Wednesday, July 19, 2006

Brocade's Former CEO Faces Criminal/Civil Charges over Options Pricing

The United States Attorney's Office for the Northern District of California, the Securities and Exchange Commission, and the Federal Bureau of Investigation (FBI) criminal and civil securities fraud charges against Gregory L. Reyes, the former CEO, President, and Chairman of Brocade Communications Systems, Inc., and Stephanie Jensen, its former Vice President of Human Resources, alleging that the two routinely backdated stock option grants to give employees favorably priced options without recording necessary compensation expenses.

Brocade Communications Systems, which is based in San Jose, California, offers a line of "SilkWorm" SAN switches that connect servers with storage devices.

The actions, which are among the first cases involving manipulation of stock option grants in violation of the federal securities laws and other criminal statutes, are the result of 18-month investigations by the Commission and the FBI.

According to the criminal complaint and the Commission's civil complaint, Reyes, 43, of Saratoga, Calif., and Jensen, 48, of Los Altos, Calif., regularly caused Brocade to grant "in-the-money" options (i.e., the exercise price is below the stock's market price on the day of grant, giving the recipient an immediate paper gain) to both new and current employees between 2000 and 2004, but backdated documents to make it appear that the options were "at-the-money" (i.e., the exercise price is the same as the stock's market price on the day of the grant) when granted, thus concealing millions of dollars in expenses from investors. Under well-settled accounting principles applicable at the time, options granted "at-the-money" did not need to be expensed. In contrast, options granted "in-the-money" needed to be recorded as a compensation expense.

The separate criminal and civil complaints allege that Reyes repeatedly used hindsight to select a date with a lower stock price from the recent past as the supposed option grant date.

According to the SEC, in order to facilitate the scheme, Jensen created, or directed others to create, paperwork making it appear that the options had been granted on the earlier date. In some instances, employment offer letters and compensation committee minutes were falsified and purported to document option grants to employees before they had even been hired by the company. As a result of this practice, Brocade was able to give employees "in-the-money" stock options without having to recognize compensation expenses as required by accounting rules. When these stock option abuses surfaced, Brocade was required to restate and revise its financial statements for fiscal years 1999 through 2004.

Brocade issued a statement saying it has no comment with respect to the former executive officers. It also noted that it has taken a number of steps to strengthen disclosure controls and procedures, and internal control over financial reporting, including personnel and executive changes and procedural changes to improve the stock option granting and employee change in status processes. No executive officers involved in the historical stock option granting practices remain employed with Brocade.


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