Saturday, September 22, 2007

Prosecutors File Preliminary Sentencing Memo for Reyes Backdating Convictions

Federal prosecutors in San Francisco filed a "preliminary" sentencing calculation at the request of U.S. District Judge Charles Breyer to get some initial information on the application of the Federal Sentencing Guidelines for the sentencing of Gregory Reyes, the former CEO of Brocade convicted for backdating options.  The loss calculation under USSG Sec. 2B1.1 will be the key, and the government discusses some ideas about how to calculate the loss (or gain) from a case in which the defendant was not convicted of reaping any direct benefits from the backdating.  The government offers a couple different possibilities in its brief (available below), and it may ask for a combination of them when it files a brief with its final position.  One possibility is to measure the effect on Brocade's stock price on the day of the initial announcement of the backdating in January 2005.  Under the analysis outlined in the brief, the 7.5% stock decline resulted in a loss to investors who sold that day of approximately $2 million.  The government also offers the $7 million civil penalty Brocade paid to the SEC to settle the case, and the $3 million it paid for the tax liabilities incurred due to the backdating.  Put those possibilities together, and you have a loss of $12 million.

The brief outlines another surprising calculation, based on Reyes' gain.  At trial there was no claim that Reyes received any of the options that were backdated, but in its brief prosecutors assert: "It is true the government did not try to prove at trial that the defendant backdated his own options.  It is not true, however, that the defendant did not backdate his own options.  He did."  The government alleges that an April 2001 award included options Reyes received, and the backdating resulted in a gain of $5 million.  This is an intriguing approach that seeks to use unprosecuted (and apparently heretofore unmentioned) conduct as a basis for estimating the defendant's gain.  It is not using acquitted conduct, but uncharged similar conduct that the government would only have to prove by a preponderance of the evidence.  Reyes is sure to oppose this strongly, arguing that the alleged backdating is outside the charges and irrelevant for calculating the loss from the counts of conviction.  The addition of the $5 million from this backdating would not affect the loss/gain calculation under Sec. 2B1.1 if the other amount were the $12 million discussed above because the fraud loss table increases the offense level at $7 million and then at $20 million.  It could be important, however, if the court rejects the other methods of calculating the loss. 

Other enhancements the government expects to seek include a four-level increase for a senior officer's involvement in securities fraud, a six-level enhancement for a crime involving over 250 victims, and a two-level addition for use of a sophisticated means.  Using the $12 million loss figure and the additional enhancements, that would give an offense level of 32, for which the sentencing range is 121 to 151 months -- more than ten years.

The filing is only a preliminary assessment and subject to change, and at this point the U.S. Probation Office has not made a sentencing recommendation.  The defense is sure to object to the loss calculations and the enhancements.  In addition, the government is using the 2004 version of the Guidelines, arguing that this was a continuing offense that did not end until the revelation of the backdating in January 2005.  That results in a higher potential sentence because the enhancements are greater under that version, and the changes to the fraud loss table in 2001 trigger a higher offense level.  Reyes is sure to argue that the crimes were complete when the options were issued, which occurred before November 1, 2001, when the major changes in the fraud Guidelines occurred.  A key issue will be which version of the Guidelines will be applied, because the older version could result in a sentence of two to four years, depending on the loss calculations, versus a potential ten year sentence under the more recent version. (ph)

Download us_v_reyes_government_sentencing_brief_sept_21_2007.pdf

http://lawprofessors.typepad.com/whitecollarcrime_blog/2007/09/prosecutors-fil.html

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Comments

Very hard to believe the employees "unknowingly" got backdated options when they clearly state the grant amount in every new hire stock option grant letter at every company- this is just another sad testament to this overreaching scandal. Every employee gets his/her offer letter and assumes, as CEOs no doubt assumed, that it is within the perview of the company to assign any stock date it wants within the quarter, assuming the stock traded there. Seeing a CEO get 10 years jailtime for what is a standard business practice with a measly 12 million "loss" (in corporate terms) - is fairly disconcerting.

Posted by: Smort4 | Sep 22, 2007 5:22:08 AM

Very hard to believe the employees "unknowingly" got backdated options when they clearly state the grant amount in every new hire stock option grant letter at every company- this is just another sad testament to this overreaching scandal. Every employee gets his/her offer letter and assumes, as CEOs no doubt assumed, that it is within the perview of the company to assign any stock date it wants within the quarter, assuming the stock traded there. Seeing a CEO get 10 years jailtime for what is a standard business practice with a measly 12 million "loss" (in corporate terms) - is fairly disconcerting.

Posted by: Smort4 | Sep 22, 2007 5:22:24 AM

Technically legal or not, as to having the leeway of an entire quarter, backdating options is dangerous. All kinds of sinister long term motives can be surmised.
I just wrote an article on the stock options scam of the late 1990s in hi-tech, where stock brokers were largely sucessful in getting options converted to brokerage accounts via "exercise and hold." Now there were some real obvious scams, if ever I saw any.

Posted by: Jack Payne | Sep 22, 2007 2:20:54 PM

You need to get the emotion out of this issue and look at the facts. Apple's restatement for backdated stock options largest year was 10 million. Thats over the entire year, or loosely annualizing it, 2.5 million per quarter, for a company doing 5.5 billion per quarter revenues and 1.2 billion EBIDTA. Thats billion with a "B". Brocade is a 1.2 billion dollar company. I can tell you that literally *every* non cash expense in any company of this size or even much smaller size can generate anomalies of 2.5 million in non cash expenses if you went in and did an audit with a fine tooth comb of things like depreciation. All this stuff is a fuzzy art, which is why analysts look at cash flow. What has happened here is a CEO was convicted and prosecutors are looking at 10 years hard time for a rounding error. 12 million over a 5 year period is that. Any company with a CEO that sits around managing accounting for non cash expenses is a bad CEO. We have a serious problem here- we have a judicial system especially prosecutors who are devoid of common sense, and new sentencing guidelines that are absurd. Judges are supposed to check for unbridled public frenzies and this didn't happen here. I will also point out that in Marmaro's motion to dismiss, it is clear that in this particular Brocade case that finance controller was aware of, and felt accounting was acceptable for, Brocade's compensation policies (there is a statement from the controller, I believe). The prosecutor disingenuously (to say the least) presented this Brocade case as something where the CEO hid a "scheme" from finance, something that appears to be an overt misrepresentation fo the facts and not in good faith.

The judicial system in the US should be, but is not, above witch hunts or McCarthyism. Can sanity prevail? Steve Jobs is next.

Posted by: Smort4 | Sep 23, 2007 7:39:17 AM

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