a)(3). This year, these trends have continued.
Typically, option backdating cases are brought against the company and the specific officers involved based on fraud and books and record charges. Most of these cases settle. SEC v. Sycamore Networks, Inc., Civil Action No. 1:08-CV-11166 (D. Mass. July 9, 2009) typifies many of these actions. Here, an action was brought against Sycamore Networks, an optical networking company, its former CFO, Frances M. Jewels, former Director of Financial Operations Cheryl E. Kalinen and former Director of HR Robin A. Friedman. The complaint alleged that between 2000 and 2005 Sycamore used backdated options to compensate employees without properly accounting for about $250 million in related expenses. Between October 1999 and July 2002 defendants repeatedly backdated option grants, providing themselves and employees with options with prices at which they could purchase shares which were lower than the market price at the time the options actually were granted. To conceal these practices, grant documents were falsified.
The case was resolved with the company consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. Defendants Jewels, Kalinen and Friedman also consented to the entry of permanent injunctions. In addition Ms. Jewels agreed to pay disgorgement of $30,000 plus prejudgment interest and agreed to the entry of an order requiring that the company be reimbursed under SOX Section 304 for the $190,000 in cash bonuses she received. She also agreed to pay a penalty of $230,000 and to the entry of an order barring her from serving as an officer or director of a public company for five years. In a related administrative proceeding, Ms. Jewels agreed to be barred from appearing or practicing before the SEC as an attorney or accountant for five years. Ms. Kalinen agreed to an order requiring her to pay $28,000 in disgorgement plus prejudgment interest and to the payment of a civil penalty of $150,000. Ms. Friedman agreed to pay a civil penalty of $150,000.
SEC v. Karatz, Civil Action No. 08-06012 (C.D. Cal. filed Sep. 15, 2008) is another example of a settled options backdating case. This action was brought against the former chairman and CEO of KB Home, Inc. The complaint alleged that Mr. Karatz engaged in a multi-year scheme to backdate stock options for himself and others at the company. From 1999 through 2005, Mr. Karatz used hindsight to pick advantageous grant dates according to the complaint. This resulted in Mr. Karatz receiving a total of 2,860,000 shares of KB Home stock which yielded $6 million when exercised.
To resolve the case, Mr. Karatz consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. In addition, he agreed to the entry of an order requiring him to pay approximately $6.7 million in disgorgement and interest and a civil penalty of $480,000. Under the order, Mr. Karatz is also bared from service as an officer or director of a public company for five years.
In some instances, these cases serve as a reminder of the obligations of directors and officers. SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sep. 17, 2008) should serve as a warning to all officers and directors of the Commission’s views regarding the performance of their obligations.
Kohavi is an option backdating case brought against three outside directors. The complaint claims that from 1997 through 2002, the directors approved 21 separate backdated option grants. A series of “red flags” that were ignored by the directors when they approved these grants are detailed in the complaint. Those red flags, which are the predicate for the directors’ liability, included approving grants which were “as of” date which preceded the time the three directors executed the approval papers. In two instances, the three directors executed approvals that were backdated for employees and, a short time later, again executed a consent for backdated options for the same employees, but with different “as of” dates to take advantage of a share price drop. In essence, the complaint alleges that the directors simply went along with management.
To settle the action, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions of the federal securities laws. In addition, each defendant consented to the entry of an order requiring that they pay a civil penalty of $100,000. The action against the company had previously settled. SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal. May 31, 2007).
In some instances, the Commission has encountered difficulties because many of these cases are based on years old conduct. For example, in SEC v. Berry, Civil Action No. C-07-04431 slip op. (N.D. Cal. May 7, 2008), part of the case was dismissed on statute of limitations grounds.
Berry is an option backdating case brought against Lisa Berry, former General Counsel of Juniper Networks, Inc. and KLA-Tencor. The SEC’s complaint claimed that from 1997 to 2002, Ms. Berry routinely used hindsight to identify dates which 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 disclosure and overstated net income at KLA and Juniper. Violations of the antifraud, proxy and books and records provisions were alleged.
Ms. Berry moved to dismiss based on the statute of limitations and a failure to plead fraud with particularity as required by Federal Civil Rule of Procedure 9(b). The motion was granted in part. A five year statute of limitations applies to any relief that is a penalty, but not to the equitable relief. The court held that the request by the SEC for a penalty is time barred, but permitted repleading to demonstrate equitable tolling.
The court also held that Rule 9(b) applies. Here, the SEC’s complaint against Ms. Berry fails to detail her role in the backdating scheme and thus fails to meet this standard. In this regard the court held “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.”
In many of the option backdating cases, the issuer cooperates with the SEC in an effort to earn “cooperation credit” in the charging decision. Two examples from the inventory of option backdating cases brought last year illustrate the approach of the Commission in some, but not in all cases.
SEC v. Brooks Automation, Inc., Civil Action No. 08 CA 10834 (D. Mass. May 19, 2008) is a settled option backdating case in which the SEC termed the cooperation of the company “swift, extensive and extraordinary … .” The company was able to settle the action by consenting to the entry of a permanent injunction prohibiting future violations of the reporting provisions, but without a fraud charge.
A second example is SEC v. UnitedHealth Group, Inc., Case No. 08-CV-6455 (D. Minn. filed Dec. 22, 2008). In this settled option backdating case, the SEC also gave the company credit for cooperation. In an unusual statement, the SEC outlined the cooperation of the company. According to the Commission, that cooperation consisted of: 1) conducting an internal investigation; 2) disclosing the findings and conclusions of that inquiry in a Form 8-K; 3) sharing the facts uncovered with the government; and 4) adopting extensive remedial actions.
The company settled the case by consenting to the entry of a permanent injunction base on the books and records provisions. The company was not charged with fraud and a penalty was not imposed.
Finally, while most option backdating cases are based on conduct involving scienter, in some instances the Commission has based its claims on negligence as in SEC v. Tullos, Civil Acton No. SACV 08-242 AG (C.D. Cal. filed March 4, 2008). This option backdating case was brought against Nancy M. Tullos, the former vice president of human resources of Broadcom Corporation.
According to the complaint, Ms. Tullos participated in a scheme from 1998 to 2003 to backdate options at Broadcom. As part of the scheme, grants were backdated to the low closing price for the company’s stock. Ms. Tullos communicated the grant dates within the company, provided spreadsheets of stock option allocations for the backdated grants to the finance and shareholder services departments knowing that they would use the information to prepare Broadcom’s books and records and periodic SEC filings. She also personally profited.
To resolve the case, Ms. Tullos consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(3) and Exchange Act Section 13(b)(5). She also agreed to the entry of an order requiring her to pay over $1.3 million in disgorgement and prejudgment interest to be offset by the value of her exercisable stock options which were cancelled and to pay a civil penalty of $100,000.
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