The Conviction of Gregory Reyes and the Criminialization of Executive Compensation

As we have discussed, Gregory Reyes, the former CEO of Brockade, was convicted in early August of 10 counts in a backdating case. One of the critical issues in the case concerned the materiality of any misstatements. Often, the misstatements associated with backdating result in only a modest amount of change to the financial statements.

The materiality issue was recently addressed in the order denying a motion for acquittal and issued on August 27. A copy is posted on the DU Corporate Governance web site. The trial judge conceded that "stock option expenses do not say very much about the potential for a company to make money, which is what investors care about most." Nonetheless, "[i]t does not follow from this evidence, however, that investors necessarily consider stock option expenses immaterial." Instead, as the court concluded:

• "Regardless of whether or how a company granted options, it is likely that many investors still would be interested in buying shares of that company for the simple reason that it is wildly profitable. This does not mean that investors necessarily consider the stock options program immaterial. In other words, although investors consider some information more important than non-cash compensation expenses, it does not follow that they consider stock options expenses unimportant."

So why then was the information important to a reasonable investor? Because the behavior suggested that management was not acting in the best interest of shareholders. "[I]nvestors would have cared that Brocade was concealing in-the-money grants, which were perceived by investment professionals as a 'a giveaway of shares' that failed to align the interests of shareholders and employees." Moreover, materiality received some support from a “statistically significant drop” in share prices following announcement of an investigation into stock options. The information "permitted an inference that investors bought and sold shares of Brocade based on the company’s non-cash compensation expenses."

This case, therefore, resembles the old qualitative materiality cases. The court is essentially concluding that the inappropriate behavior essentially called into question the quality of the company's management. The reinvigoration of the qualitative materiality doctrine may well be one of the most significant consequences of the federal involvement in the backdating scandal.

Having said that, the Supreme Court's decision in Dura Pharm., Inc. v. Broudo, 544 U.S. 336 (2005) makes it clear that private parties must present evidence of causal loss to sustain a claim under Rule 10b-5. In the case of matters of managerial integrity, at least in private actions, plaintiffs would need to show that shareholders were harmed presumably through a fall in share prices.

Comments

[SV VC]

Judge Breyer came to what I feel were a few incorrect conclusions in his assessments as to why stock options are used, in some of his prior opinions. He has stated that “A juror in this case is confronted with a simple question,” he wrote. “Why backdate? . . . The most plausible answer is to hide expenses.” (I can't see this in the motion on the corporate governance site, but my acrobat search is not working correctly). There are a number of citations of this particular quote on the web, from this trial. The fact that a judge is stating that "hiding expenses" are the only reason to backdate stock options is incorrect, and can be verified as such easily (since all options are expensed today and backdated options have not been replaced with the alternative cash hire on bonuses in growth companies, statistically speaking). Backdated options are a hire on bonuses with vesting period, that means the employee can't take the money until he/she vests (4 yrs), and only then if the stock price is favorable to the options grant. Obviously this court missed that, and it seemed to be a key plank with which to convict Reyes- basically the notion that there "must be" something going on in order to use backdated options as compensation- rather than the much simpler answer that they are a superior compensation vehicle, which benefits all shareholders. Hopefully this ruling will be reevaluated on appeal.