Option Backdating: A Flawed SEC Complaint Raises Questions About the Enforcement Program And Its Direction

Last week, the court granted in part a motion to dismiss portions of the claims brought against Lisa Berry, former General Counsel of Juniper Networks, Inc. and KLA-Tencor. The motion was based on the statute of limitations and the failure to plead fraud with particularity as required by Federal Civil Rule 9(b). SEC v. Berry, Civil Action No. C-07-04431 slip op. (N.D. Cal. May 7, 2008).

The Commission filed a complaint against Ms. Berry based on option backdating claims for the time period 1997-2002. That complaint alleged that Ms. Berry routinely used hindsight to identify dates with historically low stock prices, facilitating the backdating of option grants by KLA’s stock option committee. After moving to Juniper, Ms. Berry established a similar backdating process at that company, creating minutes of fictitious stock option committee meetings to document false grant dates. This resulted in materially false disclosures and overstated net income at KLA and Juniper. The complaint alleges violations of Sections 10(b) and 17(a), as well as the books and records and proxy provisions. It seeks a permanent injunction, disgorgement of ill-gotten gains, monetary penalties and an officer director bar.

Ms. Berry’s motion to dismiss was granted in part and denied in part. First, Ms. Berry sought dismissal based on the statute of limitations. In this regard, the Court noted that under 28 U.S.C. § 2462, there is a five year statute limitations. This applies to any relief that is a penalty but not to the equitable relief. The request for a penalty is barred. In contrast, a request for disgorgement is not a penalty. Since the SEC argues that the statute is subject to equitable tolling, the court granted an opportunity to amend the complaint.

Second, the court held that under Section 9(b) the SEC must plead fraud with particularity. While this does not apply to allegations regarding state of mind, it does apply to other facts relating to the fraud. The court ruled that the SEC failed to meet this standard for most of the allegations in the complaint:

The SEC’s entire complaint against Ms. Berry regarding KLA focuses on her role in backdating stock options to employees. The complaint makes cursory references to option grants to executives, and at one point uses a discussion regarding executive stock options grants to suggest Ms. Berry possessed scienter. But, at no point does the SEC clearly allege with particularity that KLA backdated stock options to executives. Absent such an allegation, there is no basis for concluding that the discussion regarding executive stock option grants in the proxy statements was false. On the contrary, the option discussion in the proxy statements could be true. To recap, Ms. Berry has carried her burden of demonstrating the SEC has failed to allege with particularity any securities fraud based on misstatements, other than the SEC’s allegations arising from Ms. Berry signing KLA’s two Form S-8. With respect to the Forms S-8, the SEC’s allegations are sufficient.

Slip Op. May 5, 2008.

This is not the first time the SEC has filed a case based on years-old conduct or that part of its claims have been held time barred. Undoubtedly it is not the first time that it has failed to meet the pleading standards. But, it should be the last. There is no excuse for the SEC to file cases based on conduct which on its face appears to be time barred without at least pleading facts sufficient to establish tolling. Likewise, there is no excuse for the SEC to file a complaint which lacks specificity, particularly in view of the Commission’s vast investigative powers. Bringing enforcement actions is not a game where one hopes to slide by. Bringing enforcement actions is a deadly serious business which scars those named as defendants for life, whether the SEC ultimately prevails in the litigation or not. Regardless of whether the SEC prevails in this case, more is required of a good prosecutor than filing actions which are time barred on their face and lack the basic facts. It is time to conduct a complete review of enforcement policies and procedures to re-energize the program.

This Week In Securities Litigation (May 9, 2008 edition)

This week familiar themes continued: Option backdating, the FCPA and insider trading. The SEC continued to work through its inventory of option backdating cases, moving toward a conclusion of this scandal. The DOJ and the SEC resolved three FCPA cases against individuals, a key focus in this area. At the same time, an announcement was made that letters rogatory were about to be served from an Indian proceeding for information about a settled SEC FCPA case. Finally, reports suggest that the SEC and the Ontario Securities Commission are conducting a significant insider trading case involving 11 different Canadian takeover deals in which a major U.S. law firm may be involved, while U.K. watchdog FSA released a report on insider trading in London markets.

Option backdating

The SEC filed another settled option backdating case this week. Marvell Technology Group, Ltd. and its co-founder Weili Dai, were named as defendants in an SEC civil injunctive complaint which charged violations of the antifraud and books and records provisions of the federal securities laws.

