Backdating Scandal Ends With a Whimper - Bernard L. Madoff

Before Lehman Brothers imploded, before Bernard L. Madoff’s arrest and before the global economy’s near-collapse, there was the backdating of stock options.

On Wednesday, a federal judge in Los Angeles sentenced Bruce E. Karatz, the former chief executive of KB Home, to five years of probation. His case is likely to be the last criminal trial relating to backdating, a scandal that ensnared dozens of executives over allegations that the dates of stock-option awards had been manipulated to enrich recipients.

When the first cases emerged in 2006, they looked like low-hanging fruit for federal prosecutors. The Securities and Exchange Commission and the Justice Department investigated more than 100 companies. Internal investigations by companies led to scores of financial restatements and dozens of executive dismissals.

But on the criminal front, the government had mixed results, winning several trials but also losing a number of prominent cases. In all, 12 executives across the country were received criminal sentences, five of them prison terms. The others were sentenced to probation.

“These prosecutions went out with a whimper rather than a bang,” said Christopher J. Clark, a criminal defense lawyer at Dewey LeBoeuf who has done work on backdating cases. “With few convictions and no substantial sentences, juries and the courts simply did not agree with the government’s position that stock option backdating represented a serious financial crime.”

That was not the view of several judges. Judge Jed S. Rakoff of Federal District Court in Lower Manhattan gave the longest prison term to an executive charged with conduct related to backdating. In September 2009 he sentenced James J. Treacy, the former chief operating officer of Monster Worldwide, to two years in prison for improperly accounting for backdated stock options.

“I don’t have any doubt the jury’s verdict was correct,” Judge Rakoff said at sentencing. “It is appalling; it is disgusting that this practice went on.”

Mr. Treacy’s conviction is on appeal.

The backdating scandal was set off in 2005 after Erik Lie, a finance professor at the University of Iowa, published a study that showed an uncanny number of cases where companies granted stock options to executives right before a sharp increase in their stocks. The S.E.C. and The Wall Street Journal then began to look at individual companies.

“I never expected my study would lead to anything,” Professor Lie said. “At the time we published the paper, it wasn’t clear that regulators would view the activity as illegal.”

That was a major challenge for prosecutors in these cases: The practice, which involved complex accounting, disclosure and tax issues, was not necessarily illegal. It was not the backdating that was against the law, but the improper accounting of it that was illegal.

In a number of cases, convictions came not from the crime but the cover-up as the government charged several executives with lying to federal agents. That happened with Mr. Karatz, who was convicted not of backdating but of lying about the practice.

The backdating scandal has created a fugitive — Jacob Alexander, known as Kobi, the former chief executive of Comverse Technology, who fled to Namibia under suspicion of conspiracy, securities fraud and other offenses.

On the civil side, the S.E.C. filed about 50 cases. The largest one involved Dr. William W. McGuire, the former chief executive of the UnitedHealth Group, who paid $468 million in civil fines and restitution to the company.

Irrespective of whether stock-options backdating resulted in penalties, the practice turned out to be relatively common. About 150 companies issued restatements because of allegations of backdating stock options, a list that included Apple and Cablevision. In a study published last year, Professor Lie and a colleague concluded that about 29 percent of American businesses, more than 2,000 companies, that made stock-option grants to executives from 1996 through 2005 had manipulated them.

Critics of backdating prosecutions argued that the small number of criminal prosecutions resulting from the practice, given how widespread it was, exemplified the arbitrariness of prosecutions for alleged business crimes.

“The corporate crime lottery was never cranked up more than it was in the backdating cases,” said Larry E. Ribstein, a law professor at the University of Illinois. “Concern about justice becomes most intense when you’re talking about criminal violations, and you don’t really don’t want randomness.”

Some of the cases also were hurt by missteps by prosecutors. The case against Henry T. Nicholas III, the co-chief executive of the Broadcom Corporation, one of the highest-profile backdating trials, fell apart after the judge found evidence of prosecutorial misconduct.

On Wednesday, Judge Otis D. Wright II criticized prosecutors in Mr. Karatz’s case. He sentenced Mr. Karatz to five years probation, rejecting the government’s request to send him to prison for six and a half years.

Judge Wright called the government’s sentencing memorandum “mean-spirited and beneath this office” for suggesting that sentencing Mr. Karatz to home detention in his “24-room Bel Air mansion” would suggest “a two-tiered criminal justice system, one for the affluent … and a second for ordinary citizens.”

“To invite public ridicule and scorn on this institution, I think, is unspeakable,” the judge said.

He said he “lost a lot of sleep over the right thing to do,” but in sentencing Mr. Karatz to probation he noted the lack of evidence that his crime had damaged KB Home and its shareholders.

By Peter Lattman


source:
http://dealbook.nytimes.com/2010/11/11/backdating-scandal-ends-with-a-whimper/

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