Looking Back at Backdating

Investigations Quarterly

Potential Juror Number 18 appeared to harbor an overwhelming bias against our client. His senior thesis focused on stock option backdating. To trial counsel for a corporate controller accused of backdating stock options, this presented a quandary. The pervasiveness of backdating was an important part of the defense, and we were concerned about our ability to communicate that message. That would not be a problem with Juror Number 18. On the other hand, the negative publicity that influenced his choice in senior thesis may have instilled in him an insurmountable bias against our position. After a fairly vigorous voir dire, Juror Number 18 cracked – he said he would try to maintain an open mind if selected for the jury, but he admitted that he held the general belief that stock option backdating was done by executives for self benefit. Juror Number 18 was excused.

Juror Number 18's reaction was not surprising, but it showed the incredible difficulty faced by defense counsel in backdating cases and, more generally, defending government claims of alleged corporate "fraudulent schemes." What lessons can be drawn four years after the so-called stock option backdating scandal first broke? What can we learn when the government seeks to punish or criminalize routine or widespread accounting or business practices? In this article, we explore the spectrum of outcomes in several litigated stock option backdating cases. While evidence in each case is unique, the government's uniform approach offers insight to litigants facing claims in the next fad to attract the government's attention.

While there are many lessons to be learned from the stock option phenomenon, from improved compliance to changing corporate culture, this article focuses on how best to attack the government's case – points that can make the difference between a good outcome or a blown case assessment.


D's Position


SEC v. Jasper 


Defendant was found liable on 8 of 11 causes of action filed, including fraud.

United States v. Karatz


Defendant was found guilty of conduct related to the company's internal investigation, but was absolved of charges related to backdating and prevailed on 16 of 20 counts.

SEC v. Pattison


Defendant prevailed on the fraud and false reporting charges. He was found liable for minor violations related to books and records and internal controls. Post-trial motions for judgment as a matter of law are pending.

United States v. Reyes


Defendant, who was found guilty of fraud at his first trial, was found guilty of 9 of 10 charges against him, including fraud. His appeal is pending.

United States v. Ruehle


Shortly before the criminal trial the Judge dismissed all claims, criminal and civil, because of prosecutorial misconduct. The SEC, although publicly indicating that it might re-file its complaint, never did so.

SEC v. Shanahan

Outside Director

Defendant prevailed on a Rule 50 motion for judgment as a matter of law at the conclusion of the SEC's casein-chief. The SEC has appealed the ruling.

Lesson 1: Identify, understand and distinguish the highly-charged terms

In each of these cases, the government's complaint and arguments to the jury contained inflammatory rhetoric by characterizing the alleged conduct with phrases such as "secret scheme to defraud," "secretly grant[ing] backdated stock options," "self-dealing," "stealing," "cheating and lying." The following excerpts are actual statements made by the government during opening statements in three of the cases. The descriptions certainly evoke images in a juror's mind of thievery and embezzlement rather than the potential misapplication of an arcane accounting rule.

  • From the recent Karatz case: "The defendant stole $6 million from shareholders. He stole it without shareholders knowing about it, and he used stock options to do it … he secretly padded his pay each year, without revealing it to shareholders and without their knowledge."

Despite these strong allegations by the government, Karatz was absolved of all charges that related to the backdating of stock options.

  • From Pattison: "This trial is about how the defendant told lies, hid the truth, and made money at it. The defendant and the other top management at the company that he worked for schemed to give a special deal to company insiders. They gave out stock options to company insiders at a better price. Those insiders included the defendant, himself, who made thousands of dollars while hiding millions in expenses." The inflammatory allegations about lies, special deals, and hiding millions of dollars painted a much darker picture of the defendant's actions than the evidence would eventually show. As it turned out, the defendant was not part of "top management," had no authority to grant options, and the "company insiders" were merely rank-and-file employees.
  • In Jasper, the government compared the backdating of stock options to cheating to win the lottery: "This case is about cheating and then lying about it. And here's how: if any of you like to buy lottery tickets – it's pretty fun to imagine what life would be like if you won the lottery. So imagine what it would be like if, once the lottery results were announced, you could go travel back in time and then pick the numbers because you knew what they already were." This analogy ignores the uncertain nature of stock prices, and that options vest over time and have no immediate value to the recipient.

