Backdating Fine May Set Model: Brocade Is the First to Pay Penalty in Options Probe; SEC Debated Punishment
Brocade Communications Systems Inc. agreed to pay a $7 million penalty to settle allegations it improperly issued stock-option grants, making it the first company to pay a fine in connection with the backdating scandal, according to people familiar with the matter.
The technology company's settlement with the Securities and Exchange Commission paves the way for similar cases to be resolved. Two other companies -- Analog Devices Inc. and Mercury Interactive Corp. -- previously announced preliminary settlements with the SEC that are to include penalties.
The Brocade settlement, which could be announced this week, has been in the works for more than 15 months. Brocade first struck a deal with the SEC to pay $7 million in March 2006, but the settlement was held up as the number of companies under investigation for backdating options expanded to more than 100. Brocade declined to comment yesterday.
The rapid spread of backdating probes spurred a lengthy debate among the five SEC commissioners about whether or not backdating warranted a penalty. In general levying penalties against companies involved in a financial fraud is a hot-button issue for the commissioners. Republicans, in general, oppose them as a double hit to shareholders, who already have been penalized once by being defrauded. Democrats argue that penalties serve as deterrents.
The options-backdating cases presented some unique questions in the debate. A typical stock option gives its recipient the right to buy shares at a future date at a fixed price, usually the market price on the date a grant is made. If the stock rises after that, the recipient can cash in an option for a profit. By backdating a grant to an earlier date, when the price was lower, the potential gain increases.
Commissioners debated several thorny questions in connection with the backdating scandal. Among them: Were shareholders actually hurt by the backdating of options, by the revelation of potential wrongdoing or by being deceived about how executives were compensated? The answer mattered in helping determine penalties, but it isn't clear how the SEC decided this question in the Brocade case.
More than 140 companies currently remain under investigation for backdating. Some, such as Apple Inc., have not been sued by the SEC for backdating, though former executives at those companies have been. Others remain under the microscope by the SEC as well as state and federal prosecutors. It is unclear how many of those investigations may result in criminal or civil charges, much less lead to SEC penalties.
Any new settlement talks inspired by the Brocade agreement will proceed under a pilot program set up by SEC Chairman Christopher Cox earlier this year. Under the program, enforcement staff must get permission from the commission to engage in talks involving a penalty against a corporation, as well as approval on a settlement range. In the past, staff members negotiated deals and only went to the commissioners for final approval.
Mr. Cox has said the new approach may result in more and stiffer penalties. Critics say it could slow down cases or deter the staff from seeking penalties.
Brocade first restated its financial results in early 2005 for several years to reflect additional option-related compensation expenses. The San Jose, Calif., networking-storage company said it had incorrectly accounted for grants to new hires as made on the date they accepted an offer, rather than the date they started work.
Source: Wall Street Journal, May 31, 2007
SURETY'S TAKE ...
Tech Company Burned by Lack of Technology...It is ironic that a technology company such as Brocade Communications did not have the technological infrastructure in place to thwart against data manipulation. Brocade learned the hard way that data management is of the utmost importance for today’s companies. Implementing an easy-to-use data management and security system would have saved the company millions and help keep its name from being associated with an all too common corporate scandal.
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GovernanceBrocade’s executives must institute a new data management policy that implements the use of a trusted third-party time-stamping solution such as Surety’s. Organizations that fail to protect the integrity of their electronic records are exposing themselves to financial losses, such as Brocade’s, as well as a loss of revenue, customers and quality employees. The proliferation of companies facing stock option backdating allegations make it clear that many businesses have not made data security and management the priority that it needs to be.
Litigation ReadinessIn addition to a $7 million penalty, Brocade’s stock scandal also cost the company millions in legal costs, auditing fees and lost revenue. The amount of time and money lost to a stock option case is staggering but there is a simple way for companies to protect themselves against such losses. Implementing a time-stamping solution like Surety’s is a cost-effective and simple way to deter misconduct, prove the integrity of electronic data and mitigate the costs of legal action.