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Guilty!

By Megan Kinneyn | Dec. 2, 2007
News

Law Office Management

Dec. 2, 2007

Guilty!

The aggressive tactics of defense attorney Richard Marmaro appeared to overwhelm prosecutors in the Greg Reyes stock-options backdating case. But a San Francisco jury convicted Reyes anyway, sending a chill through the boardrooms of Silicon Valley.


     
In July 6, 2007, Richard Marmaro appeared to be on the verge of vindication.
      Marmaro sat quietly at the defense table as his legal adversary, Assistant U.S. Attorney Timothy Crudo, labored to explain why Greg Reyes, Marmaro's client and the former CEO of Brocade Communications Systems, should not be acquitted.
      Since the beginning of the trial on June 18, it had been Marmaro?a partner in the Los Angeles office of Skadden, Arps, Slate, Meagher & Flom?who squabbled with U.S. District Judge Charles Breyer, the brother of U.S. Supreme Court Justice Stephen Breyer. Already, Marmaro had filed three mistrial motions?including one accusing the judge of bias against his client.
      But on this day the attorney in Breyer's crosshairs was Crudo, and the government's entire case teetered in the balance. Though Marmaro had raised a host of arguments in his motion to dismiss, Breyer was particularly interested in one of them: whether Reyes knew enough about accounting rules to have the criminal intent to violate the law.
      "What did Reyes know about the alleged scheme?" Breyer asked Crudo. "What did he understand? What is the evidence of his understanding of the accounting requirements?"
      Breyer's questions about criminal intent struck at the heart of the government's case. After two weeks of testimony, the judge was asking whether Reyes, who is not an accountant, knew enough about the complex array of accounting opinions in place at the time to realize he was violating the law by backdating stock options and failing to report compensation expenses on Brocade's financial statements.
      The answer mattered not just to Reyes?the first defendant accused of backdating crimes to take his case to trial?but also to the many company executives and attorneys under investigation by federal prosecutors and the Securities and Exchange Commission for years-old allegations of backdating. The Reyes trial was a test case.
      Crudo, a 45-year-old San Francisco native with graying hair and an unruffled demeanor, seemed uncharacteristically thrown off guard by the judge. He said the government didn't need to prove Reyes knew everything about the accounting rules, only that "he knew what he was doing was wrongful."
      "You have to tie it to something," Breyer replied, apparently unimpressed with some of the prosecution's ballyhooed evidence, including the statement of a former human resources employee who said Reyes told her, "It's not illegal if you don't get caught."
      "That statement ... was pretty untethered," Breyer said dismissively.
      Later, Crudo tried another tack, arguing that Reyes's signature on Brocade's annual financial statements proved he understood that accounting charges were required when stock options are granted at a discount. Breyer appeared to like that argument even less, saying cases that relied on a chief executive's signature on the 10-K as proof of knowledge of applicable accounting standards for backdated option grants would be "very short then, from now on."
      Finally, Crudo recalled testimony earlier in the week by Craig Martin, a partner in Morrison & Foerster's San Francisco office. Martin had been hired by the audit committee of Brocade's board of directors to conduct an investigation of the options matter, and he testified for the prosecution. Martin told the court that Reyes, during a January 2005 interview, denied that Brocade backdated employee option grants.
      Crudo told the judge Reyes had lied in that interview because he "was aware back throughout the time they were doing it that it was improper to do, that it did have accounting implications throughout the time."
      Breyer decided to postpone ruling on Marmaro's motion. Instead, he demanded that prosecutors file papers listing all of the evidence they wanted him to consider on the following Monday morning?the day Marmaro was scheduled to begin calling the defense case.
      Marmaro persisted, urging Breyer to dismiss the case. The government's argument might be weak, Marmaro said, but a jury, inflamed by a bias against CEOs in the aftermath of scandals at Enron and WorldCom, might convict Reyes anyway.
      "Your Honor, with all due respect, you can't let this case go to a jury," Marmaro said. "No rational juror on this state of the record could do anything but speculate, and that's what scares me, because there is an anti-CEO bias out there."
      The judge responded that he knew the implications of granting the defense motion before allowing the jury to decide. Prosecutors would be unable to appeal a dismissal granted at this stage of the proceedings, a crushing and unreviewable defeat.
      In an interview a month after the trial, Crudo said he had been encouraged by Breyer's caution and remained confident the judge would not take the extraordinary?albeit not unprecedented?step of dismissing the case. But he acknowledged, "You don't sleep particularly well during a trial. I probably slept worse that night."
      Breyer's skeptical attitude toward the government's case only reaffirmed what the defense team believed and had been hearing from other courtroom observers. Prosecutors had spent more than a year investigating and preparing for trial. They had called all of their witnesses, only to find that the judge was unconvinced Reyes had the criminal intent required to be found guilty of any crime, much less the ten felonies charged from the indictment.
      Still, if Breyer would not dismiss the case, Marmaro faced the uncertainty of dealing with a jury. As they left the courtroom and got into the elevator, Marmaro turned to Reyes and said: "We were so close."
     
