That’s what happened to Greg Reyes. From 1998 to 2005, Reyes was the chief executive of a small Silicon Valley firm, Brocade Communications System, which he made very successful. Reyes followed the standard practice of using stock options to attract high-quality employees and, on the advice of various people, used “back-dating” to maximize the value of stock options to these employees. This backdating landed him in a legal mess that could have put him in prison for 30 years. The good news is that he went to prison for “only” 18 months and was fined “only” $15 million. In Rich-Hunt, philosopher Roger Donway tells the detailed story of how Reyes ended up in this position and how little the prosecutor cared about truth, let alone justice. The result is a chilling page-turner. If you don’t know much about how vague federal laws and regulations can put innocent people at risk, or if you already know but want to know more, Rich-Hunt is for you.
Backdating | Donway, who heads the Business Rights Center of the Atlas Society, makes his position clear from the outset. He sees Reyes as a hard-working, clear-thinking, entrepreneurial hero. He also sees the law that Reyes was charged with violating as pernicious and vague. But even if one thinks that Reyes was not a hero, and even if one thinks that the law was a good law, Donway gives ample evidence that the legal system badly abused an innocent man. The abuse involved prosecutorial misconduct and mischievous actions by a federal judge. Another player that comes off looking very bad is the Wall Street Journal’s news section, which hyped the backdating controversy as if it was obvious that options shouldn’t be backdated.
A little explanation is in order. The stock options at issue are “call” options. They give the holder the right to buy a stock only after the end of a “vesting period” and at a certain price, called the “strike price.” The lower the strike price, the more valuable is the option. Why use options to pay employees? As an incentive to attract good employees.
Reyes had chosen as his “consigliere” and corporate-governance expert a legendary Silicon Valley lawyer named Larry Sonsini. Donway calls that choice “the worst decision of Greg Reyes’s life.” Sonsini suggested that, to decide on the number of stock options, the strike price, etc., to offer to lower-level employees, Reyes appoint himself as a “compensation committee of one.” But Sonsini, allegedly a corporate-governance expert, did not bother to tell Reyes about the need to comply with various regulatory and accounting options, a fact that Sonsini, in a later deposition, admitted.
A big issue for anyone who awards options is what strike price to set. A method that many companies used was to backdate so as to set the lowest price that the stock had reached in the previous quarter. This made the option more valuable to the employee than if the strike price had been set at, say, the average of prices in the previous month. Reyes, as a committee of one, chose this backdating method. At no point did he get to choose the strike price for his own options.
In 2005 and 2006, the Wall Street Journal ran a series of articles on backdating, treating it as a scandal. In a May 22, 2006 article, for example, Journal reporters Charles Forelle and James Bandler wrote, “[A]n analysis by the Wall Street Journal found the probability that that pattern [choosing the date in the previous time period when the share price was at its lowest for that time period] occurred merely by chance is tiny—around one in 20 million.” Well, duh. Of course it was not random, but the news story’s unstated implication was that somehow it should have been. In a May 31, 2006 Journal article, Forelle and Bandler argued, “[B]ackdating an option grant to yield a better price vitiates the incentive purpose of the grant.” But that assumes that the main purpose of the option grant is to incentivize employees to increase the firm’s value and, thus, the price of the firm’s stock. As Donway notes, though, that is unlikely for employees “with the possible exception of the CEO.”
On July 21, 2007, Christopher Cox, the head of the Securities and Exchange Commission and a former “conservative” Republican congressman from southern California, and Kevin V. Ryan, the U.S. attorney for northern California, held a joint press conference at which they announced their pursuit of criminal charges against Greg Reyes and Stephanie Jensen, previously Brocade’s vice president of human resources. Earlier that day, the Wall Street Journal had run an article by Steve Stecklow titled, “How One Tech Company Played with Timing of Stock Options.” The “One Tech Company,” of course, was Brocade. Was it a coincidence that the article ran the same day as Cox and Ryan made their charge, or had Stecklow been tipped off? Donway, quite reasonably, thinks the latter.
