Brocade And Backdating – Gatekeepers Fail

Thanks to this site from Russia for this joke….

A politician, a thief and a KPMG manager died and went straight to hell.
Politician said “I miss my country. I want to call my country and see how everybody is doing there.” She called and talked for about 5 minutes, and then she asked “Well, devil how much I need to pay for the call????
The devil says “Five million dollars.”
The Politician wrote him a cheque and went to sit back on her chair.
The thief was so jealous, he starts screaming, “My turn! I wanna call the my crew members, I want to see how everybody is doing there too.”
He called and talked for about 2 minutes, and then he asked “Well, devil, how much do I need to pay for the call????
The devil says “Ten million dollars.”
With a smug look on his face, he made a cheque and went to sit back on his chair.
The KPMG manager was even more jealous & starts screaming, “I want to call my office friends, senior managers and partners.”
He called the other KPMG employees and he talked for twenty hours about his Audit files and jobs, he asked about new clients, he talked and talked & talked, then he asked “Well, devil how much do I need to pay for the call????
The devil says “Twenty dollars”.
The KPMG manager is stunned & says “Twenty dollars??? Only??”
Devil says:
– Calling from Hell to Hell is considered Local Call

Former Brocade CFO faces civil fraud charges
Regulators tie Byrd to backdated stock options scheme
“The Securities and Exchange Commission filed civil fraud charges today against the former chief financial officer of Brocade Communications Systems, saying “he turned a blind eye” to the high-flying company’s stock option backdating scheme.

Michael J. Byrd, a 45-year-old Saratoga resident, is the fourth former Brocade executive to face civil charges. Two of them also have been charged with criminal fraud. Former CEO Greg Reyes was convicted last week in the nation’s first criminal trial involving backdated options and is awaiting sentencing, while former vice president of human resources Stephanie Jensen is awaiting trial.

“This case confirms the commission’s commitment to pursuing not just those who perpetrate financial fraud, but those corporate gatekeepers who allow it to happen,” SEC enforcement director Linda Chatman Thomsen said in a press release.”

KPMG has been Brocade’s auditors for a while, having inherited this account from Arthur Andersen with the 2002 fiscal year. Andersen was the auditor of record for the fiscal year ending October 27, 2001. In February 2002, the proxy recommended reappointment of AA.

“The Board has selected Arthur Andersen LLP, independent auditors, to audit our financial statements for the fiscal year ending October 26, 2002…Arthur Andersen LLP has audited our financial statements annually since October 1997.”

On June 18, 2002, Brocade Communications Systems, Inc. dismissed its independent accountants, Arthur Andersen LLP and on June 18, 2002 engaged the services of KPMG LLP as its new independent accountants for its current fiscal year, ending October 26, 2002. KPMG issued its audit report for the year ending October 27, 2002 in a timely manner, even though they had only been appointed in June.

Brocade first disclosed it had found accounting errors in its stock options granting process in January 2005. A few weeks later, their CEO Greg Reyes was asked by Brocade’s board to resign, after KPMG would not sign off on the company’s financials if he remained CEO, it was learned during the trial.

The SEC now alleges that Byrd – whom prosecutors unexpectedly decided not to call as a witness in the Reyes trial – was aware of Brocade’s backdating scheme and helped devise the plan that enabled the San Jose networking storage products company to grant options before employees had started full-time work. In addition, he received backdated options himself, the SEC alleged.

Byrd signed on with Brocade in May 1999, the same month the company went public. Previously, he had been CFO at Maxim Integrated Products, another company tainted by the backdating scandal, and was a CPA and former partner with Ernst & Young.

“In the complaint filed in U.S. District Court in San Francisco, the SEC claims Byrd was aware of numerous examples of option manipulation. Some involved picking dates in hindsight to give recipients a head start to profits. Some of those cases enabled new hires to receive options dated before they started full-time work.
…Byrd himself benefited from 800,000 backdated options purportedly granted at $20.70 in April 2001, the SEC charged. In truth, the company didn’t settle on the number of options he should receive until mid-June, a month after he was promoted to president and chief operating officer. At that time Brocade’s stock was trading at about $40, giving Byrd an immediate paper profit of about $16 million.”

