Backdating of Stock Options under Federal Investigation

July 29, 2006, 12:00AM. By Jennifer Aikman

The U.S. Security and Exchange Commission (SEC) has announced that they will be investigating nearly 80 companies for stock option 'backdating' with nearly 40 companies facing criminal probes by the U.S. Justice Department.

Federal officials held a [press conference] on July 21 in San Francisco to announce civil and criminal charges relating to allegations of stock option backdating by former top executives of the networking-gear manufacturer, Brocade Communications Systems Inc.

The former Brocade execs were charged with leading a scheme to retroactively alter the employment start dates of key executives so the new hires could pocket gains when they later exercised Brocade stock options. Gregory Reyes, Brocade's chief executive until 2005, and Stephanie Jensen, the company's vice president of human resources from 1999 to 2004, are facing civil and criminal charges. In addition, Antonio Canova, Brocade's former chief financial officer, is facing civil charges. Brocade, based in San Jose, Calif., is a data storage networking company with 1,300 employees.

In a 12-page affidavit filed with the criminal complaint, a Federal Bureau of Investigation special agent alleged that Mr. Reyes and Ms. Jensen schemed to grant employees "valuable in-the-money stock options, while hiding the true nature and value of the stock option grants from the company's board, shareholders, auditors, the public and the Securities and Exchange Commission."

Offering stock options to potential employees is not illegal. In fact, stock options are a great way to recruit and retain a solid workforce, and they tend to align employees' interests with those of shareholders. What is being investigated is the alleged fudging of these options by top executives. If an executive is able to change the grant date of an option retroactively to when the stock was trading at a lower price—the options become more attractive.

It is this white collar fraud that has prompted the SEC, the U.S. Attorney's office in San Francisco, and the U.S. Attorney's office in New York to conduct parallel investigations. Several major high-tech companies are undergoing independent and SEC investigations including Broadcom Corp., Intuit Inc., Juniper Networks, VeriSign Inc., Michaels Stores Inc. and CNET Networks Inc.

What does this mean for you if you happen to hold one of these options?

Corporate tinkering with options can affect your tax return.

False option information can result in underpayment of income at the ordinary income tax rate and overpayment of capital gains taxes, which carry different rates.

If you're audited you may have to pay back taxes and interest and possibly penalties.

If you hold stocks in any of the companies mentioned or you are concerned that your stock options may have been backdated - you should seek legal counselling.