Feds Get New Life in Brocade Backdating

The defense of former Brocade CEO Gregory Reyes took a hit when a judge nixed arguments that investors only care about growth. The backdating case against telecom company Brocade has been on the ropes the past few months, but a judge’s ruling earlier this month has given prosecutors a second wind by saying the case does not hinge on investor harm alone.

The case, brought last summer, alleges that Reyes, ex-CFO Antonio Canova and former human resources executive Stephanie Jensen orchestrated a scheme to backdate options and then falsified board compensation committee minutes to “create the appearance” that the options were granted under lower stock prices. As the first backdating case filed by the Securities and Exchange Commission, it has been at the forefront of the backdating scandal, but some thought it might be the last such case after a slew of problems hurt the prosecution.

On May 11, however, prosecutors caught a break as U.S. District Judge Charles Breyer ruled that it didn’t matter that investors were not materially harmed by the alleged backdating. The fact that there was so much backdating and that disclosures were altered are the relevant allegations, Breyer said, turning down a motion by the attorneys representing the former Brocade executives to toss out the case.

Defense counsel Richard Marmaro had filed a motion for summary judgment based on the fact that the alleged backdating of stock option expenses did not harm investors, and that the expenses were not based on generally accepted accounting principles. In his legal briefs, Marmaro has argued that investors looked at cash flows, operating expenses and revenue growth, not whether options were backdated.

The court didn’t buy that premise.

“It does not matter that Brocade was, or is, a successful business enterprise,” Breyer ruled. “Profitable companies, too, owe a duty of honesty to their shareholders.”

Companies need to provide an estimate of the fair value of all outstanding stock options, not just those granted that are in the money, according to a Financial Accounting Standards Board rule cited by the court.

The defense and prosecution both wrestled over the dip in Brocade’s share price when the backdating was made public—SEC lawyers contend it was due to the backdating itself, while Marmaro said it could have been due to the threat of prosecution or enforcement by the government. Calls to Marmaro’s office were not returned.

The Brocade case has had its share of problems. Since the case began, leading prosecutors have been fired or have quit. Witnesses have refused to talk with Reyes’ defense counsel because of the limited immunity, shutting down crucial testimony.

These problems have staved off what could have been a feeding frenzy by other law firms. Shapiro Haber & Urmy, which has been looking to file its own civil lawsuit against Brocade on behalf of investors, now may abandon its pursuit, according to Robert Ditzion, an associate with the firm. The firm is investigating about 100 other companies for alleged backdating.

Jury selection on the Brocade case is expected to begin next month, a source close to the case said.

Filed by Nicholas Rummell of Financial Week, a sister publication of Workforce Management. To comment, e-mail editors@workforce.com.