Ninth Circuit Panel Overturns Criminal Conviction for Stock Options Backdating

A Ninth Circuit panel has overturned the first criminal conviction for backdating stock options because the prosecutor made a false assertion of material fact to the jury in closing argument. But the prosecutor’s conduct was not so egregious as to require dismissal of the prosecution against the company CEO. Rather, the case was remanded for a new trial. (US v. Reyes, CA-9, No. 08-10047).

The issue that was dispositive of the appeal concerns the government attorney’s misconduct in falsely telling the jury that the company’s Finance Department did not know about the backdating, when the prosecutor knew that statements by department employees revealed that they did. Moreover, the prosecutor was charged with knowledge of a parallel SEC investigation in which parallel evidence was produced about the knowledge of Finance Department executives. For example, the SEC complaint charged that the company’s CFO acted with knowledge of the backdating.

The appeals court found that senior Finance Department employees had given statements to the FBI describing their knowledge of the backdating scheme. Both prosecution and defense counsel were familiar with these statements. Those employees, who were themselves subject to possible criminal prosecution and had been targets of SEC civil suits, did not testify.

There was also no question that the CEO signed off on stock option grants that were priced retrospectively, and that the backdating allowed the company to understate its compensation expenses. That was indeed the way that the alleged scheme was supposed to operate, by providing a valuable option to employees at no apparent expense to the company.

During trial, the CEO’s position was that he relied on the Finance Department to make sure that the corporate books were accurate, and that he was not responsible for the false records. Thus, the CEO’s defense to the charges was that he thought the transactions were properly accounted for, in reliance on the Finance Department’s expertise to comply with the relevant accounting principles and SEC regulations. His counsel, in closing argument, therefore told the jury that the Finance Department knew about the backdating, thus supporting the defense position

The prosecutor, however, told the jury that the employees in the Finance Department “don’t have any idea” that the backdating was occurring. The prosecutor thereby asserted to the jury facts that he knew were belied by the statements to the FBI from responsible Finance Department officers, and by SEC complaints that had been filed against some of the Finance Department employees alleging they knew about the scheme.

But the appeals panel also ruled that the government satisfied its burden of proving that the false records would have affected the judgment of a reasonable investor. If the government had failed to establish the materiality of the falsification, then the prosecution would have had to be dismissed and no new trial would be possible.

Expert government testimony established that improper accounting of backdated options presents investors with an incorrect picture of a company’s finances. Thus, a rational trier of fact could find beyond a reasonable doubt that the omissions and misstatements were material to a reasonable investor. And the Ninth Circuit has recognized that information regarding a company’s financial condition is material to investment.

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