New Twist on Reyes

So, ever since Greg Reyes was convicted on all 10 counts levied against him it seems that everyone (myself included) immediately chalked it up to a "well, he got what was coming to him" for screwing with the rules. I've been quoted on the subject many times over the last year, and have been pretty consistent in my position – if he did it, he deserves to pay the fiddler.

I'm not sure what it is within me that makes me a contrarian – even versus myself it seems – but now that everyone is ready to put him behind bars, I'm no longer so sure.

I was following the trial at a very cursory level. I know some of the participants, which kept me interested, and I also know that there are about 150 other companies with the same potential issues regarding options back-dating and securities fraud that were watching this case very closely. When the verdict came down I wasn't overly phased one way or another, except to observe the ripple effects to those other 150. But then an interesting thing happened a few days later.

I took my 5 year old to the barber on Saturday. He enjoys getting his hair cut simply because he knows he will get a pop if he powers through it, and while he hates the entire notion of the actual haircut by the 67 year old former marine barber, he loves a good pop more. Anyway, as Michael is in the chair, I was reading the paper. In a small paragraph in the business section I saw an article that said "Brocade CFO Indicted on Securities Fraud".

Here's where it gets interesting – part of the government's case against Reyes relied on the argument that Reyes effectively did what he did alone – without the knowledge of his finance department, and namely CFO Mike Byrd – they guy now indicted for knowing and doing all the things Reyes was accused of doing all by his lonesome. That made me curious, so I've been spending some extra time recreationally reading the court transcripts.

Note: I am not a lawyer, but I should be. I personally believe that Greg Reyes knew he was backdating stock options. I also believe that it is irrelevant in the grand scheme because A: it isn't a crime to do it – it's only a crime if you intend to defraud others by doing so, B: because since it isn't a crime, the government has an obligation to prove fraud and how investors got hurt (they didn't – investors apparently don't even put stock option expenses into their models – at least the ones who testified) and C: that while I personally don't agree with the rational behind backdating options – to allow your employee who has the option to make more money – it's not like the employee who makes the money isn't responsible to pay their fair/unfair share to the government in the form of taxes anyway.

So, for the sake of argument, let's say that I'm not commenting on the guilt or innocence of Greg Reyes in any way. What I was interested in was the role the government played in the prosecution. In light of the Duke (Nifong) fiasco where an overzealous prosecutor went way out of bounds because he believed he represented justice, the Mike Byrd indictment made the hair on my neck stand up. I have plenty more to research, but here's some interesting things to chew on.

From the official transcript – in the closing argument of the prosecution (Volume 20, pages 4041-4212) by Mr. Crudo:

"Where is the evidence that the defendant relied upon Mr. Byrd, Mr. Bossi, Mr. Canova, Mr. Blucher or anybody else in finance? Where is the evidence of any communications where anybody from finance told him you can backdate; go ahead. Put a date on there from a date in the past. You can do that. There isn't any. Now, Mr. Marmaro said yesterday that the finance people know the most. They know the most about what was going on. Now, that's totally contradictory to our theory. Our theory is that those people didn't know anything. Elizabeth Moore told you they didn't know anything. Now, the defendant called all kinds of people who didn't know anything about the stock option process. In fact, go back and look at your notes. Not a single person that they called knew anything was involved in the stock option process. Defendant could have called witnesses in this case as well. Doesn't change that it's our burden. You shouldn't hold us to a lesser burden because they didn't call somebody. But think about that. Elizabeth Moore says finance didn't know. Did you need everybody in the finance department to come and tell you that they didn't know? But take a look, when you look at those, the document that he showed you, which was Exhibit 2539, take a look at these two, take a look at 2526 and 2536. And those will show you that Mr. Byrd was deceived as well."

Mr. Byrd was the CFO then COO of Brocade, and reading the transcripts it seems clear to a layman that the prosecution needs to make Reyes a bad guy all by his lonesome for some reason – insisting that folks like his CFO knew nothing. So why then only a few days after the verdict does the SEC indict the same Mr. Byrd for knowing and participating in the very things the government contends he knew nothing about days earlier?

From the SEC Filing (Just the first 2 complaints, but you'll see my point):

   

Plaintiff Securities and Exchange Commission (the "Commission") alleges:

SUMMARY OF THE ACTION

1. From at least 2000 through 2004, Brocade Communications Systems, Inc. ("Brocade" or

"the Company"), a San Jose computer storage networking company, concealed millions of dollars in

expenses from investors and significantly overstated its income by falsifying records relating to

employee stock option grants. The fraudulent scheme was executed by former chief executive officer

Gregory L. Reyes ("Reyes"), who routinely backdated stock option grants to give Brocade employees

and recruits valuable "in-the-money" stock options without disclosing the practice or recognizing the

required compensation expense on the Company's financial statements. To carry out this scheme, for

certain highly sought after recruits, Reyes and others falsified paperwork related to the grants to make

it look as if the employees had been hired and employed by Brocade long before the time they

actually started with the Company, so that those employees could receive options that were backdated

to a date in the past when Brocade's stock price was significantly lower.

