The Department of Justice is looking at the options issuance practices of KB Home, joining a previously-disclosed SEC formal investigation. According to a company press release (here): "KB Home’s past stock option grant practices are being investigated by the Securities and Exchange Commission. The Department of Justice is also looking into these practices but has informed KB Home that it is not a target of this investigation. KB Home has and intends to fully cooperate with any government agency looking into this matter." On November 12, 2006, the company announced (here) that long-time CEO Bruce Karatz was retiring, and he "voluntarily" agreed to repay the difference between the lower, backdated strike price and the proper price on options he had exercised. In addition, KB Home’s human resources director was fired, and its general counsel resigned. While the disclosure of a criminal investigation does not necessarily mean charges will be filed, the fact that it comes on the heels of the SEC upgrading its investigation from an informal inquiry likely means the government will be looking at a wide range of transactions, and the company’s former officers are the probable targets of the investigation. (ph)
Category: Securities
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Just in time for the end of Carnival, two Brazilians settled an SEC insider trading civil suit arising from purchases in the target of an impending tender offer. The defendants are Luiz Gonzaga Murat was the chief financial officer and investor relations director at Sadia S.A., a Sao Paulo frozen food company, and Alexandre Ponzio De Azevedo, who formerly worked for ABN AMRO’s Brazilian affiliate. Sadia planned a tender offer for Perdigão S.A., another Brazilian company, and ABN AMRO’s investment banking unit advised on the deal. According to the SEC’s Litigation Release (here):
[O]n April 7, 2006, representatives of an investment bank met with Murat and another Sadia executive to propose that Sadia make a tender offer for Perdigão. According to the complaint, Murat proceeded to purchase American Depositary Shares ("ADSs") of Perdigão both later the same day and subsequently on June 29, 2006, on the basis of material, nonpublic information concerning the proposed acquisition, and in breach of a duty of trust and confidence he owed to Sadia. The complaint alleges that Murat’s holdings totaled 45,900 ADSs of Perdigão by the time Sadia announced the tender offer. On July 17, 2006, the price of Perdigão ADSs increased to $24.50, up $4.25 (21%) from the previous closing price. According to the complaint, Murat had imputed illicit profits of $180,404 from his unlawful trading.
The Commission’s complaint against Azevedo alleges that he learned of the possible tender offer on April 11, 2006, in his capacity as an employee of ABN AMRO assigned to the tender offer financing team, and that ABN AMRO later placed Perdigão on a list of securities in which ABN AMRO employees could not trade. According to the complaint, Azevedo subsequently purchased 14,000 ADSs of Perdigão on June 20, 2006, on the basis of material, nonpublic information concerning the proposed acquisition, and in breach of a duty of trust and confidence he owed to ABN AMRO. Azevedo sold 10,500 ADSs on July 17, 2006, one day after Sadia had publicly announced its tender offer for Perdigão. According to the complaint, Azevedo realized illicit profits of $52,290 on the 10,500 ADSs he sold on July 17 and had imputed profits of $14,875 on his remaining 3,500 ADSs.
Murat agreed to pay $184,028 in disgorgement and a civil penalty of $180,404, while Azevedo will pay $68,215.45 and a civil penalty of $67,165.
An interesting aspect of the case is that neither defendant ever set foot in the United States in connection with the transaction, and none of their trading involved an American company or even any communications that passed through the U.S. The jurisdictional hook is the securities of each company, which are traded on the New York Stock Exchange as ADS. Under Section 10(b) of the Securities Exchange Act, the general antifraud prohibition applies to any person who "directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . ." The fact that the securities of the target trade on the NYSE brings the case under the Act, although it is a fair question whether conduct wholly outside the United States with only a tangential connection to this country should be subject to a civil enforcement action by the SEC. The trades were placed in Brazil, and the companies were incorporated and operated there, but the transaction ultimately occurred in New York, bringing it into the SEC’s cross-hairs. The case shows the long arm of the insider trading prohibition. (ph)
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U.S. District Judge Denny Chin reversed the securities fraud convictions of New York Stock Exchange floor broker David Finnerty, another in a series of setbacks in high-profile securities fraud prosecutions that began with a big splash and seems to be ending with a whimper. Fifteen brokers were indicted on charges alleging that they stepped in front of their customers to intercept trades at more favorable prices, leaving the clients putting in orders to pay a higher price or receive a lower one in the transaction. Called "interpositioning," it is basically front-running in which the floor broker, who is responsible for ensuring that the market trades smoothly, uses his superior position to recognize trends and trade for his firm’s own account before executing customer orders — in elementary school,, it was called "front-cuts." Judge Chin granted Finnerty’s Rule 29 motion for a judgment of acquittal, finding that the government had not proven the defendant’s conduct defrauded customers, the key to a securities fraud conviction (opinion below). Judge Chin held:
Finnerty is not arguing that evidence of customer expectations is an element of the crime that the Government must establish for a conviction under 10b-5. Rather, Finnerty is arguing that, under the facts of this case, the Government could not prove that interpositioning was deceptive without showing what the investing public expected. I agree . . . the Government was required to prove that customers expected one thing and got something different. Without evidence of what the customers expected, no rational juror could conclude that the interpositioning trades had a tendency to deceive or the power to mislead. A juror would only be able to reach that conclusion by speculating . . . .
