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Ex-CEO guilty in backdating of options

  Securities  -   POSTED: 2007/08/08 15:50

In a significant slap at Silicon Valley, the first chief executive to stand trial for the backdating of stock options was found guilty Tuesday of securities fraud and making false statements. Gregory L. Reyes, former CEO of Brocade Communications Systems Inc. of San Jose, faces the possibility of 20 years in prison and a $5-million fine for rewarding key employees with options to buy company stock at artificially low prices.

The criminal case has been closely watched by technology firms, many of which maintained that the widespread practice of backdating options was harmless and legal. This so-called scandal, executives quietly asserted, would quickly fade.

Moments after Reyes' conviction on all 10 counts, that belief began to waver, industry observers said.

"It's clear that this jury believes backdating was a serious crime," said Kirk Hanson, executive director of the Markkula Center for Applied Ethics in Santa Clara, Calif. "Every executive in Silicon Valley who has been waiting to find out if the Department of Justice will charge them now has a strong incentive to begin talking to prosecutors."

Dozens of companies throughout the valley and elsewhere have been ensnared in backdating cases.

After the verdict was read, the 44-year-old Reyes appeared stunned. He stared straight ahead, even when U.S. District Judge Charles Breyer dismissed the jury and then left the courtroom himself. Reyes finally stood up and made his way over to his wife, Penny.

She cried, and they held each other tight for a long time.

Reyes is a Silicon Valley native son with deep technology industry roots. His father, Gregorio, is a management consultant and has served as an executive and board member in the semiconductor and disk drive industries. His uncle George is the chief financial officer of Google Inc. Reyes also co-owns the San Jose Sharks hockey team with a consortium of Silicon Valley leaders.

Known in the industry for his aggressive style, Reyes built up Brocade from a company with $24 million in annual revenue in 1998 to $750 million in 2006. His antics to motivate employees included smashing pumpkins inscribed with a competitor's name and blowing up a competitor's product with a cannon.

David A. Kaplan, a technology historian, said he couldn't remember the last time an executive at a major Silicon Valley company was tried and convicted in a federal courtroom.

"Prosecutors have discovered Silicon Valley. If I were a valley executive, I'd be taking note," Kaplan said.

Reyes' lawyer, Richard Marmaro, declined to talk at the courthouse but issued a statement saying that his client would ultimately be exonerated.

"Today, we are disappointed. Tomorrow, we will continue the fight," Marmaro said.

Almost as distraught as the Reyeses were members of the nine-women, three-men jury. Three of the women shed tears. None of the jury members would talk to the media. They ejected reporters who got onto an elevator with them.

Interim U.S. Atty. Scott N. Schools dismissed the argument that the government was unfairly persecuting companies and executives over practices that were widely accepted.

"There's a test of that criticism — the jury," Schools said at a news conference at his offices. Reyes' defense was vigorous and well-resourced, he noted, adding: "I don't think anyone suggested that this was anything other than a fair fight."

Still, Schools declined to cast the verdict as symbolic. "It's our assessment that this was a single jury evaluating evidence in a single case. All of these cases stand on their own merits."

Options are the lifeblood of tech companies. They give recipients the right to buy a stock for a set amount — the exercise price — within a certain period. Typically, the exercise price is the stock's market price on the day the option is granted.

But executives who backdated looked back in time and cherry-picked particularly low prices for the options. That would give the recipient an instant paper profit.

Backdating became a widespread tool for recruiting and retaining key employees during the dot-com boom of the late 1990s. In itself it is not illegal. But it is a crime to fail to report it in financial statements, which is what Reyes was accused of doing in collaboration with Stephanie Jensen, Brocade's head of human resources. By granting discounted options, a company also could be understating its expenses and thus overstating its profit, misleading shareholders.

During the five-week trial, the government argued that Reyes knew he was violating accounting rules when he backdated options. It further asserted that he lied on securities filings to cover up his deception.

Marmaro argued that the government had failed to prove that Reyes, like many CEOs, knew the accounting rules well enough to know that backdating options and not reporting the practice was wrong. Besides, the lawyer said, Reyes never backdated stock options he granted himself.

Charles Ross, a white-collar defense lawyer at Charles A. Ross & Associates in New York, said he was surprised at the guilty verdict.

"I thought the government did not have a lot of smoking-gun evidence," he said. "But it's a tough environment out there to defend any corporate fraud charge these days."

The verdict, Ross predicted, "will embolden some prosecutors."

The government's pursuit of backdating has caused more than 100 companies to restate their financial results.

Brocade, a designer of data storage networking products, restated its earnings between 2000 and 2004 and was fined $7 million by the Securities and Exchange Commission in May.

The SEC is pursuing a civil case against Reyes, former human resources Vice President Jensen and former Chief Financial Officer Antonio Canova.

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