We still haven’t had a trial or other investigation that that tells us what role or culpability the audit firms had in the backdating scandal. With the filing of charges against Byrd, we come a little closer. As a CPA and former audit firm partner, Byrd was a classic candidate for these types of CFO positions and profited handsomely from that profile. Having been involved since the IPO, he was the classic “outside” CFO type versus “inside” CFO type. “Outside” CFOs are the kind that understands financing, IPOs and working with analysts and outside investors. They are also, presumably, the kind that understands SEC reporting, GAAP and other requirements of a fast growing public company with lots of market exposure.

As an aside, here’s an interesting article in Financial Week, written prior to the verdict, about what the jury in the Greg Reyes trial didn’t hear:

“Gesturing from the bench with a dismissive wave of his hand, the (Judge Breyer)concluded: “[What] these transcripts…demonstrate to me is how incomplete and inadequate and less than forthcoming people are during these calls…Why isn’t the government then entitled to show how artificial and how structured and how incomplete these discussions are which go out to the market in terms of information…. But then it becomes quite a different trial.”

That trial, Judge Breyer went on to explain, would become one concerned less with any specific transgressions that might have taken place with the accounting at Brocade under Mr. Reyes’ watch and more to do with the nature of interactions between executives and their boards, between companies and their accounting firms and between managers and Wall Street. In short, a trial about much that is dysfunctional with procedure in public companies.

“It becomes, why did KPMG insist on [Mr. Reyes’ resignation]?” Mr. Breyer continued. “[Whether] the board of directors was browbeaten…whether or not in these investor meetings the company was forthcoming…and how information was disseminated to the public and so forth.”

In the end, Mr. Breyer accepted a bargain between the legal teams, if only to keep the case moving: No conference call transcript would be shown to the jurors; out also is the government’s e-mail allegedly revealing an embittered Mr. Reyes damning a cowardly board. Jurors will know that Greg Reyes resigned from Brocade, but they won’t know whether it was because he was pumped to move into a new role or because he was forced to concede his post in shame, and by the same directors who then continued to laud him in public after the fact.”

When searching for information about how and when KPMG got involved as the auditor, I was not surprised to find that they inherited the client from Andersen. As we have seen with many others, Andersen had a style and that style has inevitably resulted in many of their former clients representing a disproportionate share of the companies that are in the worst trouble now, in my non-scientific observation and very personal opinion.

In fact, I was relieved to see KPMG’s involvement starting fairly recently. It seems that they may have looked the other way when accepting this high flying, risky client from Andersen but they put their finger on the issues and stood hard and fast when they did. They led the investigation which resulted in the restatements and Reyes’ resignation as CEO.

But KPMG Consulting had been involved with Brocade in the past, while Andersen was the auditor. Here is a whitepaper they co-authored with Brocade in 1999-2000. This was right before KPMG Consulting spun off from KPMG the audit firm and became BearingPoint.

Well, we all know what happened to BearingPoint. I remember during that heady time how KPMG Consulting leadership tried to flash the dollar signs in our eyes at every moment, attempting to attract new staff and retain existing staff with promises of riches from the stock options we would be getting in the IPO. In fact, one of the main arguments for the IPO of the consulting arms of the audit firms at that time was the need to issue stock options and other stock based incentives in order to attract the technology expertise they needed to compete with the SAPs, Oracles, Scients, Viants, RazorFish and Sapients, the dot-com technology startups that were creating billions on paper for their employees.

I think the expression they used was, “to create currency” needed to attract talent and to make acquisitions of promising firms for
the formerly stodgy consulting arms of the private, partnership managed audit firms that were intent on growing and expanding into global powerhouses. Well, you don’t hear much these days about PwC and their “Monday” firm. It was gobbled up by IBM after screwing up the chance to become part of HP. Then there’s Capgemini Ernst & Young. In April 2004, they reverted to Capgemini (the current name). In the summer of 2005, due to heavy financial losses, Capgemini sold its North American healthcare consulting practice, including both payer and provider practices, to Accenture but retains its life sciences practice. They’re finally starting to revive after a few acquisitions and other strategic moves.

And then, finally, BearingPoint. Well, enough said about them.

There was also Accenture, the early spin-off of Arthur Andersen and probably the only viable independent one of the bunch. But given their pedigree, after all, all these firms were run by former auditors when they first went out on their own, it may be interesting for the SEC to look at stock options backdating at all of the former consulting arms of the Big 5, circa 1999-2003. I wish I would have been granted some of those backdated, already “in the money” options when I was at BearingPoint. If I had, I may not have ever started writing a blog for only the satisfaction of one hand clapping somewhere in Malaysia