Litigation News

SEC Charges Former Brocade CEO, Vice President And CFO

San Francisco, July 20, 2006 — The Securities and Exchange Commission today announced the filing of civil securities fraud charges against Gregory L. Reyes, the former CEO, President, and Chairman of Brocade Communications Systems, Inc., and Stephanie Jensen, its former Vice President of Human Resources, alleging that the two routinely backdated stock option grants to give employees favorably priced options without recording necessary compensation expenses. The action, which is among the first cases involving manipulation of stock option grants in violation of the federal securities laws, is the result of an 18-month investigation by the Commission.

According to the Commission’s complaint, Reyes, 43, of Saratoga, Calif., and Jensen, 48, of Los Altos, Calif., regularly caused Brocade to grant “in-the-money” options (i.e., the exercise price is below the stock’s market price on the day of grant, giving the recipient an immediate paper gain) to both new and current employees between 2000 and 2004, but backdated documents to make it appear that the options were “at-the-money” (i.e., the exercise price is the same as the stock’s market price on the day of the grant) when granted, thus concealing millions of dollars in expenses from investors. Under well-settled accounting principles applicable at the time, options granted “at-the-money” did not need to be expensed. In contrast, options granted “in-the-money” needed to be recorded as a compensation expense.

The complaint alleges that Reyes repeatedly used hindsight to select a date with a lower stock price from the recent past as the supposed option grant date. To facilitate the scheme, Jensen created, or directed others to create, paperwork making it appear that the options had been granted on the earlier date. In some instances, employment offer letters and compensation committee minutes were falsified and purported to document option grants to employees before they had even been hired by the company. As a result of this practice, Brocade was able to give employees “in-the-money” stock options without having to recognize compensation expenses as required by accounting rules. When these stock option abuses surfaced, Brocade was required to restate and revise its financial statements for fiscal years 1999 through 2004. In January 2005, Brocade announced the following restatements (fiscal years):

2004: Net loss increased from $2 million to $32 million
2003: Net loss increased from $136 million to $147 million
2002: Income increased by $60 million to $126 million
1999-2001: Income declined by a total of $304 million

The complaint also names Antonio Canova, Brocade’s former CFO, who is alleged to have learned of the backdating after joining Brocade. According to the complaint, Canova was specifically warned in writing that option paperwork had been forged to enable an employee to get favorably priced options; he took no action and failed to advise Brocade’s auditors and Audit Committee. The complaint alleges that despite this knowledge, Canova signed Brocade’s false and misleading financial statements and SEC filings.

The Commission’s complaint, filed in federal court in San Francisco, Calif., charges Reyes, Canova, and Jensen with fraud and other violations of the federal securities laws, including the books-and-records, internal controls, misrepresentations to auditors, and Sarbanes-Oxley certification provisions.

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