      In many ways, the defendant and his counsel were a well-matched pair. Reyes, 45, exudes youth and vigor despite his prematurely silver hair. In a March interview, Reyes said he had no interest in pleading guilty to lesser charges in exchange for a short jail term and a fine?as two former executives at New York?based Comverse Technology had done four months earlier. "I've got my eyes wide open," Reyes said. "Rich has been articulate in laying out the options."
      Like many successful chief executives, Reyes was accustomed to winning. He was not well versed in the technology of Brocade's networking-storage products, but he was hired in 1998 anyway because of his leadership skills and sales experience. He did well, and made quite a bit of money when the company went public in 1999.
      Marmaro, 56, grew up on Long Island before establishing a legal career in Los Angeles. A former federal prosecutor, he made his reputation representing corporate executives accused of fraud by the SEC or the Justice Department. His biggest win as a criminal defense attorney came in 1994, when he persuaded a jury to acquit the former chief executive of Columbia Savings and Loan on 60 counts of fraud, bribery, and other charges. And in early 2006, Marmaro had been on a winning streak before the SEC, successfully defending both the former chief executive officer of PC company Gateway and a board member of Fidelity National Financial.
      Going to trial in the Brocade case, however, represented a gamble. Reyes was indicted in August 2006, and backdating had been in the news since March of that year, when the Wall Street Journal ran an exposé about the suspicious practice of companies granting stock options at their share prices' monthly, quarterly, or annual lows. Suddenly, backdating investigations were being launched or stepped up all over the country. In San Francisco, the SEC and the U.S. Attorney's office were looking into Brocade Communications, which in January 2005 restated its earnings for several previous years after an internal investigation found that employee options were granted at discounted prices. Reyes was forced out as chief executive officer, and he left the company later that year.
      As in the earlier scandals, backdating appeared to be yet another example of corporate malfeasance in which executives and company insiders rigged the system for their own benefit, reaping millions of dollars in excess compensation. And jurors were unlikely to be sympathetic. Marmaro's own jury consultant, Steven Lybrand, warned of "significant anti-corporate juror bias." Writing in a Legal Times article in 2005, a year before the backdating scandals hit, Lybrand cautioned that those same attitudes extended to corporate executives themselves.
      But Brocade was not the reviled Enron, and Greg Reyes was not Andy Fastow. Prosecutors weren't even accusing Reyes of backdating his own stock options. This made it much more difficult to establish motive, and it allowed Marmaro to argue that Reyes was acting only for the good of the company. In addition, Crudo and Reeves had called no witnesses claiming to have lost money because of Reyes's actions.
      The prosecution had no trouble proving that Brocade backdated options; there was a long paper trail, and Marmaro conceded the point. More difficult was establishing criminal intent: that Reyes knew he was violating the accounting standards. The government's case came under attack on other grounds as well. Marmaro argued that investors, far from being harmed, cared little about stock option expenses because such accounting charges did not actually cost the company any money. He also maintained that complying with accounting rules was the responsibility of Brocade's finance executives, who knew of the backdating and approved it, and noted that the rules themselves were so confusing that more than 100 companies had run afoul of them.
      Meanwhile, as the case headed toward a June 2007 trial date, the U.S. Attorney's office in San Francisco was in turmoil. U.S. Attorney Kevin Ryan had been ousted, and his deputy in charge of the backdating task force left that position. More significant, in January lead prosecutor Christopher Steskal announced that he was leaving to take a job at Fenwick & West.
      The news was met with incredulity among the many former federal prosecutors in the white-collar defense bar. Why would Steskal leave before the biggest trial of his career? "As a prosecutor, this is a case you wait for?unless you think it's a dog," Elliot Peters, a partner with Keker & Van Nest, said at the time.
      When Crudo and Reeves took a look at the case they inherited, however, they liked much of what they found. They were heartened when Breyer rejected Marmaro's motion to throw out the SEC case because investors would not consider the unreported accounting expenses to be material. "The defense briefed the SEC case extensively, and we got to see a lot of the arguments," Crudo recalled. "It was a great summary judgment motion, but a tough argument to make to the jury."
      Perhaps the prosecutors' biggest strategic decision was whether to call high-level finance executives to testify. There was no easy answer. The government had interviewed the company's two former CFOs and controllers under limited grants of immunity, and both former CFOs would later be charged by the SEC. Some of the employees interviewed had written or received emails indicating that they were aware of?or even personally involved in?Brocade's backdating process. Calling the finance executives as witnesses could provide valuable evidence of Reyes's personal knowledge of the scheme, but it would expose them to Marmaro's cross-examination. He would surely try to establish that Reyes had relied on the executives to get the accounting details right, but they failed.
      "That was one of the most difficult calls," Crudo said after the trial. In the end, he and Reeves settled on an audacious strategy: They would call only a low-level stock administrator from the finance department, and argue that Reyes and the human resources department "deceived" the financial experts about the true date that option grants were awarded.
      Without testimony from the executives, the prosecutors would have to base their case that the CEO knew what was happening at his own company on other evidence: Reyes's signature on the many option grants, financial statements, and "management representation letters" to auditors. "We wanted to keep it simple," Crudo said.
     
