Long arm of the law

28 July 2006

Criminal charges in a share options 'backdating' scandal rocked Silicon Valley this month, the latest in a string of events that show the risks directors face when things turn sour. How safe are you?

If you're of a nervous disposition and worry about your legal liabilities as a company director, this was probably a good month to experiment with Prozac. Although the business world has a long history of brushes with the law - think of the Maxwell, Barings and Guinness scandals - they've tended to be something of a sideshow. Nowadays, however, it seems you can't leave the boardroom without someone in a pointy hat and a blue uniform slapping handcuffs on you.

Most of the latest incidents seem to have been driven from this side of the pond, where our American cousins continue their post-Enron assault on anything that faintly whiffs of corruption. First there was the extradition of the Natwest Three, a move that prompted a furious row over the UK's treaty with the US and raises serious questions about just how far American law reaches beyond its own borders. Then there was the arrest of David Carruthers, former chief executive of UK-quoted BetonSports, who was not only jailed as he journeyed through the US, but then got fired by his company for good measure. And you thought you had a bad week?

On top of that, the stakes have been well and truly upped in the long-running investigation into backdating of stock options by US companies, which has set alarm bells ringing throughout Silicon Valley and led to some high-profile firings. This month saw the first criminal charges laid against two former directors of Brocade Communications Systems, the first of many anticipated criminal cases.

Reactions to these different events have varied. The sight of three well-heeled City folk being marched into court in chains understandably rankled with the British media, which puts great stock in the appearance of defendants being innocent until proven guilty (with the possible exception of alleged paedophiles and asylum seekers). The sight of Carruthers turning up in court in a jail-issue orange jumpsuit a few days later really didn't help. For the UK business community, and especially those that have dealings with the US, this was a vivid reminder that corporate wrong-doing really can have scary consequences, sartorial inelegance being just the beginning.

But while the Natwest and online gambling cases are very specific, the stock option scandal could have a far-reaching impact across the tech sector. At issue is the apparently commonplace practice during the dot com boom years of companies backdating stock option grant dates to coincide with share price lows. When those options mature, the difference between the price at the grant date and the current price is all profit to the recipient, assuming that the shares rose in between - which they once had a knack of doing. Prosecutors argue, however, that if the grant date was artificially selected and not properly disclosed at the time, backdating violates accounting laws and could have defrauded the market.

No-one disputes that stock options were an invaluable weapon for tech firms during the boom years, as they desperately tried to poach skilled employees to fuel their fast-growing businesses. But there's always been controversy about the way they were handled. Even after the tech collapse, Silicon Valley fought a rearguard action to try to stave off changes to the way they're expensed in corporate accounts. Many now believe that tech firms showed an arrogant disregard for 'old economy' governance standards during the 90s. Silicon Valley ate one slice of humble pie when the tech bubble burst, shares prices tanked and options became worthless. The new criminal charges throw the rest of the pie, the plate and the kitchen sink into the mix - and that's going to be a lot harder to swallow.

How big an impact this will have on individual companies will become clear over time, but a lot of executives are now running up big legal bills and starting to think about their negotiating position with the authorities. In the meantime, this is food for thought for today's start-ups. Granting options in private companies is a completely different game from operating in the public markets, but this saga does send a message about how the past has a very nasty habit of creeping up on you when you're least expecting it. With every corporate issue, whether it's structuring your company or dealing with the VAT man, you can't beat good, independent advice from people who play it straight - because the alternative can be hard to stomach.

By Keith Rodgers, Webster Buchanan Research