With all of the media attention focused on the first options backdating criminal complaint, filed July 20, 2006 against two former officials of Brocade Communications Systems, and with published reports suggesting (for example in the July 21, 2006 front page article of the Wall Street Journal , subscription required) that prosecutors are investigating “over 80 companies” for options timing manipulations, it would be easy to conclude that the tide of federal white collar criminal prosecutions is mounting. And indeed with the options backdating story just beginning, it may well be that we are at the leading edge of a growing prosecutorial crackdown on corporate fraud.

But a July 18, 2006 Legal Times article entitled “Has the Wave of White-Collar Prosecutions Crested?” raises the question whether the crackdown on corporate criminals is in fact on the decline as a result of changing prosecutorial priorities. Citing the United States’ Attorneys’ Annual Statstical Report for Fiscal 2005, which can be found here, the article notes that “there was a 30 percent drop in the number of defendants charged with corporate fraud in 2005 over the previous year and a more than 50 percent decline in the number of corporate fraud investigations opened by federal prosecutors last year.” The 2005 figures were the lowest for any year since the 2002 post-Enron crackdown on corporate crime. The Legal Times article quotes a number of sources for the proposition that the decline in new prosecutions is due to a continued shift in resources toward terrorism investigation and public corruption. However, factors such as the options backdating scandal may yet relieve what could prove to be an otherwise temporary stall.

A Closer Look at the First Options Backdating Criminal Case: Wayne State University Law School Professor Peter Henning in a thoughtful July 21, 2006 post on his White Collar Crime Prof blog raises some interesting questions about the criminal complaint filed against the former Brocade Communications officials. First, he questions why the prosecutors chose to “proceed by criminal complaint rather than seeking a grand jury indictment,” and speculates that there may be plea agreements or statute of limitations concerns that motivated prosecutors to use a criminal complaint, but that there could be “an indictment in the next few weeks that may well contain more charges, perhaps including books-and-records accounting.” Professor Henning also raises questions about the merits of the criminal complaint:

While the charges allege numerous instances of options grants involving backdated documents, it remains unclear what constitutes the securities fraud….[I]t is not clear what constituted the fraudulent scheme when the employees received the proper amount of options while their additional paper gains were not “taken” from the company. To the extent that fraud is a type of larceny, it is not easy to see the company as a victim of the deception, and [defendant] Reyes did not gain from the transactions, at least not directly. Not all lies are frauds, and the government’s case may be a difficult one, at least on a securities fraud charge.

The D & O Diary notes that while the SEC filed a parallel civil complaint against three former Brocade Communications executives, thus far other Brocade officials, including Brocade’s outside directors, have not been named. The non-involvement of Brocade’s outside directors stands by interesting contrast to the Mercury Interactive investigation, where three former outside directors of Mercury have been served with “Wells” notices. As has been noted on prior this D &O Diary post, Brocade’s former outside directors include Larry Sonsini, of the Wilson Sonsini Goodrich & Rosati law firm and one of the most prominent lawyers in Silicon Valley. The WSJ.com law blog has an interesting post discussing the fact that Wilson Sonsini has represented over half of the more than 30 Silicon Valley companies that have been named in connection with the options backdating investigation. A July 22, 2006 New York Times article discussing the significance of options backdating in Silicon Valley during the dot-com boom and afterwards, and the role of the Wilson Sonsini firm, can be found here. A cool feature of the Times article is an interactive map showing the geographic location of Silicon Valley firms involved in the options backdating investigation.

Finally, The D & O Diary notes that the Brocade Communications options timing scandal presents an example of hiring-related options timing, which as discussed on this prior D & O Diary post, involves important differences from options backdating and options springloading. The most important difference that is that hiring-related options timing may not involve self-dealing or personal enrichment. According to this WSJ.com law blog post, the absence of self-dealing or personal benefit is precisely the basis on which the defense attorney for Gregory Reyes, Brocade’s former CEO, is raising in Mr. Reyes’ criminal defense.

More Statistical Analysis of Options Backdating: Graef Crystal has an interesting July 20, 2006 article on Bloomberg.com analyzing opportunistic option timing. Crystal looked 16,211 options grants made to chief executive officers between 1992 and 2005. He analyzed the actual and expected option exercise prices compared to the share prices in the 180-days before and after the date of the awards. The expectation would be that the exercise price would fall at the mid point of the price range. But instead the exercise price was consistently lower than the share price following the award. Interestingly, Crystal’s analysis shows that the statistically unexpected rise in share price after the award has continued even after the enactment of the Sarbanes Oxley Act. (Crystal estimates the probability of this outcome as a result of chance as “way less than 1-in-100 trillion.”) His analysis suggests even after Sarbanes Oxley made it more difficult for CEOs to backdate options, they have continued to springload options grants.

Not Your Average Blogger: Attentive readers may have noticed that I have added my photograph to this blog. I am feeling defensive about my blogger identity as a result of Pew Internet & American Life Project survey of bloggers, which may be found here and is discussed in this July 20, 2006 Washington Post (registration required) article. According one source quoted in the Post article, “the average blogger is a 14-year old girl writing about her cat.” My newly added picture is your assurance that I am, let us say, well over 14 years old and that posts about my cats (I have two of them, actually) will never appear on this blog. Disappointed cat lovers are directed here.