The Reyes Backdating Conviction: What's Next For Criminal Defendants and Civil Litigants?
This article was published by Thomson-West Andrews Litigation Reporter in Volume 23, Issue 7, of Corporate Officers & Directors Liability (October 1, 2007), and in Volume 22, Issue 7, of Delaware Corporate (October 8, 2007).
Introduction
On Aug. 7, in what media reports variously described as a surprising," "shocking," "astounding" and "stunning" verdict, a federal jury in San Francisco convicted former Brocade Communications CEO Gregory Reyes on all 10 criminal counts relating to his alleged "backdating" of stock-option grants to Brocade employees. Although reasonable minds may differ on how stunning the verdict was, its fallout will certainly extend beyond the confines of the case itself.
Backdrop of the Case
The backdating "scandal" exploded on the scene in the spring of 2006, when the Wall Street Journal ran a series of articles about the unusual correlation between the dates of stock-option grants and share values on those dates. Specifically, the Journal found that share values decreased immediately before the granting of stock options, usually to corporate executives, and increased immediately after the grants. By the Journal's estimation, the odds of such an event occurring randomly were, in some cases, more than 1,000,000,000-to-1.
As the Securities and Exchange Commission and various U.S. attorneys' offices began investigating the phenomenon, it became clear that numerous companies, especially the high-tech and startup ventures where stock options play such an integral role in attracting and retaining employees, had backdated their options grants to coincide with a periodic low in their respective companies' share values. While backdating stock options is not illegal per se, it may be criminally and civilly actionable if a company fails to disclose such backdating to shareholders or properly to account for such options grants on its books. Thus, the key issue in these investigations was whether the company (or, more pertinently, particular employees) intentionally backdated options and failed to make the necessary disclosures and accountings.
Reyes' Indictment and Trial
Among the companies swept up in the backdating frenzy was Brocade Communications, a Silicon Valley data storage networking provider. Based on the company's own internal investigation (conducted by outside counsel), Brocade determined that backdating had occurred from 2000 to 2004. In short order, the company forced Reyes to resign, restated its earnings and cooperated with the federal government to avoid criminal prosecution of the company. That left Reyes in the government's cross-hairs.
In a first-of-its-kind indictment Aug. 10, 2006, the U.S. attorney's office in San Francisco formally charged Reyes with conspiracy, securities fraud, mail fraud (later dropped) and "books and records" violations, based on his allegedly willful backdating of stock options for the benefit of Brocade employees. With the Department of Justice and the white-collar criminal defense bar looking on nervously, the case proceeded to trial in June.
Throughout the trial, both sides seemed to focus on the critical issue of intent, i.e., whether Reyes willfully oversaw the backdating of stock options with the intent to defraud shareholders.
The government introduced numerous documents, including SEC filings, in which Reyes attested that Brocade had properly accounted for all stock-option grants and kept accurate minutes and records to support its actions when, in fact, it had not.
The government also introduced an e-mail from Reyes that said, "It is illegal to backdate stock options"; testimony from a former compensation manager that Reyes once told her that "it's not illegal if you don't get caught"; and testimony from an attorney who assisted in the company's internal investigation of Reyes' denial of having ever backdated stock options and assurance that he understood the accounting implications of "in-themoney" options. (So important was this last bit of evidence that the jury later asked the court to read back the entirety of the attorney's testimony.)
The defense countered that Reyes' signature on public filings reflected his belief that backdating was proper and that at the time he did not understand the accounting implications of in-the-money options. The defense vigorously attacked the company's former compensation manager, June Weaver, who could not recall the context in which Reyes had made the "it's not illegal" comment and who benefited personally from backdated options. The defense argued that the e-mail and Reyes' professed understanding of accounting implications occurred after he stopped authorizing the options backdating, such that the evidence had no bearing on his state of mind when the backdating occurred.
So strong was the defense attack on the government's case that presiding U.S. District Judge Charles Breyer openly questioned the government's proof of intent and ordered it to brief the issue before Reyes began his defense. Judge Breyer's skepticism appeared to influence Reyes' defense team, which previously promised five weeks of testimony, but ended up concluding his defense in only one. Despite the judge's doubts, pundits' predictions and more than a week of deliberations, the jury returned a guilty verdict on all 10 counts remaining in the indictment. United States v. Reyes, No. 06-0556, verdict returned (N.D. Cal. Aug. 7, 2007).
Implications of the Verdict on Criminal Backdating Cases
Anyone who has ever tried a criminal case knows that every trial is as unique as a snowflake. The Reyes jury, like every jury, is a black box, and we simply do not know what motivated them to convict him. Thus, there is no direct correlation between the Reyes verdict and the outcome of any future backdating prosecution.
Having said that, the verdict did answer a question that had perplexed criminal defense practitioners from the outset: Will a jury impose criminal liability for what many would argue amounts to "sloppy bookkeeping," especially where the defendant did not personally benefit (or even intend to benefit personally) from the alleged wrongdoing? The Reyes jury said "yes" in a big way. As such, the verdict may have lowered the bar for future backdating prosecutions. But the fallout from this verdict likely will have more of an influence on mass psychology than on decisions about what charges to bring in backdating cases or on the specific outcomes of particular cases.
First, the government is highly unlikely to start running out and indicting people it otherwise would not have indicted before the Reyes verdict. True, the case could serve a "bellwether" function, but what drives government prosecution decisions are the underlying facts of specific cases, Justice Department policy and ethical considerations. Indeed, the government has specifically denied that Reyes' conviction will lead to a run-up in backdating indictments. Thus, it likely will not "embolden" the government to lose sight of its obligation to do justice in individual cases.