As difficult as those statements are to defend, the most basic and harmful tactic was the government's use of the term backdating itself. Government attorneys would prefer the jury believe the general theory articulated by one SEC attorney in speaking to a news outlet that "…stock option backdating is, in fact, a fraudulent practice…" In reality, backdating is not a term of universal or defined meaning, nor a term used at the time of the underlying transactions. And as the results of these cases show, nor is backdating a universal fraudulent practice. Each of these cases involved unique option-granting practices, from the use of unanimous written consents by executives or board members to the granting of options under delegated authority. In some cases options were granted to the executives and board members that were making the decisions, while in others the options were limited to low-level, rank-and-file employees. The variation in the options practices highlights how unfair the use of the pejorative term backdating is to defendants since the only common element in the cases was the government's use of the term backdating.

In the most successful outcomes, the defense recognized and challenged the government's reliance on rhetoric. For example, some trial courts sustained objections to the government's repeated use of backdating as without foundation. Other courts instructed the jury – at the defendant's request – that selecting in hindsight favorable option terms was not illegal, allowing defense counsel to focus on the benign steps inherent in any employee stock option granting process. The key for attorneys confronted with this situation in the government's next accounting litigation fad is to recognize, and then neutralize, the government's use of unfair terms that will bias a jury into believing the defendant is guilty until proven innocent.

Currently, defendants seeking to settle or defend claims under the Foreign Corrupt Practices Act face this challenge. Just as the nefarious-sounding term backdating was used as an undefined catch-all, so too the government relies on allegations of bribery and corruption to suggest fraudulent and illegal conduct. The reality, of course, is often a benign or well-intentioned series of business practices and accounting decisions.

Lesson 2: Understand the government's key accounting assumptions

Beyond the rhetoric, the government's next tactic in proving securities fraud was to portray the conduct of the defendants as a clear and "obvious" accounting wrong. Because the government needed to prove intentional or reckless conduct to prevail on its fraud charges, it made the tactical decision to argue corporate self-dealing and disregard the ambiguity of the accounting rules at issue. It claimed quite clearly that corporate executives understood the (obvious) accounting rules and intentionally defrauded investors by giving themselves "in-the-money" options, while hiding the extra compensation from shareholders. Who needs expert testimony when a company has already admitted the bad accounting in a restatement?

In order to prove reckless conduct, the government is required to prove an extreme departure from the standard of ordinary care. But what was that standard for stock option accounting? The rules are less clear than the government portrayed them to be. As Judge Cormac Carney stated in the Ruehle case, "[t]he accounting standards and guidelines were not clear, and there was considerable debate in the hightech industry as to the proper accounting treatment for stock option grants." (United States v. Ruehle, Central District of California Case No. SA CR 08-00139, December 15, 2009 transcript, p.5201.) When hundreds of companies restate their financial statements as a result of their stock option programs (some academics have estimated thousands of additional companies with option-pricing issues), can the government reasonably claim a defendant's conduct is an extreme departure from the standard of ordinary care?

One key to tackling these problems is to present evidence that leads a judge or jury to question the government's key assumptions and conclude that legitimate ambiguity, rather than fraudulent intent, was the origin of the problem. In the case of backdating of stock options, that meant understanding both the accounting literature and the key terms in the government's case – terms like "grant date" and "measurement date."

The accounting rule at issue in backdating cases, APB 25, is fraught with ambiguity. After its initial promulgation in 1972, the Accounting Principles Board repeatedly amended and interpreted key provisions. Over the years, a diversity of practice developed as to the approval and documentation of employee stock options. The government, however, repeatedly claimed that the accounting literature and terms such as "grant date" and "measurement date" were clear. Because the rules were clear, it followed that the conduct of defendants constituted an "obvious wrong." But the ambiguity surrounding the relevant accounting terminology is undeniable. Take, for example, the key term "grant date," which was used by a number of companies to describe the effective date of their stock options. While the government claimed that the "grant date" was clearly established at the time the options grant was approved, APB 25 itself does not reference or define the term. It is unclear why the selection of an earlier "grant date" and exercise price is any different than the use of an earlier "effective date" in a normal contract. Instead, APB 25 discussed stock option
compensation in terms of a "measurement date." The confusion surrounding these terms was born out by the repeated disagreement among government witnesses as to the meaning of these key terms, specifically "grant date." Whereas in one trial the engagement partner of a Big 4 accounting firm testified that "grant date" was a "legal term," a lawyer working for the same company called it an "accounting" concept. And this disagreement was occurring years after the backdating scandal arose.

It is baffling how the government could ignore the ambiguity of the key accounting concepts in light of the hundreds of restatements, inconsistent language in the various accounting pronouncements, and wide variety of stock option practices and documentation. But this is the challenge faced by defendants to securities fraud matters.

