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Close ties, bad timing

Gregory Reyes, Stratton Sclavos and Scott Kriens were each CEOs of hot tech companies during the boom years.

Gregory Reyes, Stratton Sclavos and Scott Kriens were each CEOs of hot tech companies during the boom years.

But they were not just executives of prominent fast-growth companies during those high-flying years -- they also served on each other's boards of directors, traveled in the same social circles and two of them became investors in San Jose's professional hockey team.

Now, their names are among a handful of valley luminaries who turn up repeatedly in connection with the companies singled out by lawsuits or Securities and Exchange Commission inquiries in connection with stock option backdating. Only Mr. Reyes has been named a defendant in a criminal complaint or an SEC action, so far.

Silicon Valley boards of directors are self-selecting, chosen for their knowledge of a technology, experience with startups or familiarity to the CEO. This is helpful to new companies looking for experienced hands, but the stock-option backdating scandal has also revealed a weakness in the you're-on-my-board-I'm-on-your board system-- it doesn't encourage vigilant oversight. Moreover, the closed system creates a social network in which ideas -- good and bad -- spread quickly.

Apparently, one of those ideas was the backdating of stock options.

In one of the clearest patterns of interlocking directors at companies ensnared in the spreading stock options investigation, Mr. Reyes, Mr. Sclavos and Mr. Kriens all served on the board of directors at Verisign, where Mr. Sclavos is chairman and CEO. Mr. Sclavos and Mr. Kriens were on the board at Juniper Networks, too, where Mr. Kriens is chairman and CEO.

Being both chairman and CEO, as Mr. Reyes was at Brocade, Mr. Sclavos was at Verisign and Mr. Kriens was at Juniper, meant that the top company executive was the head of the board which is supposed to make sure his actions were in the best interest of shareholders as well, something that corporate critics say is a clear conflict of interest.

Mr. Sclavos did not respond to requests for an interview. A spokeswoman for Mr. Kriens said he was not talking about stock option backdating at the moment. Brocade issued a statement pointing out that neither Mr. Reyes nor other executives charged with backdating are still employed at the company. Mr. Reyes' attorney Richard Marmaro says his client is innocent.

"He will unquestionably be found innocent, and everyone will wonder why the government indicted him in the first place," Mr. Marmaro said in a statement.

On July 20, Mr. Reyes and two other executives at Brocade became the first charged in the backdating controversy. Mr. Reyes and the company's former human resources chief face both criminal charges filed by the U.S. Attorney's Office and a civil complaint filed by the SEC. Brocade's former chief financial officer faces only civil charges.

Brocade also faces a lawsuit brought by investors who claim that the board of directors "because of their inter-related business, professional and personal relationships, have developed debilitating conflicts of interest that prevent the board members of the company from taking the necessary and proper action on behalf of the company."

The lawsuit names Mr. Reyes and prominent Silicon Valley attorney Larry W. Sonsini, chairman of Wilson Sonsini Goodrich & Rosati, but not Mr. Sclavos and Mr. Kriens, who left the Brocade board last year. Mr. Sonsini also has left the board.

The lawsuit, filed by stockholder Chean Shee Lim, also points to the professional connections between two other board members -- Michael Klayko and Robert Walker, who worked at Hewlett-Packard Co. Mr. Lim contends that because of their business connections neither can be counted on to force the board of directors to straighten out the backdating controversy.

The problem, Mr. Lim contends, is that the board of directors looked the other way as executives enriched themselves with backdated options to the tune of $752 million.

"The entire Brocade Board and senior management participated" in the scheme, Mr. Lim contends in the lawsuit, filed in Santa Clara County Superior Court.

Although the SEC complaint takes a different tack, singling out CEO Reyes and two executives, it, too, implies that directors were sleeping watch dogs.

Brocade's board gave Mr. Reyes "virtually unchecked authority" as the sole member of the compensation committee, according to the SEC complaint. From 2000 to 2004, Mr. Reyes used that authority to grant "in-the-money options to employees by falsifying in the options documentation the date on which the grants were made," the feds allege.

Other lawsuits also take to task directors of high-profile valley companies.

Directors at KLA-Tencor Corp. are accused in a shareholder lawsuit of either receiving or authorizing and approving the backdating. Kenneth Levy, KLA-Tencor's founder, director and CEO and chairman at various times, also served on the board at Juniper Networks Inc. with Mr. Kriens and Mr. Sclavos.

One reason that Silicon Valley technology companies turn to people they know to sit on boards is because of the specialized technological areas many of the companies inhabit.

"You want people with expertise, who are interested and willing and don't live a thousand miles away," says Regis McKenna, the Silicon Valley marketing guru who helped launch companies like Apple Computer Co. and Compaq. "If you make a wrong decision about technology it will set you back decades."

Technology companies also frequently create spin-offs that encourage those interlocking relationships, says William Sherman, a partner at Morrison Foerster's primary office in Palo Alto.

He also attributes overlapping boards in part to geography.

"It's the natural outcome of a small geographical area with an enormous number of companies and all the founders living here -- they know each other and invite each other onto their boards."

Natural or not, overlapping boards can lead to lax oversight.

