Criminalizing backdating

The backdating so-called scandal triggered its first criminal charges yesterday against Brocade CEO Reyes and its former human resources VP, per the WSJ. The SEC's civil complaint also charges the former CFO with knowing of the forged paperwork but taking no action, not telling the auditors, and signing false and misleading financials.

There are questions here about what went on.  But the biggest questions are about whether it is, or should be, criminal.

The government says there was a deliberate scheme to defraud that "contributed to the restatements of hundreds of millions of dollars of Brocade's financial results." 

The defense says that Reyes didn't gain, and he "did . . . what his Board authorized him to do. During a time where competition was extremely high in Silicon Valley for employees, he awarded options to new and current employees of the company -- from the receptionist to engineers -- to attract and retain talent. Additionally, the amounts of under-reported stock option compensation expenses alleged in this case did not have any impact on the company's financials, or on the value of the stock."

So there seems to be some discrepancy about whether there was any fraud. Assume there was – what's the issue?

Well, as I said above, this is about criminalizing agency costs. By all reports, backdating was a very widespread practice, potentially affecting a significant percentage of all public companies. While some smaller firms were doing it ad hoc, other bigger ones probably had advice of big accounting firms and at least in house counsel, at least some of whom were not gaining personally from the options. For example, the WSJ's scorecard of companies under scrutiny includes, among others, Apple, Barnes & Noble, Home Depot, Intuit, Microsoft, Monster.

And the reason backdating was widespread is that it grew out of firms' need to balance important compensation objectives with problemmatic accounting rules, as discussed, e.g., here.

Are we nevertheless going to indict executives in all of these companies? And if you're going to indict the HR director at Brocade, how far down in the other companies? If the Brocade CFO knew about this and furthered the fraud, as the SEC charges, why not indict him, too, instead of just a civil complaint? Then why not all the other CFO's at all the companies in such a position.  What about all the non-executive employees who got the options and knew about the accounting/disclosure problems?

And of course it's not just backdating – it's springloading, and maybe even 9/11'ing, and who knows what other compensation practices?

Does the government need to make an example for deterrence purposes? But these companies (including Brocade) starting investigating and restating as soon as the problem was flagged. Moreover, as I pointed out recently, the problem already has been mostly solved by SOX's fast reporting provision – indeed, the virtual cessation of the practice after that provision kicked in is what indicates there was backdating instead of foreknowledge.

If the companies were inflating their earnings by not recording expenses, that's a problem. But criminalizing this business practice is not the answer. There is little doubt that the combination of regulation, civil liability and markets can solve -- indeed, probably already has solved -- any problems here. In fact, criminal charges are so patently not the answer that I suspect that one big effect of this scandal will be a reexamination of the whole issue of criminalizing agency costs.

Update: My estimable friend Steve Bainbridge responds:

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.

But from what I've seen, it wasn't theft, and this "simple" fraud was apparently engaged in by a very significant fraction of U.S. companies. I don't see how characterizing the conduct as "fraud" avoids the problems with criminalizing it that I discuss in my post.

Comments

[Steve Bainbridge]

"Everybody else is doing it" stops being a defense sometime around age 5, doesn't it? The fact that a lot of internet companies engaged in "tweaking" their recognition of revenues and expenses during the tech bubble doesn't make it any less fraudulent. If it's a material misrepresentation of fact, which in Brocade's case it sure looks like, it's fraud.

[Larry E. Ribstein]

So, should everybody who commits "fraud" go to jail? If so, why? What makes a wrong criminal, as opposed to subject only to civil redress?