      On the first day of opening arguments, Judge Breyer's San Francisco courtroom was filled with Reyes's family, friends, large legal team, and other supporters. In addition, a group of summer associates from Skadden jammed the gallery to watch Marmaro's performance.
      During the first week of trial, Marmaro and Breyer engaged in a running verbal battle that resumed each day after the jury left the courtroom. Breyer questioned Marmaro's and other defense lawyers' endless cross-examination of Brocade's former HR employees and others as irrelevant or beyond the scope of their knowledge. Marmaro, for his part, was frustrated by what he saw as an attempt to prevent him from examining witnesses.
      Marmaro wanted Breyer to block testimony from June Weaver, the former HR employee who said Reyes told her, "It's not illegal if you don't get caught." Breyer allowed the testimony, which prompted Marmaro's first mistrial motion.
      The tension bubbled over on June 26, when Marmaro accused the judge of having "expressed a disdain for what we are doing" through facial expressions and by making his own objections to defense questions. Marmaro then made his third mistrial motion in six days, saying that Breyer's conduct "is giving the jury an unfair impression of its bias against us."
      Breyer fired back, "If you want to turn this into a popularity contest, so be it." His voice dripping with sarcasm, the judge added, "I will not be guided by the fact that others in the courtroom share your view."
      The judge was angry, but Marmaro had made his point. Afterward, Breyer appeared to make a conscious effort to control his irritation with the defense team. As the prosecution's case wore on, the defense appeared to gain confidence. Weaver's damning testimony about remarks attributed to Reyes lacked context. She remembered only the single sentence, and assumed it was work-related because she had been in Reyes's office at the time.
      One expert witness spent time on the stand admitting a series of mathematical errors. Another witness, called to prove that some investors cared about "noncash" expenses Brocade didn't take because of backdated stock options, admitted he removed some of those accounting charges from his analysis of companies he evaluated. But doing so, said Steve Catricks, a portfolio manager with Delaware Investments, "was a common practice among analysts."
      However, prosecutors repeatedly displayed Reyes's signature on grant documents and financial statements certifying that Brocade was complying with the accounting rules. And they presented an email Reyes wrote in 2004 to the chair of another technology company saying it was illegal to backdate option grants. Still, the defense team seemed reassured when Breyer appeared to brush the email aside.
      Marmaro wanted to get the case to the jury as quickly as possible. Though he originally said his defense could take as long as five weeks, it ended up lasting a little more than five days. Larry W. Sonsini, chair of Wilson Sonsini Goodrich & Rosati, was one of several witnesses who had been scheduled to testify but were not called to appear. Sonsini, a member of Brocade's board of directors, reportedly had advised Reyes personally; in the spring he was deposed for the SEC case.
      Always the picture of confidence, Reyes began to mouth off a bit in the courtroom. During a break in the testimony of the final defense witness, Reyes spotted a couple of SEC attorneys in the front row, taking notes in preparation for the civil case against him that would follow the criminal trial. "You're next," Reyes told them with an impish grin.
     