Finding no evidence that the customers were misled, the conviction could not stand. The opinion also questions whether Finnerty even owed a fiduciary duty to customers who had no clue about the floor broker’s role in a transaction, which is usually a linchpin in a fraud prosecution based on an omission rather than a misstatment.
The government earlier dismissed a number of cases against other floor brokers, and some were acquitted after trial. Two broker were convicted of securities fraud in July 2006 after trial before a different judge, and two others entered guilty pleas. Challenges to the two convictions likely will be bolstered by Judge Chin’s decision. (ph)
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Veritas Software Corp. settled an SEC securities fraud action alleging that the company engaged in accounting fraud, including round-trip transactions with AOL to increase revenues. The company, which was acquired by Symantec Corp. in 2005, was also accused of smoothing out its earning through "cookie jar" accounts to keep up the appearance that revenue and earnings were not fluctuating, which is anathema to Wall Street. The SEC Litigation Release (here) describes the accounting problems:
- In the fourth quarter of 2000, Veritas artificially inflated reported revenues in connection with a $20 million transaction with AOL and smaller transactions with two other Internet companies. In the three round-trip transactions, Veritas agreed to "buy" online advertising in exchange for the customer’s agreement to purchase software from Veritas at inflated prices. To conceal the true nature of the AOL transaction, the company structured and documented the round-trip as if it was two separate, bona fide transactions, conducted at arm’s length and reflecting each party’s independent business purpose. In addition, the company lied to and withheld material information from its independent auditors about the AOL transaction and the other two transactions.
- AOL improperly recognized revenue on the round-trip transaction and reported materially misstated financial results to its own investors. Through its conduct, Veritas aided and abetted AOL’s fraud.
- During 2000 through 2002, Veritas engaged in three improper accounting practices to manage its earnings and artificially smooth its financial results. Specifically, Veritas improperly (a) recorded and maintained excess accrued liabilities, employing "accrual wish lists" and "cushion schedules"; (b) stopped recognizing professional service revenue it had fully delivered and earned upon reaching internal targets; and (c) inflated its deferred revenue balance. As with the round-trips, the company took concerted steps to conceal these improper practices from its independent auditors.
In addition to the usual "sin-no-more" injunction, which will have little effect because Veritas has disappeared, the company will pay a $30 million civil penalty. (ph)
- In the fourth quarter of 2000, Veritas artificially inflated reported revenues in connection with a $20 million transaction with AOL and smaller transactions with two other Internet companies. In the three round-trip transactions, Veritas agreed to "buy" online advertising in exchange for the customer’s agreement to purchase software from Veritas at inflated prices. To conceal the true nature of the AOL transaction, the company structured and documented the round-trip as if it was two separate, bona fide transactions, conducted at arm’s length and reflecting each party’s independent business purpose. In addition, the company lied to and withheld material information from its independent auditors about the AOL transaction and the other two transactions.
