At issue was the fact that, during part of the time Greg Reyes was CEO of Brocade Communications Systems, the company’s financial reports failed to follow an SEC rule (called APB 25) regarding the treatment of options used to compensate employees. As I have explained here , the rule was so economically absurd in the way that it valued options, and was so universally recognized to be absurd, that it was ignored by many companies—in fact, by 30 percent of all publicly traded companies in the United States. Even the SEC recognized how absurd the rule was and required companies to put footnotes into their financial statements that offered a somewhat more reasonable calculation of what their compensation options entailed for their company’s financial health. That SEC footnote requirement was called FAS 123, and it meant that if anybody was truly concerned about the implications of a company’s options programs then he had all the information he needed on which to base his investments.
So one might think that the government would have responded to the media-generated frenzy over backdated options merely by telling Brocade (and the thousands of other companies who avoided using APB 25) that they had to restate their financial reports in a manner that followed the SEC’s absurd APB 25 rule. Then the rules would have been followed, and nobody would have cared. As Daniel Warmenhoven, the (non-backdating) CEO of storage gear maker Network Appliance from 1994 to 2009, explained during an interview with BusinessWeek: The reason that so many companies had ignored APB 25 was precisely because investors did not care about it. “What difference did it make?” he asked reporter Peter Burrow, regarding the nonuse of APB 25 accounting. “It was going to be removed from the pro forma reports anyway, and that’s all the investment community cares about.” (Pro forma reports are corporate financial statements with unusual and nonrecurring items excluded.)
The Scapegoating of Greg Reyes
Unfortunately, an SEC requirement that businesses reformulate their past financial statements in a manner that no one cared about was not to be the whole of backdated-option frenzy. Nor could it have been: The anti-business journalistic-legal-political complex demanded a full-blown business scandal and that meant a certain number of scapegoated businessmen had to be sent to prison in order to certify the seriousness of the violation in question.
Such was the role of Greg Reyes. The witch-hunters needed to take Brocade’s avoidance of the absurd APB 25 rule and transmogrify it into a vicious fraud perpetrated by a greedy Reyes.
The Justice Department’s attempt to perform that metamorphosis ran as follows: Investors who buy and sell stock are interested in a company’s earnings; following APB 25 would have produced lower earnings for Brocade; therefore, Brocade executives responsible for the company’s failure to follow APB were trying to deceive investors into thinking the company had higher earnings than it did. Greg Reyes held stock in his own company and thus profited from a higher stock price.
But obviously the prosecutors who put Greg Reyes on trial had to persuade jurors not to notice one egregious flaw in their theory. Even if company financial statements failed to follow APB 25 correctly, those same financial statements (because of FAS 123) contained all the information about option grants that were needed for an investor to assess the company’s condition. How then could an investor who was reading the company’s financial statements, and was interested in the company’s use of options, claim to have been significantly misled by the incorrect statement of APB 25 calculations?
This paradox became painfully apparent during the Reyes prosecution, for the government had advertised nationwide in order to find some investor somewhere who would testify that Brocade’s false APB statements had actually misled him as regards the firm’s condition. What they came up with was pitiful.
The prosecutors got one investor, Kevin T. Kilgannon, to say that the accuracy of the information Brocade generated by the absurd rule was important to him. But when defense attorneys showed him the availability of FAS 123 information regarding option grants, he admitted: “I don’t use 10-Ks for my research.” What he did use were various financial newsletters and services. And what information did they use: “Um, they show growth—I’m not sure exactly.” The other investor, David Mark Ryan, was a technical investor who followed only a stock’s trail in the market and not the company’s financials at all. Whenever prosecutors tried to get him to talk about the numbers generated by APB 25, he rebuffed them: “I do not break down fundamentals,” he said. Those two were the most plausible investors that the prosecution could come up with after its nationwide search.
The Ninth Circuit’s Irrationality
Despite this pathetic testimony, Reyes was found guilty and the Ninth Circuit panel has just upheld the verdict, declaring that the prosecution did show that investors considered the numbers generated by APB 25 to be important. This was the circuit court’s argument: “While the Brocade investors’ testimony is not specific to APB 25 non-cash expenses, it is sufficient to help establish materiality in this case because inventors care about earnings, which at that time were required to reflect APB 25 non-cash expenses.”
Well, both halves of that sentence a
re true, but when they are combined they constitute a fallacy. Yes, investors care about earnings, and, yes, at that time the SEC required that APB 25 non-cash expenses be deducted from earnings. But that does not mean investors were interested in the sorts of earnings
defined by APB 25. As Daniel Warmenhoven said: They were actually interested in the sort of earnings defined by ignoring APB 25!
To see the Ninth Circuit’s fallacy, it might help to consider an analogy. Suppose an adult child lives at his parent’s home rent-free and wants to save some money. He draws up his budget in order to figure out how much he can earn over and above expenses. Now, suppose someone declares that his budget must “expense” his rent as a “noncash” cost equal to what he would pay in the market. Suddenly, his net earnings drop. Does he care about his net earnings? Absolutely. But just because some absurd rule says he must “expense” a rent that is not really an expense does not mean that he cares about his net earnings with that “rent” deducted. Investors held the same view of corporate “earnings” when APB 25’s rule required that noncash expenditures for options be deducted from them. Yes, they cared about “earnings.” No, they did not care about “earnings” as defined by APB 25’s absurdity.
Not the End
In a couple of months, Greg Reyes will be released from prison. Effectively, his judicial options came to an end with the unanimous decision of the Ninth Circuit panel. But at the Business Rights Center, this is only the end of the beginning for his case. I am finishing up a lengthy monograph on the whole backdated-options frenzy, with the Greg Reyes case as its particular focus. By the beginning of next year, the BRC will be seeking a reversal of the Greg Reyes verdict—in the court of public opinion.