End of the Options Backdating Era

Before the clamor about the lack of prosecutions from the financial crisis and the current crackdown on insider trading, the practice of backdating stock options came to light seven years ago and prompted a flurry of prosecutions. The practice is now long forgotten, but it looks as if the last of those cases has finally concluded, and as the Grateful Dead put it so well, “What a long, strange trip it’s been.”

Last week, the former chief executive of Vitesse Semiconductor, Louis Tomasetta, and its former chief financial officer, Eugene Hovanec, pleaded guilty to conspiracy to obstruct an investigation into the company’s options awards to cover up that they had been backdated. This came after two trials in which jurors could not reach a verdict on charges of conspiracy to commit securities fraud related to the backdating and inflation of the company’s revenue.

For those whose memories have faded, options backdating became known publicly in March 2006 when a Wall Street Journal article questioned whether executives selected an earlier date for the price at which options could be exercised, effectively giving them a lower price and making them more valuable. At the UnitedHealth Group, one of the companies mentioned in the article, its former chief executive paid a $468 million civil penalty and restitution to the company for mispriced options.

A number of companies â€" particularly those in the technology industry, which gave out stock options like candy on Halloween â€" began internal investigations into their awards. Because publicly traded corporations must properly report the value of options on their financial statements, any backdating could result in a misstatement that can be the basis for a charge of securities fraud.

The prevalence of options backdating led to a near feeding frenzy among different United States attorney’s offices throughout the country who were fighting for cases. Charges were eventually filed in a number of different jurisdictions against executives responsible for approving the practices, usually accompanied by a parallel civil enforcement action by the Securities and Exchange Commission. But a few tied in with backdating were never accused of wrongdoing, like Steven P. Jobs at Apple.

The United States attorney in San Francisco went so far as to set up a “Stock Options Task Force” to look at Silicon Valley companies. That office obtained the most notable conviction from this era involving the former Brocade Communications chief executive, Gregory Reyes. But even that was not an easy case. The conviction after his first trial was reversed on appeal.

Not to be left behind, the Southern District of New York in Manhattan, which frequently pursues prominent securities cases, brought the charges against Dr. Tomasetta and Mr. Hovanec in December 2010.

One significant problem that prosecutors in New York faced was that Vitesse Semiconductor is based in Southern California, and almost no conduct related to the charges took place in New York. After the first trial ended in April 2012, Paul A. Crotty, a judge for the Federal District Court for the Southern District of New York, dismissed six of the seven charges in the case because no part of the securities fraud took place in the district, so venue was improper there.

The guilty plea Dr. Tomasetta and Mr. Hovanec entered does not involve actual options backdating but instead their efforts to create a paper trail at the company to make it appear that the options were properly backdated. And the information lists the location of the crime as “the Central District of California and elsewhere,” showing that Manhattan may not have been the best place to pursue the case.

Compared to the Justice Department’s recent run of successes in insider trading cases, the options backdating prosecutions were a mixed bag in singling out senior corporate executives. The cases show that prosecutors can be susceptible to jumping on a bandwagon when it appears that corporate misconduct took place.

Among the chief executives convicted, in addition to Mr. Reyes, were James Treacy of Monster Worldwide and Bruce Karatz of KB Home. Mr. Treacy received a two-year prison term, and Mr. Karatz was sentenced to eight months of home confinement after the district judge rejected the government’s request for more than six years imprisonment. And much like the Vitesse Semiconductor executives, Mr. Karatz was convicted only on charges related to covering up the transactions. He was acquitted on 16 counts related to the actual backdating.

Other cases were more problematic for the Justice Department. The prosecution of former Broadcom executives collapsed, and the case was dismissed after charges of prosecutorial misconduct by an assistant United States attorney. A jury acquitted the former general counsel at McAffe, after which the S.E.C. dropped its parallel case.

In a civil enforcement action against a director of Engineered Support Systems, a district judge dismissed the S.E.C.’s case without requiring the defense to offer any evidence, noting that the government’s own experts did not agree as to what was required for the issuing of stock options.

The guilty pleas by Dr. Tomasetta and Mr. Hovanec are perhaps a fitting close to the options backdating era, admitting to the cover-up in exchange for a government recommendation that they receive probation for the violations. It was a practice that seemed to fit the old kindergarten excuse that “everyone else was doing it, so I didn’t really think it was wrong.”

The conduct usually had a minimal effect on shareholders, centering mainly on disclosure about an obscure part of a company’s financial statements. And the trials showed how difficult it was to prosecute senior executives for corporate misconduct that involves arcane accounting issues.

As we say goodbye to the options backdating cases, you can almost hear those final words of the Grateful Dead â€" it’s time to “get back truckin’ home.”