Wednesday, August 8, 2007
The conviction of former Brocade Communications Systems, Inc. CEO Gregory Reyes on ten counts for conspiracy, fraud, and filing false financial statements related to options backdating at the company raises interesting questions for sentencing. A key driver in fraud cases is the amount of the loss from the misconduct, or gain to the defendant. Because Reyes did not receive any of the options improperly backdated, gain is most likely off the table, although prosecutors may try to make an argument that his sale of almost $400 million of company stock around the time of the options backdating could be attributed as a type of gain -- but that's quite a stretch. For the Brocade options at issue, virtually all of them became worthless in the dot-com meltdown in 2000-2001, so there no way to measure loss by looking at the gain to those who received them by way of Reyes' backdating.
The options themselves were proper, so the issue is the reporting of them as an expense, which brings with it certain tax consequences. The problem of measuring of loss is rather thorny because it is not clear whether the backdating resulted in any direct harm to the company. The impact on the stock price could be one measure of loss, but the disclosure in 2005 of the backdating did not have much of an effect on Brocade's price. It's hard to say that backdating options five to six years earlier was a direct cause of any price fluctuation as much as the questions that would surround the integrity of its financial statements. I think the government is likely to argue that Brocade's restatement of its financial statements in 2005 is the best way to measure the harm to the company. In an amendment to its 2005 10-K (here), Brocade disclosed that it had to restate its income for the relevant years by approximately $50 million for the non-cash compensation expense related to the backdating. Using that as the loss figure would result in an offense level of 23 under the 2000 Federal Sentencing Guidelines, which is the most likely edition to be used because the bulk of the alleged backdating occurred in 1999 and 2000. Potential enhancements that could add two points each are for "more than minimal planning" and "abuse of a position of trust," bringing the offense level to 27. Under the Sentencing Table, that would lead to a potential sentence of 70-87 months -- interestingly, the same offense level calculated for former Qwest CEO Joseph Nacchio, who received a seven-year prison term for insider trading back in 2001.
Reyes will argue rather strenuously that the loss figure is much lower, and at trial the defense argued that there was no direct harm from the backdating so the likely loss counsel will advance is zero. Even with the other enhancements, a zero loss calculation would result in a sentencing range of 6-12 months, which would allow U.S. District Judge Charles Breyer to impose a sentence of home confinement or assignment to a half-way house rather than a term in a federal correctional institution. Reyes' lawyers will also seek a downward departure from any higher Guidelines calculation based on his history of community service and charitable contributions, if past practice in other CEO sentencings (e.g., Bernie Ebbers, Jeff Skilling, Joseph Nacchio) is a guide. In addition, Reyes could analogize his case to that of former Vice Presidential aide I. Lewis Libby to argue that a prison term would be "excessive" because he did not gain anything from the misconduct but only intended to help the company.
Of course, Judge Breyer is not required to follow the advisory Guidelines, but the calculation provides the starting point for a punishment decision. Sentencing is set for November 21, 2007, just a bit before the sentencing of former Hollinger International CEO Conrad Black. Being a CEO just isn't as much fun as it used to be. (ph)