      The jury that deliberated about Reyes's fate, and ultimately convicted him on all ten counts, apparently did not share Breyer's qualms about whether prosecutors had established criminal intent. Half of the jury was convinced from the beginning of deliberations on July 30 that Reyes was guilty, according to Lisa Lambert, one of two holdouts in favor of acquittal. The rest, she said, came around by the second week, especially after the foreperson?Gerald Roberts, an immigration attorney?decided the evidence supported guilty verdicts.
      Lambert said that although the jurors who favored conviction listed many reasons for believing Reyes was guilty, the "damning" testimony they cited again and again was that of investigator Martin. When the jurors wanted to hear testimony read back on their fourth day of deliberations, they asked for short snippets from three witnesses. But they asked to hear all of Martin's testimony, and several took careful notes as they listened.
      During his investigation Martin, a former SEC enforcement attorney, had interviewed Reyes twice?once in November 2004 and again in January 2005. By then Reyes had hired Marmaro, who attended the second interview. Still heading the company, Reyes had chosen to cooperate with the probe.
      Patrick Robbins, a San Francisco?based partner with Shearman & Sterling and a former federal prosecutor, said it is difficult for attorneys to convince executives not to talk, because that silence will likely end their careers at the company. "It's pretty hard for them to say they are going to allow themselves to be fired," Robbins says, especially if the executive believes he did nothing wrong.
      Shortly after Martin's final interview with Reyes, Brocade's outside attorney?Nina Locker of Wilson Sonsini?contacted representatives at the SEC's San Francisco enforcement office to let them know the company planned to announce it would have to restate its earnings due to problems with stock option accounting. Subsequently, the SEC started an informal inquiry of Brocade's stock option practices, Locker noted in a November 2006 declaration.
      Brocade and its law firms tried to walk a fine line, cooperating with what became a joint investigation by the SEC and the U.S. Attorney's office while refusing to waive its attorney-client or attorney work-product privileges. The agreements were formalized and signed in January 2005 by Brocade's chair and a top SEC enforcement official. In March 2006 Locker drafted a nearly identical agreement, which was signed by Steskal on behalf of the U.S. Attorney's office.
      Brocade's strategy was simple: The company would supply the government with confidential information about its investigation and interviews, including those of Reyes. But the briefings would be oral?nothing in writing.
      Marmaro, however, did not accept the distinction. He filed a subpoena seeking Martin's notes of his Reyes interviews, disputing the Brocade law firms' assertion of the attorney-client and work-product privilege and arguing in court papers that both "were waived by MoFo's oral disclosures to the government and others."
      The judge agreed. In a December pretrial opinion denying the law firms' motions to quash the subpoena, Breyer acknowledged that the Ninth Circuit had not "directly" addressed the question of whether to allow partial waiver of the attorney-client privilege, but commented that other circuits had "overwhelmingly disapproved of the practice." He also noted diverse court rulings on the work-product privilege issue in both criminal and civil cases involving McKesson HBOC. "Nonetheless," Breyer wrote, "for the reasons set forth above?namely, the opportunistic use of privileged work product and its disclosure to an adversary?the confidentiality agreements do not save the day for MoFo and WSG&R." Brocade's deals with federal prosecutors and the SEC were no more than "fig leafs" that allowed the government to do whatever it wanted with the company's information, he concluded.
      Early in his investigation Martin questioned Stephanie Jensen, the former vice president of HR, who described Brocade's process for pricing new employees' stock options. An outline in a company memorandum instructed HR employees to check Brocade's stock price during the previous quarter and choose one of the lower closing prices when selecting grant dates.
      Ultimately, those stock options would be signed by Reyes. But when Martin recounted Jensen's statements about their pricing to Reyes during his interview, Reyes seemed taken aback, Martin testified. "Mr. Reyes responded by saying, 'If that's what she said, that's what she said,' " he stated. Reyes repeatedly denied pricing employee stock options using "historical lookbacks."
      Reyes also acknowledged to Martin that he had become aware of the accounting implications of backdating stock option grants. Almost as damaging was what Reyes did not tell the investigator. At trial, Martin made no mention that Reyes relied on the company's high-level finance executives to deal with stock option accounting issues.
      As recounted by Martin, Reyes's statements during the internal investigation conflicted with the account presented in Marmaro's defense. But Marmaro made little attempt to discredit or explain the apparent contradiction. "That is the classic kind of evidence that prosecutors use in cases that turn on a defendant's state of mind," says James Brochin, a New Yorkbased partner at Paul, Weiss, Rifkind, Wharton & Garrison who represents executives in backdating cases.
      On cross-examination, Marmaro poked a few holes in Martin's testimony, getting the investigator to concede that he never asked Reyes when he learned of the accounting implications of backdated option grants. Martin stated the former CEO also acknowledged that he did not type up his notes from the January 2005 interview until 14 months later, after receiving a request from the U.S. Attorney's office.
