The looming trial of Bruce Karatz, former chief executive of KB Home, promises to be one of the biggest local legal showdowns of the postcrash years.
The federal government will try to prove that Karatz failed to fully disclose backdating his stock options with intent to mislead shareholders.
Defense lawyers will try to show that Karatz followed the rules as best he could. They likely will portray him as a generous philanthropist committed to civic causes. They also could trot out his pals, including former L.A. Mayor Richard Riordan and Playa Vista Chief Executive Steve Soboroff, as character witnesses.
If the matter isn’t settled first, the trial is set to begin March 9 in a Los Angeles federal courtroom and could last four to five weeks. It could provide an inside look at the overheated rise and quick meltdown of the residential real estate industry during the past decade.
If convicted on all 20 counts, Karatz, 64, faces up to 415 years in prison.
But no other backdating case has resulted in any standing convictions. So Karatz goes into the courtroom with that in his favor. Even so, the stakes are high and insiders predict a strongly fought case.
“The prosecutors will likely try to portray Mr. Karatz as someone who improperly sought to enrich himself,” said Mark Holscher of Kirkland & Ellis LLP, who is not involved in the case but has represented other high-profile white-collar defendants, including Jeffrey Skilling of Enron. “They will also need to explain to the jury why backdating matters.”
Meanwhile, Holscher said that defense attorney John Keker will emphasize the complexity of the rules about options backdating and Karatz’s good standing in the community.
“I expect Keker will focus on how the dating of Karatz’s stock options was known to others at the company and is permissible. Keker will humanize Karatz in front of the jury and explain how Karatz did not intend to mislead anyone. Keker will likely explain how Karatz worked tirelessly to build KB Home and that his stock-based compensation was a result of his great work for the company.”
In a typical backdating scenario, an executive gets a stock option that begins not on the date it was granted but on whatever previous day the stock was priced at a low point. That way, the executive stands to get a bigger payout. The practice is legal if it is disclosed to shareholders and regulators, and if the company reports the expense.
In a statement provided to the Business Journal last week, Keker said: “The recent decisions in the backdating trials show just how misguided the criminal prosecution of these option pricing cases is. The accounting rules made little sense. Company after company applied those rules in good faith, in a way the government now says was wrong.”
Federal prosecutors, who declined to comment for this article, will present their case that Karatz, with help from Gary Ray, former vice president of human resources, and others at KB Home, took part in backdating stock options for himself and other top executives in violation of stated company policy.
Prosecutors allege that Karatz concealed the backdating practice from KB Home’s board, its compensation committee and shareholders.
They also allege Karatz was instrumental in presenting an internal report to the board and the company’s auditors in mid-2006 that stated there was “no evidence of the backdating of options or other manipulation by management,” and that the board and company auditors relied on this report when making filings with the Securities and Exchange Commission.
All of this was occurring during a tremendous run-up in KB Home’s stock price as a result of the housing boom. Karatz’s reported compensation during the years 2003-2005 was $232 million, making him one of the nation’s highest paid executives. The reported compensation included his options, but not the higher income he gained from them due to the backdating.
When the options backdating came to light in 2008, KB Home restated its finances and reported more than $36 million in additional stock-based compensation expenses, according to the indictment. In all, the company adjusted its financial statements by $70 million, including stock options and related expenses.
Key to the prosecution’s case is the testimony of two witnesses, especially Ray, who pleaded guilty last year to conspiring with Karatz to obstruct a SEC investigation into the options backdating charges. Prosecutors are relying on Ray to testify that Karatz intentionally concealed the options backdating scheme from the board and the compensation committee.
Keker, of the San Francisco firm Keker & Van Nest LLP, represented investment banker Frank Quattrone, who was charged with obstructing a government investigation into tech bubble IPOs he helped launch. Quattrone’s conviction was overturned on appeal in 2006.
The defense is expected to argue that Karatz did not conceal the options backdating practice from the board’s compensation committee and that KB Home’s legal department said that the backdating procedures complied with the law.
The defense also claimed prosecutorial misconduct in its treatment of Ray and James Johnson, the former chairman of KB Home’s compensation committee, saying both initially gave depositions that supported Karatz’ version of events surrounding the options backdating. U.S. District Judge Otis Wright rejected a pretrial motion to exclude the testimony, however.
The defense motion was filed three weeks after prosecutorial misconduct charges resulted in a federal judge throwing out charges against Broadcom Corp. executives Henry Nicholas and Henry Samueli.
Attorneys with experience in options backdating cases said that the prosecutors in the Karatz case appear to have behaved more professionally.
Regardless, prosecutors face a significant challenge.
“These cases are immensely difficult to put together and present in understandable fashion to a jury,” said Manny Medrano, principal with the Los Angeles law firm of Medrano & Carlton.
In the few options backdating cases that have gone to trial in recent years, defendants have generally prevailed as the government has failed to convince judges and juries that the defendants willfully manipulated stock option grants to enrich themselves. Even the one conviction prosecutors obtained was eventually overturned.
Rig the system
These difficulties have persisted despite the fact that poll after poll shows members of the public think chief executives make too much money and rig the system to get even more.
Out of more than 60 investigations of allegations into criminal activity tied to options backdating, only a handful of cases have actually been brought, including the cases against Broadcom and KB Home. Some of the other cases have settled; others are still ongoing.
Technology companies were most frequently targeted for investigation because stock options were a significant portion of executive compensation during the tech boom. KB Home is a rare example of a nontech company with backdating problems.
But so far, there hasn’t been a single conviction on options backdating charges that has stood up.
In one case, against Santa Clara computer security company McAfee Inc., the company’s former general counsel was acquitted. In another case, against San Jose-based Brocade Communication Systems, the former chief executive’s conviction was overturned last year on appeal.
Last month, an Orange County federal judge threw out charges against Irvine chip maker Broadcom executives Nicholas and Samueli after the judge concluded that alleged witness intimidation harmed the defendants’ ability to receive a fair trial.
Then, on Feb. 16, a judge in St. Louis dismissed an SEC fraud case against Michael Shanahan Jr., who sat on the executive compensation committee of Engineered Support Systems Inc. Shanahan had been accused of approving the backdating of options that netted him $100,000 in personal profit.
“Options backdating cases are hard to prove because there are certain facts that are just hard to get across,” Medrano said. “You have to break it down in terms that are understandable. Otherwise the defense team can play this into a hung jury or outright acquittal.”
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