In the article, Stecklow revealed Reyes’s practice of changing employees’ start dates to give their stock options more value. Reyes did do this, and the reason was to legally get around a regulation that was part of the 2002 Sarbanes-Oxley law. Stecklow did not mention that fact in his 3,000-word article.
Stecklow completed his indictment by noting two facts: (1) Reyes was a tough manager “who was known for firing questions at any employee who passed him by without making eye contact,” and (2) Reyes was very wealthy, having bought “a 12,000-acre California ranch and hunting grounds, an Alaskan fishing lodge, a stake in the San Jose Sharks hockey team, a 10,000-square-foot home in Saratoga, Calif., and more than a half-dozen cars including a Porsche and a Ferrari.” What is American capitalism coming to when capitalists ask tough questions of employees and buy expensive things? Apparently, the only honest CEOs are the ones who hug their employees and drive beat-up Toyotas.
The trial | It is hard to summarize the courtroom drama. What I can say is that Donway is a master storyteller and that pages 53–134 are well worth reading. Still, I’ll give some highlights.
The major question in the Reyes trial was not about backdating options or giving artificial start dates to employees, because neither of those practices was illegal. The question was whether Reyes had committed fraud in accounting for the cost of the stock options. The more “in the money” the options were, the bigger the cost to Brocade’s shareholders. You might think that if the shareholders had been hurt, the prosecution would have come up with a shareholder who said he was hurt. It didn’t. Moreover, it was the prosecution, not the defense, that excluded a Brocade shareholder from the jury.
Unfortunately for Reyes, the presiding federal judge was Charles Breyer. Although Donway doesn’t mention this and possibly doesn’t know, Breyer had achieved some notoriety in 2003 by presiding over the trial of another entrepreneur, Ed Rosenthal, for growing marijuana. During that trial, Breyer had forbidden Rosenthal’s lawyers from pointing out that Rosenthal was acting as an agent for the Oakland, Calif., city government’s medical marijuana program. After Rosenthal was found guilty, some jurors expressed outrage when they learned that fact. On the surface, it looks as if Breyer was a good guy for having sentenced Rosenthal to time already served, but those of us who followed the case are not so sure. Before the sentencing, some of Breyer’s neighbors had verbally attacked him and his family members. There is some reason to think, therefore, that the light sentence was due more to pressure from neighbors than from any humanitarian leaning.
Sure enough, Breyer inserted himself into the Reyes trial in a fairly aggressive way. A witness for the prosecution had argued that the way Reyes accounted for stock options negatively affects the market’s valuation of the stock. According to Donway, the trial transcript shows that Breyer, without a single objection having been raised by the prosecution, blocked the defense’s cross-examination of this witness nine times in just 14 pages. Moreover, during the closing arguments, prosecution lawyer Timothy Crudo lied about a key issue. When defense lawyer Richard Marmaro moved on that basis for a mistrial, Breyer’s flaccid remedy was to tell the jury that closing statements are only arguments, not evidence, and that the attorneys’ “comments may have been in error.” Shockingly, though, Breyer did not tell the jury whether he had in mind the attorneys for the defense or the attorney for the prosecution.
Fortunately, a three-judge panel of the Ninth Circuit Court threw out the conviction based, in part, on the prosecutorial misconduct noted above. Unfortunately, Donway never tells that to the reader explicitly, but leaves us to figure it out. More unfortunately, the Ninth Circuit left it up to the prosecution to decide whether to have a retrial, and the prosecution, upset at being tongue-lashed by the Circuit Court, chose a retrial. Reyes, tried once again in front of Breyer, was convicted. He has now served his sentence.
Conclusion | One moral I took away from this book is that we should avoid vague laws that put people at risk of long prison sentences for what are, at most, accounting errors. The other big moral is that more books like this need to be written. Over a century ago, when Emile Zola wrote his open letter “J’ Accuse,” French society was much less wealthy than ours is. Contributors now donate at least hundreds of millions of dollars annually to think tanks that argue for freedom. But Roger Donway is the only author I know who has taken a specific judicial outrage against a businessman, examined it carefully, and told the story compellingly. There should be 10 more such books. If donors were to give a few tens of thousands of dollars to each qualified person who researches and writes such books, the world would be a better place and free markets would have a better chance.