And strangely, a critical issue surrounding the language of accounting rules and interplay with legal concepts remained almost completely unaddressed in these cases: that being APB 25's notion that the "measurement date" was defined in terms of when the legal obligation and option "rights" first arose – as with many accounting rules – most notably FAS 5, "rights" and "obligations" turn on legal concepts. Those concepts often leave room for legitimate interpretation in any particular circumstance. Despite this, government prosecutors portray the accounting rules in black and white terms. Expert testimony as to the diversity of practice and ambiguity of accounting rules provides an essential context for the judges and juries in these cases.

Lesson 3: Exploit other elements of the government's case, including materiality

When the SEC seeks to prove securities fraud, it must prove "materiality." See In re: Seagate Tech. II Sec. Litig., 843 F.Supp. 1341, 1347 n. 4 (N.D. Cal. 1994); see also McGonigle v. Combs, 968 F.2d 810, 817 (9th Cir. 1992). To prove this, the government must show that the omitted or misrepresented information was likely to alter the total mix of information available such that it would alter an investment decision. In most of the backdating cases, the government simply pointed to the company's multi-million dollar restatement and asked, "how could it not be material?"

Jurors in one recent case readily acknowledged after the verdict that the information relating to stock options would not have been material to investors. The defense team, rather than challenge whether a $14 million restatement was material, focused on the qualitative aspect of the information: stock options reflect a claim on equity – potential dilution – but the financial statements provided all of the relevant information investors would need to determine dilutive effect.

Then why the inconsistent case results? Materiality is challenging to explain to a jury, not just because of the economics, but because it sounds like an excuse: Even if the information were withheld, the defendant must argue, reasonable investors wouldn't have really cared. But we all know that, in hindsight, almost any information sounds like something an investor would like to know.

The answer? As Albert Einstein said, simplify as much as possible, but no further. Understand the nuances of the transaction, the accounting and the economics before crafting the basic theme of the defense. Work with good experts to whom a jury can relate. And for the next wave of SEC-driven securities fraud cases, look for ways to challenge some of the government's most basic assumptions.

Lesson 4: Early on, create a team of specialized consultants and testifying experts

Experienced trial counsel knows to retain experts early, rather than wait until fact discovery has been largely completed. The experience of the stock options cases teaches that working with experts early helps in every facet of the defense, from better informed depositions of the government's key witnesses to formulating alternative case strategies and trial graphics.

Lesson 5: The credibility of the defendant often overrides everything else

Proper risk assessment requires objective consideration of the credibility of the client and key witnesses, a task easier said than done. While preparing all the technical and complex accounting and materiality defenses, it may be easy to underestimate the decisive role played by the credibility and likeability of the client and key witnesses. Humanizing a defendant who has been accused of securities fraud in this charged economic climate is a difficult task. Putting damaging e-mails in their proper context can present an almost insurmountable challenge. But the evidence often tells the story of sound business judgment and a benign explanation, rather than the self-dealing fraud the government alleges.

One of the most difficult decisions for a defendant, especially in an SEC civil enforcement action, is whether to testify or assert the Fifth Amendment. The client who asserts the Fifth before a jury often digs a hole too deep to escape, regardless of the other evidence. In the Jasper trial, for example, the SEC played for the jury over an hour of video of the defendant taking the Fifth Amendment. No matter how unfair and inflammatory the SEC's deposition questions were, the jury was left only with the image of the defendant asserting his Constitutional right to remain silent. By contrast, in Pattison the defendant took the stand and withstood a lengthy cross-examination involving the worst documents and e-mails the SEC could find. Despite the government's attempt to portray the defendant's conduct as fraudulent, he was able to respond by providing some context to e-mails that otherwise would be left unanswered.


What began as a purported scandal of alleged widespread corporate self-dealing has largely ended with a whimper: Cases tossed, limited criminal convictions, and the realization that the SEC ignored Madoff and mini-Madoff investment frauds while extracting hundreds of settlements in an area many now recognize to be of little economic import. Whether the government draws any lessons from the recent history remains to be seen. Those targeted in the next wave of SEC enforcement actions, however, will no doubt want to keep in mind the mixed results of the Great Backdating Scandal.

Patrick Richard, Partner in the San Francisco office of Nossaman LLP, is Chair of the firm's Litigation Department. James H. Vorhis is a litigation Associate in the San Francisco office of Nossaman LLP.

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