To recall the facts of the case: During part of the time when Greg Reyes was CEO of Brocade, the company’s SEC filings failed to follow a commission rule in accounting for options issued to employees. (The rule is known as APB 25, and I have explained elsewhere why it is utterly absurd .) But Reyes was not charged merely with violating the SEC’s technical accounting and bookkeeping regulations. He was prosecuted for committing a criminal fraud. The prosecutors’ argument was that Reyes had purposely violated the APB 25 accounting regulation in order to avoid treating employee stock options as an expense, thereby inflating Brocade’s apparent earnings and deceiving investors about the worth of the company’s stock, which of course he held.
In the oral arguments, the main point made by Reyes’s lawyer, Seth Waxman, went to the very heart of the whole back-dated options scandal: Backdating, and the failure follow APB 25, was nothing but a records and bookkeeping flap. It was not, and could not have been, the criminal fraud that journalists and prosecutors have tried to depict. The reason that it could not have been fraud is simple: The companies that violated the SEC’s rule APB 25 when accounting for options were simultaneously accounting for those options in a second way, in the very same reports. And this second method of accounting for options (known as FAS 123) provided all the information that was supposedly being hidden from investors by the violations of APB 25. The prosecution in the Reyes case did not—because it could not—put on the stand a single investor who claimed that his decision to buy or sell or hold Brocade stock had been influenced by the figures that resulted from failing to follow APB 25.
Instead, the prosecution put four people on the stand. Two of them—Robert McCormick and Carol Bowie—advised mutual fund companies on how to vote their proxies, and specifically what sorts of option plans they should or should not approve. Of course, it is notorious that these “proxy advisors” often have “good governance” notions that vary drastically from the concerns of genuine investors. In fact, I cannot help mentioning—although it did not come out at trial—that McCormick’s current firm of Glass, Lewis is not named for two founding fathers—Mr. Glass and Mr. Lewis. No, it is an inside joke that the firm was named
for two of furthest left figures in the legal pantheon: William O. Douglas
Brandeis. Employees from Glass, Lewis have frequently been quoted by left-wing journalists who want to push “corporate social responsibility” over profitability.
The prosecution offered zero evidence that any actual investor was ever deceived about the state of Brocade—or could have been deceived about the state of Brocade—in a way that might have prompted him to make an investment decision he would not otherwise have made.
But the prosecution did call two actual investors. One was Kevin T. Kilgannon, a retired New York City firefighter who had invested in Brocade. The prosecuting attorney got Kilgannon to say that the so-called “losses” Brocade would have indicated in its financial reports had it used APB 25 accounting would have been important to his decision to buy and sell Brocade. But when a defense lawyer showed Kilgannon the FAS 123 information available in Brocade’s financial statements, he admitted: “I don’t use 10-Ks for my research.” Instead, he relied on subscriptions to financial newspapers and stock research services. And what sorts of information do his newspapers and research services rely on: “Uhm, they show growth—I’m not sure exactly. I know the charts—there’s—there’s a lot of criteria on there.”
Lastly, the prosecution called David Mark Ryan, a technical investor. Reading his testimony, one has to think: “If this is the best the prosecution can do, after advertising nationally for a suitable witness, then its case is hopeless.” Whenever the prosecuting attorney tried to get Ryan to say that he relied on a proper use of APB 25 accounting to show the “true earnings” of Brocade, Ryan rebuffed him. “When I analyze a company, again, it’s based largely on part of how the stock is acting in the marketplace [sic]. I do not break down fundamentals, where I’m getting into every single earnings per share, sales. If I get that deep into a company, I can get lost.” Prosecutors did get Ryan to say he relied on the “accuracy” of financial reports—in the sense that he relied on the market to make an accurate assessment of each stock. But obviously he could not testify as to whether FAS 123 reporting alone allowed or did not allow the market to make an accurate assessment of Brocade, even if its APB 25 reporting was inaccurate. Because Ryan did not think about such matters, he was simply not in a position to say what financial reporting was or was not required for him to make a sound investment decision.
In sum, then, the prosecution offered zero evidence that any actual investor was ever deceived about the state of Brocade—or could have been deceived about the state of Brocade—in a way that might have prompted him to make an investment decision he would not otherwise have made. As Waxman stated in his brief, and reiterated in oral argument, the standard is this:
The prosecution had to prove beyond a reasonable doubt that including APB 25 non-cash “expenses” in Brocade’s financial statements, in addition to the information already provided about stock options, would have made a material difference to investors. Information is “material” if “a reasonable investor would find it significant in deciding whether to buy, sell, or hold a security.” Materiality is assessed with respect to a particular investment decision—here, buying or selling Brocade stock. Moreover, the assessment considers all the information available to the investor. Information is “material” only if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Ultimately, the prosecution must show that “a reasonable investor would have acted differently if [a] misrepresentation [or omission] had not been made." [Citations omitted. Editorial brackets in the original]
Against this, the government’s attorney could say only that the information must have been material because the SEC had required Brocade to restate its earning. But of course that proves nothing except that there had been a misstatement according to an absurd bookkeeping and accounting rule. And that everyone agrees upon. The question is whether the misstatement could have misled a reasonable investor, given all the other and far more revealing information provided in Brocade’s financial documents.
To me, it seems clear that the government provided zero evidence that the failure to follow APB 25 accounting could possibly have deceived a reasonable investor, and thus I think that the jury was wrong as a matter of law to find Reyes guilty. But we shall see what the Ninth Circuit panel has to say. Its composition was not promising for Reyes. More on that later.
> Oral Arguments in the Greg Reyes Case
> Atlas Faces Prison
> Retrieving the Wounded
> The Scandal of the Options Prosecutions
> Truth, Hype, Hustle, and Fraud
> The Malum Insanum that Created Backdated Options
> Let's Jail Prosecutors who Obstruct Justice