According to the SEC’s complaint, Marvell engaged in a scheme to grant lucrative in-the-money options to employees by backdating the grants. From 2000 to 2006 the company overstated its income by $362 million by not properly recording the option expense. Defendant Dai acted as the company’s stock option committee. In that capacity, she regularly reviewed lists of Marvell’s historical stock prices to pick the lowest date. To make it appear that the company granted the options on the date selected, Ms. Dai signed falsified minutes which attested to meetings of the Committee on an earlier date when the option grant date was supposedly selected.

To resolve the case, the company and Ms. Dai consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records provisions of the securities laws. In addition, the company consented to the entry of an order requiring the payment of a $10 million penalty while Mr. Dai agreed to pay a penalty of $500,000. Defendant Weili Dai also agreed to an order barring her from service as an officer or director for five years. SEC v. Marvell Technology, Case No. CV 08-2366 (N.D. Cal. May 8, 2008). The Commission’s Litigation Release is here.

FCPA

This week, the SEC and DOJ continued their focus on individuals in FCPA cases by concluding actions against three ITXC Corporation executives. ITXC is an international telecommunications carrier based in New Jersey which sought to do business in Africa. The defendants, Steven Ott, Roger Michael Young and Yaw Osei Amoako, were respectively the vice president of global sales, managing director of the Middle East and Africa and regional director for sales in Africa.

The complaints in these actions alleged that the three defendants negotiated and/or approved bribes of over $267,000 paid to foreign officials in Nigeria, Rwanda and Senegal to obtain contracts necessary for ITXC to transmit telephone calls to individuals and businesses in those countries. Those agreements earned the company about $11.5 million in net profits. The SEC cases were settled by consenting to statutory injunctions prohibiting future violations of the FCPA bribery and books and records provisions. Mr. Amoako, who was alleged to have received $150,000 through embezzlement and a kickback, was ordered to pay over $188,000 in disgorgement and prejudgment interest. SEC v. Ott, Civil Action No. 06-4195 (D.N.J. Sept. 6, 2006); SEC v. Amoako, Civil Action No. 05-4284 (D.N.J. Sept. 1, 2005).

To resolve these matters with the DOJ, each defendant pled guilty to conspiring to violate the FCPA and the Travel Act. Mr. Amoako was sentenced to 18 months in prison. Messrs. Ott and Young are awaiting sentencing. U.S. v. Ott, No. 07-608 (D.N.J. July 25, 2007); U.S. v. Young, No. 07-609 (D.N.J. Sept. 25, 2007); U.S. v. Amoako, No. 05-1122 (D.N.J. June 28, 2006).

Last week, the Central Bureau of Investigations in New Delhi disclosed that it is about to issue a letter rogatory to U.S. authorities to question Dow Chemicals regarding bribes that were allegedly paid by a subsidiary of the company to Indian officials. The bribes were supposedly paid to register banned pesticides in the Indian market. The request is part of a case which was filed six months ago against CBI officials and a retired official from the Ministry of Agriculture following an SEC FCPA action.

Previously, the SEC filed a settled civil action and related administrative proceeding against the Dow Chemical Company alleging violations of the FCPA. In that case the complaint alleged that Dow subsidiary, DE-Nocil Crop Protection Ltd., based in Mumbai, India, made approximately $39,700 in improper payments to an official in India’s Central Insecticides Board to expedite the registration of three product. The complaint claimed that from 1996 to 2001 the same subsidiary made $87,000 in improper payments to state officials in order to distribute and sell its product. Finally, the complaint detailed improper gifts, travel, entertainment and other items. The civil action was settled with the payment of a $325,000 civil penalty. A consent to a cease and desist order was entered in a related administrative proceeding. SEC v. The Dow Chemical Company, Civil Action No. 07CV00336 (D.D.C. Feb. 13, 2007) discussed in the Litigation Release here.

Insider trading

The SEC and Ontario securities officials are reportedly conducting a major insider trading investigation involving 11 Canadian takeovers over the past two years. According to an affidavit filed in Ontario Superior Court, the Ontario Securities Commission is investigating a Toronto business consultant, his sister and his brother-in-law who allegedly made over $1.1 million trading in take over stocks.

Also involved in the investigation is a U.S. law firm. While the court papers do not identify the law firm, the transactions which are the focus of the inquiry are listed. A review of those deals by a Canadian news organization determined that the only firm involved in each deal is Dorsey & Whitney.

Earlier this week, the Financial Services Board in the U.K. released a study which disclosed that nearly one-third of takeover deals may have been preceded by insider trading in the London markets. The FSA has reportedly more than doubled its team of prosecutors and is promising to crack down on insider trading and bring a steady stream of cases.