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A dismissed complaint in a shareholder derivative suit against Mercury Interactive related to options backdating at the company shows once again the perils of writing things in e-mails that can come back to haunt you. Mercury Interactive is now a subsidiary of Hewlett-Packard, and the California superior court dismissed the case alleging breaches of various state law fiduciary duties because the shareholders no longer have standing to pursue the derivative claim. The complaint was sealed, but somehow the Wall Street Journal obtained a copy (available here), and it details e-mail discussions of setting the options strike prices on particularly favorable dates. Even worse, one e-mail states that to accomplish their goals an officer may need to "use her magic backdating ink." (see paragraph 45 of the complaint)
What on earth would possess someone to write something so stupid? The parties to the e-mail are lower-level employees, but other e-mails involving senior officers indicate an awareness of the effect of the rising stock price on the value of options, and the eventual backdating of them to secure greater benefits to the recipients. The notion that e-mails do not "exist" seems to perdure because people continue to write the darnedest things in them — recall the "I shouldn’t have asked" e-mail from Hewlett-Packard’s chief ethics officer about pretexting. More importantly, e-mail traffic can be potent evidence of a person’s intent at the time of a transaction because it is usually contemporaneous with the conduct being investigated.
H-P announced the buy-out of Mercury Interactive in July 2006, just as the options backdating investigations kicked into high gear, and it does not appear that there is an ongoing criminal investigation of the company or its officers, at least a publicly-disclosed one. The SEC has been investigating the backdating for a while now. There may be greater involvement from the criminal side in the near future because talk about "magic backdating ink" does not bode well for those involved in the options issuance, even if the company not long exists as an independent entity. (ph)
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UPDATE: An article in The Recorder (here) notes the source of the complaint that had been under seal: "A fourth-year associate at Orrick, Herrington & Sutcliffe inadvertently disclosed a sensitive document about stock option backdating that the firm has spent the last five months fighting to keep under seal." It can’t be a good day for that lawyer, although the complaint sat in a file at the courthouse for four months and only emerged on Friday, Feb. 16. (ph)
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The general counsel of another corporation pleaded guilty to charges related to options backdating at his company. Former Monster Worldwide GC Myron F. Olesnyckyj entered a guilty plea to one count of conspiracy and one count of securities fraud in the first options-timing case brought by the U.S. Attorney’s Office for the Southern District of New York, coming fast on the heels of a prosecution by Manhattan DA Robert Morgenthau. William Sorin from Comverse Technology pleaded guilty to similar charges in the Eastern District of New York. According to a government press release (here):
OLESNYCKYJ and his co-conspirators concealed their options backdating practices from Monster’s outside auditors, BDO Siedman, LLP ("BDO"), primarily by failing to maintain a complete set of records regarding the company’s option grants and providing BDO with documents falsely identifying the dates on which options were granted by the Compensation Committee.
In substantially the foregoing manner, the coconspirators backdated every one of Monster’s broad-based annual options grants to its employees from 1997 to 2002. During the same period, the co-conspirators also backdated a number of "one-off"grants –- i.e., grants to new employees, or to current employees for the purposes of retention. In fact, new hires at Monster were promised that they would be granted options at the lowest price within the 30 days following their start date. To conceal this practice from Monster’s auditors, OLESNYCKYJ instructed an employee in Monster’s Human Resources department, by email, that "No written document should ever state lowest price over next 30 days! The auditor[s] will view that as backdating options and we’ll have a charge to earnings …" OLESNYCKYJ subsequently prepared model language to be used in all of Monster’s letters to new hires, which made no reference to granting options at low prices.
None of Monster’s backdated, in-the-money options grants were properly accounted for as a compensation expense in Monster’s public filings with the SEC. As a result, Monster’s publicly-filed financial statements for the years 1997 to 2005 understated the company’s expenses, and inflated its earnings by a total of approximately $339,000,000. In 1999 and 2000, years in which Monster reported itself as a profitable company, the company actually lost nearly $40 million.
Once again, an e-mail provides key information. Monster fired Olesnyckyj in 2006 during its internal investigation, and Andrew McKelvey, the former CEO, resigned from the board when he refused to meet with the internal investigators for an interview. The reference to "coconspirators" likely means that Olesnyckyj will be providing information about other executives, so charges against additional defendants are likely to follow. The SEC also filed civil securities fraud charges against Olesnyckyj (complaint here), a case that will most likely settle in the near future. (ph)
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Silicon Valley software company BEA Systems, Inc., announced that it is taking an accounting charge of $340 to $390 million for a number of options grants that involved backdating and other questionable employment practices to ensure recipients received favorable strike prices. According to a press release (here), the timing issues involved senior management at the company. Two major findings in the internal investigation conducted by New York law firm Simpson Thacher are:
- Most options granted between June 1997 and June 2006 were approved via Unanimous Written Consents (“UWCs”). The Company used the effective date on the UWC as the grant date, and as per the Company’s stock option plans used the closing price of the trading day immediately prior to the grant date as the exercise price for the options. During that time period, the majority of grants were not final as of the effective date stated on the face of the UWC. As a result, the grant date recorded by the Company was not the appropriate accounting measurement date, resulting in compensation expense that, in most instances, was not recorded.