      Martin admitted to Marmaro that he never asked Reyes about his understanding of the various accounting opinions, nor did he make audio or video recordings of the fateful second interview. And Reyes told Martin he had never seen the memo outlining the company's process for granting stock options, Martin testified.
      The problem for the defense posed by the investigator's account was that it strongly suggested Reyes, in denying that Brocade backdated options, knew he had something to hide. "What [Martin] said was pretty compelling," Crudo recalls. "If you accept that [Reyes was not forthcoming] and view it as a prism to view the rest of the evidence, it was consistent with our thinking, and it was inconsistent with theirs."
      Other attorneys, including one defense lawyer involved in criminal backdating cases, say that in trying to sweep Reyes's "obvious lie" under the rug, Marmaro badly miscalculated. The defense needed to either destroy Martin's credibility or come up with a plausible way of explaining his testimony, they contend.
      "It was telling evidence, and the defense just didn't deal with it," says Samuel Buell, a former federal prosecutor who teaches securities law at Washington University School of Law in St. Louis. Reyes's backdating denial, he suggests, may have been a "reflexive comment" made by a chief executive trying to hold on to his job and not mindful of potential criminal charges. After all, at the time few people had even heard of option backdating, much less been prosecuted for it.
      "Lots of times people lie when they are being investigated?just because they are being investigated," Buell says. "But that is a tough argument for a defense lawyer to pursue. You risk that a jury will say, 'He's willing to lie to his own people,' and you give up the ability to present your client to the jury as a white-hatted individual."
      For the jury, next to Martin's testimony the most influential factor was the belief that as head of the company Reyes must have known what was happening. "He was the CEO," Lambert recalls jurors arguing. "It was his responsibility."
      The defense argument that investors would be unconcerned about the accounting charges went nowhere with the jury, according to Lambert. "A lot of jurors did feel [the charges] would be important to them," she says. Nor was the panel persuaded by testimony about other companies that also got the accounting of backdated stock options wrong; it raised questions about how many companies got it right.
      Although few jurors believed that Reyes deceived the Brocade finance executives, Lambert says, they were sure that the CEO knew the accounting rules. In fact, she added, some erroneously believed that Reyes had a master's degree in business administration, prompting the contention that anyone who's taken accounting classes must know the rules about expenses associated with discounted stock option grants.
      According to Brochin, jurors who think that a chief executive "should have known" about misconduct at a company present a challenge. "White-collar defense lawyers live in mortal fear of this type of mindset," he said.
      On August 7 Lambert and the other holdout juror, Elizabeth Balleza, finally gave in. Jurors who favored the prosecution were eager to get back to their normal routines, Lambert says, and they convinced her that any doubts she had were unreasonable. Since then, Lambert has had second thoughts. "I wasn't convinced he was guilty," she said in September.
      In the courtroom, even before the guilty verdicts were read, Lambert was crying. Several other jurors also wiped away tears as Reyes's wife, Penny, who had attended every day of the trial, began sobbing uncontrollably at word of the outcome. The defense team's last hope was then crushed when Breyer revealed he had denied Marmaro's motion for acquittal.
      Reyes faces a possible prison term of 20 years.
      After the jury was excused, Reyes rushed to comfort his wife, and they embraced for more than a minute in the packed but silent courtroom. Later, he would enfold the ashen-faced Marmaro and the other members of his legal team.
      Crudo and Reeves basked in the glow of their hard-fought triumph. Though federal prosecutors have downplayed the prospect of more backdating indictments, some are expected. Marmaro vowed to appeal, charging that prosecutors misled the jury about what Brocade's finance executives knew of options backdating at the company. And around the country, other executives under government investigation for backdating options scrambled to consult with their lawyers.
      It is reckless to draw sweeping conclusions from a single trial, especially with a pending appeal. But in retrospect, the errors made by Marmaro's defense team seem obvious. "The Reyes case is an object lesson for why sitting executives should think twice about submitting to an interview," says Robbins, the former prosecutor. Reyes's decision to talk to Martin didn't save his job. And it didn't prevent Brocade's board from cooperating with government investigators after he was gone?which Breyer later concluded had the effect of waiving the attorney-client and work-product privileges.
      The case is rife with what-ifs: What if Marmaro's defense team had drawn a more favorable jury pool? What if one juror who had been sympathetic to the defense had not been dismissed in the middle of the trial? What if the two holdout jurors had refused to budge? The outcome might have been very different.
      Then again, Reyes may have been doomed under any circumstances. Backdating cases are difficult to defend because there is so much circumstantial evidence of intent, says an East Coast defense attorney who handles them. As Crudo said in closing arguments: "There was no other purpose to this whole scheme of backdating, putting false dates on documents, trying to select low dates. It was designed to deceive the investors and the auditors who were their watchdogs."
     
      Craig Anderson (craig_anderson@dailyjournal.com) covered the Reyes trial for the San Francisco Daily Journal.
     
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Megan Kinneyn

Daily Journal Staff Writer

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