February 23, 2012 -- If backdated options affected something called “earnings,” and “investors care about earnings,” is that enough to show that backdated options were material information for investors to have—even without proof that the real earnings investors care about are the “earnings” affected by backdated options?

That’s the question former tech CEO Greg Reyes, who got out of prison at the end of last year, is taking to the Supreme Court. Last week, his lawyers, led by former solicitor general Seth Waxman, submitted their petition asking the Justices to hear his case.
 
Greg Reyes, at leftReyes was convicted of securities fraud because the company he ran, Brocade Communications Systems, gave employees backdated options—options dated “as of” a date before they were actually issued. The options enabled the recipients to buy stock at the earlier date’s lower price. But under an absurd rule called APB 25, the options were required to be accounted for as an “expense,” even though they did not require the corporation to spend money and often did not even require it to issue stock. Naturally enough, under the circumstances, there was no testimony at Reyes’s trial that any Brocade investor anywhere had ever cared about the company’s failure to follow properly the options accounting of APB 25. The important facts about options—how many had been issued and when and at what price they might be exercised—were summarized elsewhere in the company’s financial statements. Where, then, was the fraud on investors?
 
When the Ninth Circuit upheld Reyes’s conviction last October, Business Rights Center director Roger Donway responded:
 
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 investors care about earnings, which at that time were required to reflect APB 25 non-cash expenses.”
 
Well, both halves of that sentence are 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.
 
APB 25 has been replaced—with the rule Brocade followed, no less!—but Reyes’s lawyers emphasize that the issue in the case is broader than just how to account for options. A securities fraud conviction requires an “untrue statement of a material fact,” and that in turn requires “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,” according to precedents the Ninth Circuit itself quoted.
 
Yet the Ninth Circuit’s holding in the Reyes case, Waxman’s team argues, means that any technical violation of the accounting rules can be the basis for a fraud conviction, whether or not it would make a difference to the reasonable investor. All it has to do is substantially change the “earnings” reported under the rules—not the real earnings that matter to investors. By that standard, when another rule is as absurd as APB 25, and investors ignore it, failing to tell investors what they don’t want to know would be treated as fraud.
 
But an untruth that does not matter to anyone is not a fraud. And neither is a trivial violation of a useless accounting rule.

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