A key question in the great brouhaha over backdating—dating stock option grants on days when the stock was at a historic low rather than the date they were actually granted—has always been whether or not it matters to shareholders. Was backdating a trivial accounting matter that potentially increased compensation for those receiving the backdated options but had no serious effect on a company’s bottom line? Or did it represent something more serious that investors should have known about?
On Friday, a federal judge overseeing the trial of a former executive accused of fraud stemming from backdating declared that backdating was “material” to investors. But the way he arrived at this result has some legal scholars scratching their heads.
[We get scratchy after the jump]
Lawyers for Greg Reyes, the former chief executive of Brocade, had argued that the charges should be dismissed on the grounds that the backdating at Brocade wasn’t material. Two days after the company was restated its financial results to correct the grant dates and acknowledge the backdating, the stock price remained unchanged, lawyers for Reyes argued according to Law.com. The defense lawyers said that this indicated that backdating was not material to investors.
The government responded by indicating that the stock had dipped both on the day Brocade’s financials were restated and the day two weeks earlier when the company announced it planned to restate its financials due to backdating. But both these dips might have resulted from investor fears about what measures the Securities and Exchange Commission or the Department of Justice might take against Brocade and its executives. In other words, the share price may have fallen because of investor fears of backdating fines and prosecution rather than investor reactions to the backdating itself. But perhaps the best explanation to the fall and rise of Brocade’s share price is even simpler: investors initially over-estimated the seriousness of the backdating, causing the price to fall. After investors had time to examine what had happened, they corrected the error, pushing the price back up.
But judge Charles Breyer seemed to reject the market test for materiality altogether. Instead, he asked: “If this is so irrelevant, why was there all this backdating going on?” In short, the ubiquity of backdating—one scholar has recently estimated that 29% of companies backdated stock options grants—is proof of its materiality, according to judge Breyer.
“This seems to be an odd test for materiality,” Christine Hurt at the Conglomerate blog wrote in response. “Supposedly, we would want companies to disclose material things because we think that facts that rise to that level would be important to shareholders in making decisions as to whether to buy, hold or sell securities. Once we know that something doesn't seem to be a factor in those decisions, can it still be considered material?”
Investors have demonstrated an indifference to backdating at companies besides Brocade. Last week, the entire board of directors of Apple was re-elected by shareholders despite a recommendation by a proxy advisory firm that shareholders reject the director candidates for “lack of candor” in connection with backdated stock options grants at the company. Shares of Apple have climbed in recent months despite Apple admitting that its popular chief executive, Steve Jobs, participated in stock options backdating.
[Greg Reyes is represented by Skadden, Arps, Slate, Meagher & Flom, where DealBreaker's editor in chief, John Carney, worked for several years.]
Judge Rejects Dismissal of SEC's Brocade Backdating Charges [Law.com]