2. Michael J. Byrd ("Byrd") was hired by Reyes in May 1999 as chief financial officer

("CFO), just as the Company went public. As CFO, Byrd had responsibility for preparing and

reviewing Brocade's annual and quarterly financial statements, which described the Company's

accounting for stock options. In May 2001, Byrd was promoted to chief operating officer ("COO")

and president, positions he maintained until he left Brocade in 2003. On multiple occasions, Byrd

learned that Reyes was claiming to have granted options to newly-hired executives, whom Byrd

understood were not actually employed by Brocade on the purported grant date. This resulted in the

issuance of in-the-money options to the executives, which were not properly accounted for in

Brocade's financial statements or disclosed to its shareholders. Byrd was also alerted to other facts

suggesting that the CEO was manipulating options grants.

So either the prosecutor knew he was lying about Byrd in the Reyes trial (which appears to be born out in the transcript as others testified that he knew everything) and did it anyway, or Mr. Byrd is getting railroaded by the SEC. I have trouble believing it is that.

There are a bunch of other interesting things I'll point out soon – one of which is around how no one on Wall St. cares about option expensing and therefore how it made no difference in the value of the stock. Jason Gold, a fund manager at Pequot Capital owned $500 million dollars worth of the stock and testified as such. So if the options backdating expense reporting didn't affect the stock price, then individual stockholders weren't affected, so where is the securities fraud? Not that "joey was doing it too" is any excuse at all, but 130 or so other companies also not "properly" expensing stock options and a clarification memo from the SEC due to confusion around the rules does lead one to believe that if no individual nor investor was negatively impacted and confusion abounds, it seems hard to prove intent to defraud. But again, I'm no lawyer, or judge.

So, once again I'm arguing with myself – but here's the point: Even if Reyes is a guilty as sin, the government has to be held to the highest standard, and when the government lies I get irritated. If you are going to send a person to jail, that person has to be guilty beyond a reasonable doubt and the prosecution has to be above reproach. If the prosecution cheats, the whole system is screwed.

I think that this story isn't over.

  

Comments

[MDLH]

Thanks for this. I found this case disturbing due to the lack of testimony from finance professionals even before they indicted the CFO. This case almost seems like any professional with exposure to corporate data who errs in the financial reporting of such data- can be indicted for fraud. I know they went after a CEO, who in theory is responsible for all aspects of corp reporting, but that isn't reality- most CEOs are busy with other things not non-cash expenses. There wasn't anything to indicate Reyes knew he was violating some accounting rule, and if we are all going to be held to this standard then why bother having a finance dept in the first place?

Furthermore, Brocade was not the worst backdater anyway, not even close. That distinction would have to go to a large company like Microsoft or Intel. I find this harassment of some individuals involved in this, but not others such as Ballmer who is a really big fish, to be somewhat distasteful.

-----Touche. I'm in a little private company, and while as the "chief" I own the responsibility for all, in reality I sign things weekly that I don't even come close to reading. Why? Because I trust the person telling me to sign it implicitly - and it is his job to know the stuff. How many people sign their HIPPA form when they go to the doctor or dentist and have never read it? 98% I'm guessing.

If the argument (or an important element of) to convict the man was based on the fact that he really did know all and no one else did, it's such crap it is almost laughable. I haven't been through the entire transcript yet, so I have to believe that there is more to it. If not, this is a travesty. --- Steve

[MDLH]

I know it seems like there is a loud, resounding cry to hang Reyes and all backdaters from the rafters, but in the background, much more quiet are the thousands of senior managers looking at this verdict who are scared to death. This is a troubling precedent, because in the 90s everybody backdated with no intent to defraud. There was no perceived costs to options then, and since many large companies were doing it, a small company like Brocade had to also in order to attract talent. If Brocade did know these needed to be expensed (and I don't think the government proved that, personally), then if Brocade actually DID expense them, analysts would have reacted strongly negatively, since *nobody* expensed these things!
Many IT professionals, not just CIOs but VPs of IT also, are corp officers responsible for integrity of data used in financial reporting. Does this Reyes case mean that an CIO could be charged with fraud if somebody's books put deferred revenue in the wrong bucket, and the finance staff "didn't know a thing" about the error? These are just my concerns about the case itself, notwithstanding the revelation that the government lied in their closing arguments as you point out.

And in the end, Brocade was not a large backdater anyway just by virtue of the size of the the company.

There are not enough corp officers and senior managers out there to be heard with this POV over the loud crys of the masses "hang them, they are witches!!!". But that doesn't mean that what is happening is right and just.

[TM]

And Apple's Steve Jobs seems to have had his own view on what was acceptable practice in this regard...

[JR]

You know, I read all this info on the Brocade case, but very little of those commenting actually worked at Brocade when Greg was running the company. I worked there under his leadership and frankly, I thought the company was the worst place I ever worked. There were people there who made a boatload of money getting all their friends hired, whether or not they were qualified to do the job. It was nothing but a culture of greed and nepotism. If you were not part of the "in" circle you were quietly written up and fired for bogus reasons. It was a blessing the day I left there. It was a rough ride after the bubble burst, but I am in a MUCH better place now.

I read about all these ex-employees who are grateful to Greg for providing their family a good life, but what they don't realize is that money was technically made illegally based on the decision made in this case. I also think it is really sad that he has to reach out to ex-employees to vouch for his character to the sentencing judge. I view it as what goes around comes around and it was his job to be knowledgeable about what was going on within his company and make sure that what was going on was truthful and honest. As the leader he was to set an example for those working for him and look what kind of example he has set for the world.