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SEC Files Charges in Stock Option Back-Dating Case

The SEC, the FBI and the U.S. Attorney's Office for the Northern District of California announced the filing of criminal and civil securities fraud charges in a case involving the back-dating of stock option grants. The complaint alleges that the back-dating scheme concealed millions of dollars in expenses from investors, overstated the company's income between 1999 and 2001 by $304 million, and falsified records relating to the stock option grants.

The complaint names the former CEO, CFO and a vice president of human resources at Brocade Communications Systems, Inc. as participants in the scheme. The SEC has asked the court to issue an order permanently restraining and enjoining the defendants from further violations of the securities laws, directing them to disgorge all wrongfully obtained benefits, including prejudgment interest, and to pay civil monetary penalties. The SEC has also requested an order barring the CEO and the CFO from serving as officers and directors of any public company. The maximum statutory penalty for the criminal charges is 20 years in prison and a fine of $5 million, plus restitution.

SEC Chairman Christopher Cox, SEC Enforcement Director Linda Thomsen, U.S. Attorney Kevin Ryan and FBI agent Arthur Balizan jointly announced the civil and criminal charges. Chairman Cox said the alleged scheme at the computer networking company struck at the heart of shareholder interests and investor confidence by deceiving them about the company's true financial health. These types of schemes make a "hash" of a companies financial statements, he said, and are "poisonous" to the securities markets. The SEC is committed to bringing an end to this practice, Mr. Cox said. He added that the SEC currently has over 80 companies nationwide under investigation for back-dating abuses.

The complaint alleges that Brocade's CEO orchestrated the back-dating scheme which he was able to do as the sole member of a compensation committee with the authority to grant stock options to employees. He chose when to grant options, how many to grant and the date on which the grants would be recorded. The vice president of human resources assisted in the scheme by providing the company's stock price history over a period of time and highlighting the lowest closing price during the period. She and the CEO provided the minutes that documented the options grants which others recorded in Brocade's books and records.

The complaint also alleges that the CFO, having learned of the back-dating scheme, facilitated the fraudulent reporting of material misrepresentations about the company's earnings and expenses, including material misrepresentations in the company's filings about its employee stock option program.

The external auditors relied on the false documentation that was supplied to them in concurring that no compensation expense should be recorded for the options. Late in 2004, Brocade's audit committee began to investigate allegations by a former employee regarding the back-dating practices. The investigation resulted in a restatement of the financial results from 1999 through 2004.

U.S. Attorney Ryan noted that a task force has been formed to investigate other back-dating abuses. He said that some of the cases may include tax implications in which case the IRS and Treasury may become part of the team.

Ms. Thomsen assured that the Brocade case will not be the last. The SEC is actively pursuing dozens of cases, she said, involving companies both large and small. The officials would not comment on whether the company was a complete victim to the scheme or whether charges would be filed against any of the directors of the firm. The investigation is continuing, according to the officials.

During a follow-up question-and-answer session, a reporter noted that the Sarbanes-Oxley Act was intended to fix these types of abuses. He asked whether additional regulations are now needed. Chairman Cox advised that the risk of these abuses was reduced by the Sarbanes-Oxley Act provision which requires the acceleration of the reporting date when stock options are granted and by the Financial Accounting Standards Board's adoption of FAS 123R.