Second, while the government may attempt to use Reyes' conviction as a sword to induce pleas from other backdating defendants and targets, the success of this strategy ultimately hinges on how those individuals and their counsel view the verdict's impact on the facts of their particular cases. While it is true that Reyes did not benefit from any backdated options grants at Brocade, and though Judge Breyer expressed doubts about the government's evidence of his intent to defraud, Reyes conceded that he intentionally backdated stock options, and the government produced evidence to contradict his claims that he did not understand the implications of what he was doing. Future defendants may make no such concessions or have "better facts" to support their defenses, thus frustrating pundits' ability to predict specific future outcomes.
At base, Reyes' conviction most likely will cause many defendants, targets and their counsel to take a long, hard look at the recently confirmed downside of proceeding to trial in a backdating case, decide that discretion is the better part of valor and cop a plea to reduced charges. Just as market makers lead markets, convictions often beget plea bargains. But while the Reyes verdict may motivate the government to talk tough in plea negotiations, it knows as well as the defense bar that jury trials often are a roll of the dice, and the government is unlikely to risk a highly publicized acquittal that turns the Reyes decision on its head.
Setting aside possible global implications, the Reyes verdict illustrates several issues that criminal defense lawyers must carefully consider when handling backdating cases. First, the most prevalent defenses in white-collar prosecutions are:
- I didn't do it;
- The government didn't prove I did it;
- I did it, but I didn't know it was wrong.
In Reyes' case, the defense focused almost exclusively on the last defense, which raises the issue of criminal intent. The government, in turn, probably believed it had a strong case on intent, as it presented signed documents and Reyes' own statements suggesting that he knew it was illegal. In contrast, the typical criminal case often requires intent to be inferred from circumstantial evidence. Going forward, defense counsel must assess whether other factual or legal defenses may be more persuasive to a jury, such as a client's professed lack of knowledge that backdating was even occurring, as well as the type and strength of the government's evidence of intent.
Second, counsel must recognize the distinction between judge and jury with respect to questions of fact. Here, it appears that Reyes' defense team dramatically scaled back its planned defense in light of Judge Breyer's skepticism about the government's evidence of intent. Although the jury may have acquitted or deadlocked on this issue, there was no guarantee that they shared the judge's sentiments. Indeed, the verdict shows they did not.
Third, when the element of intent is the lynchpin of the government's case, defense counsel must carefully consider the value of the defendant's testimony. Although the decision on whether to put the client on the stand is a tough one in almost all criminal cases, an educated, polished and credible defendant might be able to turn the jury on the potentially dispositive issue of intent in a backdating case.
Finally, the Reyes case highlights an issue addressed in U.S. District Judge Lewis Kaplan's recent decision in a suit against former officers of accounting firm KPMG, United States v. Stein et al., No. S1 05 Crim. 0888 (LAK) (S.D.N.Y. July 16, 2007). If the testimony of outside investigating counsel was the final nail in Reyes' coffin, how does defense counsel prevent a company's attempts to curry favor with the government from incriminating their clients?
As those of us who conduct internal investigations know, one must always caution company employees that outside counsel represents the company, not the individual, and the company can waive any privilege that otherwise might attach to an employee's interview. When the company decides to waive that privilege and cooperate with the government, the employee's statements, however incriminatory, may be turned over to the government and used against the employee.
This scenario apparently unfolded in Reyes' case, with devastating consequences to him as evidenced by the jury's request to hear a rereading of outside counsel's testimony regarding Reyes' incriminatory denials during the company's internal investigation. In light of the KPMG case, where the government put heavy pressure on KPMG to waive privilege and stop paying for its employees' separate counsel, and the Reyes verdict, criminal defense counsel must carefully consider the implications of their clients' possible cooperation in company-sponsored probes of wrongdoing.
Implications of the Reyes Verdict on Civil Backdating Cases
Reyes' conviction is likely to spill over into civil backdating litigation in that the plaintiffs' bar will be more inclined to file new lawsuits and there will be higher likelihood to settle pending civil cases. Both of these effects derive from the "mass psychology" mentioned above, in that defendants now will perceive backdating cases as more risky (and plaintiffs, as less risky), because a jury of 12 citizens now has imposed criminal fraud liability in a backdating case.
Civil litigation is fundamentally about risk management, with both plaintiffs and defendants attempting to calculate the value of their cases based on the probability of success on the merits, the magnitude of potential liability and the anticipated costs of litigation. Whatever the civil plaintiffs' estimates of expected value were before Reyes' conviction, they likely will be higher now, because the successful criminal verdict will lead them to anticipate a greater probability of winning at trial, especially given the lower burden of proof and broader discovery available in civil litigation. Thus, as a matter of simple economics, plaintiffs will be inclined to file more cases and to demand larger settlements.
Of course, just because plaintiffs believe they are more likely to win future backdating cases does not mean they will. As mentioned above, Reyes' conviction reflects the conclusions of a particular criminal jury in a particular criminal case. It is difficult, if not impossible, to extrapolate this outcome to civil cases with entirely different facts and circumstances.
Moreover, the fact that the government seemed to struggle, at least initially, in its effort to establish Reyes' criminal intent may be of concern to civil plaintiffs who face similar challenges in establishing fraudulent intent and other scienter-related elements of their claims. All this ultimately will come to a head when the first civil backdating case goes to trial and when a jury verdict provides another data point. But for that to happen, at least one defendant must be willing to risk an adverse verdict. After the Reyes decision, there probably won't be many volunteers.
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