Was backdating material?

I wrote yesterday about a defense summary judgment motion in SEC v. Reyes, a civil case arising out of the Brocade alleged backdating. You can find the motion on the AEI documents page.

As noted yesterday, the motion is based on the lack of materiality: investors simply didn’t care much about non-cash options expense once the basic facts about the options were disclosed. The brief makes four basic points:

1. Brocade financial statements clearly disclosed how much Brocade’s warnings would be reduced from charging the value of the options. Indeed, the expense disclosed (a total of $1.45 billion) was higher than what the SEC says Brocade should have recognized in its income statement, and what was disclosed in the accounting restatement.

Specifically, the memorandum lists the following disclosures in Brocade’s filings:

• the number of options granted, exercised, and cancelled
• the weighted-average strike price of all outstanding, exercisable, exercised and cancelled ESOs, aggregated by fiscal year
• the weighted-average expected life of ESOs from their vesting dates
• the number of shares and strike prices of all ESOs granted to section 16(b) officers, directors, and stockholders
• the vesting schedules of all ESO granted to section 16(b) officers
• the expected volatility of the stock underlying the ESOs
• the potential dilutive impact of all ESO exercises

2. The announcement of the accounting charges resulting from alleged backdating did not have a statistically significant effect on Brocade’s share price. The company also presents a study showing no statistically significant relationship between stock option expense and share price.

3. Analysts consider ESO expenses irrelevant in valuing companies like Brocade.

4. The SEC complaint’s reliance on Brocade’s restatements is “grossly misleading” because only the smallest portion of the restatement related to alleged backdating conduct.

In general, the motion says:

The distinction must be drawn between what reasonable investors actually considered important to valuing Brocade shares in 2000-04, on the one hand, versus the public frenzy surrounding a wide array of corporate conduct which the SEC has branded collectively “backdating” in 2006-07, on the other. The latter exploits the wave of outrage with executive pilfering and self-dealing not raised by the facts of this case. Mr. Reyes was not self-enriched by the conduct alleged; he did not exercise any of the options at issue.

The memorandum supports its assertion of immateriality, among other ways, by noting:

in the one reported decision addressing a private securities fraud suit grounded on alleged improper accounting for stock-based compensation, the court dismissed the case at the pleading stage for failure to allege facts giving rise to a strong inference of scienter, as required by the Private Securities Litigation Reform Act. In re Sportsline.com Sec. Litig., 366 F. Supp. 2d 1159 (S.D. Fla. 2004).

The motion also points out that, given the above facts about the materiality of ESO expenses, Brocade’s outside auditors considered its ESO program to be “low risk” because if a company were going to engage in fraud, it would do so by manipulating actual revenues and cash expenses, not through options.

The arguments that key facts were disclosed and concerning the “public frenzy” will be familiar to readers of this blog. Indeed, the memorandum cites the summary of my arguments about backdating on the Harvard Corporate Governance Blog.

Clearly this pleading is not the last word in this litigation. But surely a fair-minded reader would come away from this document wondering what the “frenzy” about backdating – which has resulted in criminal as well as civil charges, and acres of hysterical newsprint -- was really all about.  It will be interesting to see what the SEC has to say.