Video: Brocade indictment

updated 7/20/2006 5:32:53 PM ET 2006-07-20T21:32:53

The former chief executive of Brocade Communications Systems Inc. was charged on Thursday with fraud, the first criminal complaint in a stock options probe that involves more than 55 U.S. companies.

Gregory L. Reyes, 43, became the first chief executive to be charged criminally for improper practices related to the accounting of stock options grants.

Reyes and another executive, Stephanie Jensen, also face civil charges by the Securities and Exchange Commission, according to a release issued jointly by that agency and the United States Attorney’s office in San Francisco.

An attorney for Reyes said in a statement that his client was innocent. Jensen could not immediately be reached for comment.

Reyes resigned in January 2005. That was shortly after the San Jose, Calif.-based maker of data storage devices said an internal audit had uncovered suspicious accounting of stock options, which allow employees to buy shares of their company’s stock in the future at a set price — and potentially reap a big windfall if share prices later rise

Brocade was once worth as much as $24 billion. It had to restate financial results for fiscal years 1999 through 2004, shaving 20 cents off previously reported earnings per share figures.

At least 58 companies have disclosed that their stock options practices are being investigated by the U.S. Department of Justice or the SEC. At issue in many of the probes, and a central allegation in Thursday’s actions, is a practice known as backdating, in which options are retroactively issued to coincide with low points in a company’s share price.

The criminal complaint, filed in U.S. District Court in Northern California, is the strongest sign yet that federal authorities plan to vigorously prosecute companies whose stock options practices skirted the law.

“It demonstrates the seriousness of the perceived unfairness of the practice,” said James Aquilina, a former assistant U.S. attorney who has prosecuted dozens of white collar crimes and is now in private practice at the national consulting firm Stroz Friedberg. “There are a lot of ramifications for this practice.”

Stock options give a person the right to buy shares in the future at a set fee, often called an exercise price. If the stock price rises following the grant of the options, they can represent a profit worth millions of dollars.

According the complaints, Reyes authorized options grants with exercise prices that were below the price of Brocade’s stock on the day they were issued, giving the recipient an immediate paper profit.

Reyes, who in 2000 landed on Forbes list of the 400 richest Americans, then backdated the documents so strike prices appeared to be the same as the company’s share price on the date they were issued, according to the complaints.

In a release, Richard Marmaro, a Los Angeles attorney at Skadden Arps, Slate, Meagher & Flom representing Reyes, criticized the allegations and said they were not based on the facts in the case.

“Financial gain is always the motive in securities fraud cases, and here there was none,” Marmaro said in the release, which was issued shortly before authorities announced the charges. “There is not even an allegation of self-enrichment, or self-dealing. Nor is there any evidence of an intent to misstate the financial statements of the company.”

Companies began increasingly relying on options in the late 1990s, when corporate executives touted them as an important compensation and retention tool and as a way to align employees’ and shareholders’ interests.

Backdating seeks to take advantage of fluctuations in a company’s stock by retroactively pinning the options’ exercise price to low-points in the shares. The practice can run afoul of accounting and tax laws if the companies don’t recognize the backdated profit as a compensation expense.

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