UIUC law professor and blogger Larry Ribstein has been one of the leaders in pointing out the extent to which the US legal system has far too often invoked the criminal law to deal with routine corporate governance problems. Indeed, I believe Larry was the one who coined the apt phrase "criminalizing agency costs."
In general, I'm on Larry's side on this issue, for reasons I explained in this TCS column. In addition, as I argued in another TCS column, the only real problem with the current media scandal over backdating options is lack of disclosure.
Having said all that, however, I don't agree with Larry's analysis of the criminal indictments at Brocade.
Here's what the SEC alleges happened at Brocade:
According to the criminal complaint and the Commission’s civil complaint, Reyes, 43, of Saratoga, Calif., and Jensen, 48, of Los Altos, Calif., regularly caused Brocade to grant “in-the-money” options (i.e., the exercise price is below the stock’s market price on the day of grant, giving the recipient an immediate paper gain) to both new and current employees between 2000 and 2004, but backdated documents to make it appear that the options were “at-the-money” (i.e., the exercise price is the same as the stock’s market price on the day of the grant) when granted, thus concealing millions of dollars in expenses from investors. Under well-settled accounting principles applicable at the time, options granted “at-the-money” did not need to be expensed. In contrast, options granted “in-the-money” needed to be recorded as a compensation expense.
Unlike what happened at Tyco (yet another TCS column), this isn't a case in which the government turned a simple related party transaction into a criminal case. Nor is this a case in which the government indicted an entire company for the wrongdoing of a few managers.
The indictment in this case narrowly focused on two Brocade managers - Gregory L. Reyes, the former CEO, and Stephanie Jensen, the former Vice President of Human Resources - whose conduct resulted in Brocade making corporate disclosures that apparently contained extensive material misrepresentations over a period of several years, requiring "restatements of hundreds of millions of dollars of Brocade’s financial results." The indictment also alleges "that these defendants altered and backdated Board of Director meeting minutes and employment offer letters in a scheme to defraud in connection with the pricing and granting of stock options."
In my TCS column on the Tyco case, I concluded that "shareholders deserve protection from theft, but not from risk taking, even when the risk in question is how much to pay an executive." The Brocade case looks like the former to me. It's a simple case of fraud and unless you think we shouldn't use the criminal law to punish fraud, it's hard to see why these indictments are a problem.