"It's not conducive to good governance," says Benjamin Hermalin, Willis H. Booth Professor of Banking and Finance at the Haas School of Business at the University of California at Berkeley. "It's pretty hard to be the boss of someone who is your boss. It's not very conducive to being vigilant."

There is statistical evidence to support that view. David Larcker, the James Irvin Miller Professor of Accounting at the Stanford Graduate School of Business, is the co-author of a recently updated study showing that boards with "fewer degrees of separation" among the directors tend to overcompensate executives, and the companies themselves tend to underperform.

That study of 22,074 directors at 3,114 companies found that "monitoring by the board of directors is hampered by social relationships between directors."

"If I'm on your board and you're on my board, that is going to impair my objectivity or independence," Professor Larcker says.

Silicon Valley is known for its overlapping boards, says Mr. Hermalin, but that could become a more common feature elsewhere. Reforms promulgated since Enron have encouraged boards to increase the number of outside directors -- those not otherwise employed by the company. And as they do, they are likely to turn to people they know, just as Silicon Valley CEOs have done for years.

"It's a game to get a board tough enough to look out for investors but friendly enough to keep tabs on the CEO," he says.

In the case of Mr. Reyes and Mr. Sclavos , they were intertwined not just in the board room but also at the arena -- the Shark Tank to be precise. In February 2002, Messrs. Reyes and Sclavos joined with venture capitalist Kevin Compton to form a new organization, Blue Line Associates, to buy the largest share of the San Jose Sharks National League Hockey team. Mr. Compton served on the board of directors at VeriSign at the time with Messrs. Reyes, Sclavos and Kriens.

Regulators tighten rules to head off future pay scandals

The Securities and Exchange Commission has approved new rules that will force companies to spell out more clearly how they award stock options. In particular, companies will now have to make it clear if they are granting in-the-money options that give a recipient an immediate profit. It is widely assumed that such grants often go unreported to the IRS.

To make it even more difficult to fudge the exercise date in order to make the value of the option even greater, the SEC will now require companies to state the date that the compensation committee or full board of directors took action to make the option grant, if that date is different than the actual grant date.

And if the exercise price of an option is not the same as the closing price on the company's stock on the date the option is granted, the directors will have to explain just how they came up with the exercise price.

Perhaps the most difficult task, however, requires that everything be put into easily comprehensible language.

"Shareholders need intelligible disclosure that can be understood by a lay reader without benefit of specialized expertise or the need for an advanced degree," said SEC Chairman Christopher Cox. "It's our job to see that they get it."

Grand Prix charity's founder caught up in controversy, too

The stock backdating scandal has ensnared in some form or other over 80 companies, with people both famous and obscure on their boards of directors. Here are a few of the more widely known figures who find themselves at the center of this storm:

Al Gore. The former vice president is a director of Apple Computer Co. of Cupertino. Two lawsuits have been filed against the company, and it has conducted an internal review of options granting after it found irregularities, according to a statement on its corporate Web site.

Millard Drexler. Also serving on the board at Apple is the former CEO of the Gap, now the CEO of J. Crew.

Larry Sonsini. The chairman of the Wilson Sonsini Goodrich & Rosati law firm, which has been much employed in valley IPOs, was on the board at Brocade Communication Systems Inc. from 1999 to 2005 and served as a member of the audit committee. His law firm also served as principal legal counsel. Former Brocade Chairman and CEO Greg Reyes said in a Business Week interview that Mr. Sonsini approved the company's stock granting program. Assumed to be a central figure in the investigation into Brocade, Mr. Sonsini's name does not appear in the SEC complaint.

Don Listwin. The jeans-and-blazer wearing former tech executive is now known for his efforts to find a cure for cancer. His Canary Foundation, formerly Canary Fund, puts on the Grand Prix auto race in San Jose as a fund raiser for the foundation. But a lawsuit filed against him and the company creates a much less altruistic portrait. The lawsuit alleges that Mr. Listwin, the chairman, CEO and a director, and the other executives and directors at Openwave were busy backdating options to enrich themselves.

John Doerr. The widely known venture capitalist with Kleiner Perkins Caufeld & Byers, serves on the board of Intuit Inc., which is responding to inquiries from the SEC and the U.S. attorney.

Donna Dubinksy. The co-founder of Palm Inc. and Handspring Inc. and currently the CEO of Numenta also serves on the board of Intuit.

Steve Young. The former San Francisco 49er quarterback is on the board of Foundry Networks Inc., which has received inquiries from the SEC and Department of Justice.

William Hearst III. The scion of the Hearst publishing empire serves on the board of Juniper Networks Inc., which has been sued by shareholders and has received an inquiry from the U.S. Attorney's office.

E. Floyd Kvamme. A partner emeritus of Kleiner Perkins Caufield & Byers, Mr. Kvamme serves as a director of Power Integrations Inc., which is reviewing its option grants and is dealing with SEC and Department of Justice inquires.

Abraham Sofaer. A director at Rambus Inc. and a senior fellow at the Hoover Institution at Stanford University, Mr. Sofaer is a former U.S. District Court judge for the Southern District of New York and a former professor at the Columbia University Law School.