- With respect to a number of grants, most made prior to 2003 when certain improvements were made to the stock option granting process, some members of senior management appear to have chosen grant dates with the benefit of hindsight and submitted those grants for approval through UWCs to be executed by the Chief Executive Officer. The UWC approving such grants reflects the chosen date of the grant rather than the date of the approval. As a result, the grant date recorded by the Company was not the appropriate accounting measurement date, resulting in compensation expense that, in most instances, was not recorded.
Unlike other companies involved in options backdating of this variety, the CEO did not lose his job, nor apparently will any other senior officers, although some will be demoted and all will have their options repriced and pay back any improper gains from an exercise. BEA Systems’ current general counsel will step down from that position, and the office "will be strengthened by providing that the position will be filled with a new executive officer who reports directly to the CEO and who also has a reporting responsibility to the Board’s Nominating and Governance Committee." It is always a welcome development when the GC’s office is not treated like an ugly step-child to be tolerated when necessary but otherwise avoided at all costs. The company’s former CFO, who was promoted to being an executive vice president in 2005, will give up that title and become a regular vice president, another apparent demotion. Whether the SEC, which is conducting an informal investigation, will push ahead with a case remains to be seen. (ph)
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Ryan Brant, the founder and former CEO of Take-Two Interactive Software Inc., which inflicted the "Grand Theft Auto" videogame on the world, entered a guilty plea and settled an SEC action related to options backdating. Brant resigned as CEO of Take-Two in October 2006, as the company’s internal investigation of its options practices reached a conclusion, and now admits to having received a large slug of options with favorable strike prices based on after-the-fact selections of the issuance date over a seven-year period. The SEC settlement calls for Brant to pay disgorgement of $4,118,093, prejudgment interest of $1,143,513, and a $1,000,000 civil penalty (see SEC Litigation Release here).
The criminal part of the case involves a new, but familiar, sheriff on the options backdating beat: Manhattan DA Robert Morgenthau. His office is well-known for its involvement in various white collar crime cases, including the recent prosecution of former Tyco CEO Dennis Kozlowski and former CFO Mark Swartz on larceny charges, In this instance, Brant pled guilty to first degree falsification of business records, and will pay an additional $1 million to the City and State of New York. While the offense, a Class E felony, is punishable by up to four year imprisonment, the plea agreement only calls for the fine, a significant benefit for Brant in avoiding jail time. According to a press release (here) issued by Morgenthau’s office:
In a seven year period, from 1997 to 2003, BRANT received ten backdated option grants for a total of approximately 2.1 million shares of Take-Two stock, all of which he exercised before resigning from the company in October 2006. For example, Take-Two’s records reflect that, on February 22, 2002, fifteen people received grants of 511,000 stock options, 100,000 of which went to BRANT. On February 22, 2002, Take-Two stock closed at $15.25 per share, the lowest price during the company’s February to April 2002 fiscal quarter. In fact, however, the decision to award many of those options was not made until mid-April 2002, when the stock price was above $20 per share. Take-Two’s business records, including purported Compensation Committee minutes, were falsified after the fact to reflect the earlier grant date.
