The Backdating Embarrassment

How did a meaningless violation of accounting rules become the crime the of century?

An array of influential friends urged leniency for Bruce Karatz in his stock-option backdating sentencing last week, including former Los Angeles Mayor Richard Riordan and philanthropist Eli Broad. But these personages weren’t the reason Judge Otis D. Wright II rejected prosecutors’ request for a six-year prison sentence and instead gave Mr. Karatz probation. Judge Wright said he couldn’t see putting the former CEO away for a crime that did no harm to his company, KB Home, or its shareholders.

So endeth another episode in the annals of backdating, in which a fairly meaningless violation of accounting rules (though violation it was) became trumpeted from the media pulpits as the business crime of the century.

We suppose it’s humanly understandable that, finding themselves compelled to bring these cases, federal prosecutors stretched and kneaded the evidence to fulfill the media’s stereotype of backdating as theft and fraud against shareholders. Let this be a lesson to the children in how not to respond constructively to cognitive dissonance.

Such prosecutorial misconduct led to the dismissal of the backdating case last year against Broadcom founder Henry Nicholas. A judge also threw out the guilty plea of his partner, Henry Samueli, saying he didn’t think Mr. Samueli committed any crime. The first conviction of former Brocade Communications CEO Greg Reyes was similarly overturned on grounds of prosecutorial misconduct (though Mr. Reyes was retried and convicted by a new jury, and now is appealing).

A further irony is that backdating was abetted by a nonsensical accounting rule at the time that treated one kind of option as having value and another kind as having no value (though both have value). This split-the-baby rule itself arguably evolved out of the media’s perennial insistence on portraying stock options as emblems of greed rather than as business tools.

By the estimate of the University of Iowa’s Erik Lie, some 2,000 public companies must have engaged in backdating at some point, as testified by otherwise inexplicable patterns of options pricing. Some 150 companies eventually restated their past results to conform to the proper rule for expensing such options. Yet only a few executives were singled out for criminal prosecution, in a manner that left an observer scratching his head as to why the justice roulette wheel chose some but not others.

Further reason for pause: The handful of subsequent convictions seemed to turn less on the act of backdating than on the self-preserving prevarications executives uttered once the posse arrived at their doorstep.

The ultimate statement in this vein, of course, was the decision by Kobi Alexander, former CEO of Comverse Technology, to decamp to Namibia. We can think of two reasons somebody might flee the law—because he fears he will get justice, or fears he won’t. Presumably Mr. Alexander will one day appear in a U.S. court. It will be interesting to see what countenance he puts on his decision to become a fugitive—perhaps he will cite as a precedent the behavior of the legal system in Salem, Mass., circa 1692.

Meanwhile, the larger lessons of the backdating furor were drawn in an epic piece in May in the American Bar Association’s ABA Journal. By freelance reporter Anna Stolley Persky, the piece connected the dots between (among other things) the backdating witch-hunt, the tainted prosecution of Sen. Ted Stevens, and the government’s use of the vague “honest services” statute to criminalize various kinds of behavior post hoc (a practice the Supreme Court finally curbed earlier this year).

One critique can be found in the title of a book by Boston defense attorney Harvey Silverglate: “Three Felonies a Day: How the Feds Target the Innocent.” Mr. Silverglate believes that only a mobilization of “civil society” can stop what he calls rampant abuse of prosecutorial discretion.

In contrast, former federal prosecutor Joseph diGenova puts the onus on DOJ overseers: “If anyone thinks it’s anything other than prosecute at any cost, then they are wrong. . . . The department has been AWOL in supervising the ethics of its prosecutors,” he told ABA Journal.

But it’s also hard not to see the self-interested ethics of the plaintiff’s bar spilling across the entire legal profession. In their official roles, prosecutors invent Kafkaesque new ways to ensnare the unpopular wealthy in legal trouble, then jump to private law firms and make seven-figure livings protecting the wealthy from the monster they themselves unleashed.

Shakespeare had a solution, but, alas, this would also be illegal. Thus it must fall to bloggers, the media and judges like Judge Wright to protect Americans from overzealous prosecutors.

Holman W. Jenkins Jr., Wall Street Journal

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Full article and photo: http://online.wsj.com/article/SB10001424052748704312504575618612636493250.html