On the "Where’s Waldo" front, it is interesting that the Southern District of New York does not appear to be involved in the case, and has yet to file criminal charges in any of the options-timing cases. If the Manhattan DA has gotten into the game, can the SDNY’s prosecutors be too far behind? (ph)
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The defendants in the first options backdating prosecution, former Brocade CEO Gregory Reyes and HR manager Stephanie Jensen, are seeking dismissal of seven of the twelve counts of the indictment because the charges are tainted by a questionable theory of honest services fraud. The defendants rely on the Fifth Circuit’s decision in United States v. Brown, 459 F.3d 509 (5th Cir. 2006), in which the court overturned the convictions of defendants in the Enron Nigerian Barge trial because the government could not establish the defendants’ intent to deprive the company of their honest services. The key quotation in Brown is:
We do not presume that it is in a corporation’s legitimate interests ever to misstate earnings–it is not. However, where an employer intentionally aligns the interests of the employee with a specified corporate goal, where the employee perceives his pursuit of that goal as mutually benefitting him and his employer, and where the employee’s conduct is consistent with that perception of the mutual interest, such conduct is beyond the reach of the honest services theory of fraud as it has hitherto been applied. Therefore, the Government must turn to other statutes, or even the wire fraud statutes absent the component of honest services to punish this character of wrongdoing.
In the Brocade prosecution, neither Reyes nor Jensen received the backdated options, and they were doled out to entice prospective employees to join the company. The use of the options as a means to attract good workers is arguably a goal "mutually benefitting [them] and [their] employer" so the backdating could be viewed as "consistent with that perception of the mutual interest." The government urged the District Court to reject Brown as controlling precedent, and asserts that the indictment is sufficient to go to trial without the court having to determine what theory will support a conviction. (Briefs available below)
The Fifth Circuit decision could turn out to be a significant problem for federal prosecutors if it spreads to other circuits. The court’s view that employees who believe their interests are aligned with the employers could make it much more difficult to prosecute honest services fraud cases when the defendant does not directly receive a pecuniary benefit from the breach of fiduciary duty. Perhaps even more troublesome for the government would be if courts applied Brown outside of private honest services fraud cases to those involving public officials. Many of those cases involve dishonest conduct but not direct financial gain to the official, and it could be difficult to pursue cases if it were a good defense that the defendant "perceived" his or her interest as being aligned with the government
The defendant filed a petition for certiorari in Brown on January 16, 2007, and the government has until mid-March to respond. It will be interesting to see if the Solicitor General seeks to have the Fifth Circuit’s honest services analysis overturned by the Supreme Court. The danger in seeking cert, of course, is that an unfavorable decision would have a broad impact on honest services fraud cases of all types. Then again, after the Court took a narrow view of the mail fraud statute in McNally v. United States, 483 U.S. 350 (1987), Congress promptly enacted Sec. 1346 to restore the right of honest services theory. The current atmosphere of curtailing corruption could work in the government’s favor. (ph)
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Federal prosecutors and the SEC filed criminal and civil insider trading charges against a father, two of his sons, and a family friend for transactions in the securities of the company where the father was an executive and later in companies retaining the accounting firms of one son and the friend. The defendants in the criminal case, who entered guilty pleas, are Zvi Rosenthal, who was a vice president of Taro Pharmaceuticals Industries, Inc., his sons Amir and Ayal, and Amir’s childhood friend, David Heyman. The SEC suit also alleges insider trading by Oren Rosenthal, Zvi’s third son, Amir’s father-in-law, and Amir’s supervisor. Ayal worked at PricewaterhouseCoopers, and Heyman worked at Ernst & Young. They admitted tipping Amir about pending mergers before the public announcement of the transactions, and Amir in turn tipped his supervisor. The SEC Litigation Release (here) describes the insider trading at Taro Pharmaceuticals:
In its complaint, the Commission alleged that Zvi Rosenthal, a Vice President at Taro, abused his position at Taro by systematically stealing material, nonpublic information concerning 13 separate company announcements, including earnings results and pending generic drug approvals by the Food and Drug Administration. Zvi then traded on the information and passed it on to his family members who then traded in Taro stock and options. Typically, Zvi provided information to his son, Amir Rosenthal who traded in personal accounts he controlled, and in the account of the family- owned and controlled hedge fund, Aragon Partners, LP.
The Commission alleged that the gains and losses avoided total $3.7 million over a period from 2001 to 2005. In addition to managing the family hedge fund — which seems to be another way of saying he managed the family’s investments — a press release issued by the U.S. Attorney’s Office for the Eastern District of New York (here) states that Amir is an attorney in New York City. According to court records, there is an attorney with the same name admitted to practice in New York in 2006 after graduating from a New York area law school. An AP story (here) states that Zvi Rosenthal has a prior fraud conviction, which means his sentence may be higher if the court applies the Federal Sentencing Guidelines’ criminal history provisions. (ph)
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