Setting the Date
A Smashing-Pumpkins Show

At the high-tech company Brocade Communications Systems Inc., employees received an unusual request from human-resources managers in 2002: Alter the employment records of several executives to make it seem they joined the company later than they really did.

The reason for this strange request was to give their stock options more value.

The executives had received options when they joined. But with the tech bubble then fast deflating, Brocade's stock price had fallen below the price at which the options could be exercised. With a change in start date, the options could be replaced with some that carried a later date when the price was lower. That would enhance their value, since options give recipients the right to buy shares at the stock's price when they're granted.

This episode, related by two former employees, is part of a detailed picture of what went on inside one company caught up in the stock-options scandal. The events at Brocade, according to nine former employees and to company documents, involved not only altered start dates but a one-man options committee and a technique for influencing options grant dates through part-time employment.

It's a pattern of options practices that has drawn the attention of federal prosecutors. They are considering bringing criminal charges against a former Brocade chief executive, Gregory L. Reyes, says a person familiar with the situation -- in what would be the first criminal case in the spiraling scandal over the timing of options. The Securities and Exchange Commission also is considering civil charges in the matter, according to people familiar with the SEC probe. Mr. Reyes denies any wrongdoing.

So long as Brocade's stock was on the rise, employees wanted their options to be dated sooner, not later, since an earlier date would carry a lower exercise price. So to make it seem that employees had begun their careers at Brocade sooner, ex-employees say, the company would offer them temporary part-time employment from the moment they agreed to join, but before they actually did.

Several former employees described the offer to work part-time as a charade: Few actually worked any hours prior to starting full-time, other than making a few phone calls. New recruits were told, "We want you to start part-time -- wink-wink, nod-nod," says one former employee. "This was not a secret. Everybody knew about it."

A Brocade letter offering to employ Antonio Canova, who eventually became chief financial officer, was dated Nov. 13, 2000. It told him he'd get options for 180,000 shares with a grant date of "the first date of your employment." According to documents on file with the SEC, the letter went on to say: "To accelerate your on-boarding with Brocade, we extend to you the opportunity to join us on a part-time basis" of up to four hours per week prior to joining full-time. Mr. Canova, who has since left Brocade, couldn't be reached for comment.

Brocade, based in San Jose, Calif., is a data storage networking firm with just over 1,300 employees. It provides storage switches that are a sort of virtual traffic cop, allowing storage devices to be interconnected. A close look inside Brocade reveals some of the questionable practices now being exposed in the unfolding stock-options scandal. It also suggests why the scandal has engulfed so many Silicon Valley technology companies.

During the tech mania of the late 1990s and early 2000s, many firms were short of cash but high on promise. They used options as their primary lure and currency during the height of the boom. Pressure grew to make this currency as valuable as possible.

But any manipulation of stock-option grant dates can mean that a company has made false disclosures in the past -- a violation of federal law -- and perhaps has reported financial results incorrectly. Among dozens of companies now under federal investigation for options practices such as backdating them to low-price dates, several firms have already restated their financial results.

Brocade was early to do so. After an internal probe, the company twice restated past results, the first time in January 2005. The changes were significant. For example, Brocade originally reported a profit of $67.9 million in the year ended Oct. 28, 2000. In restatements, that became a loss of $951.2 million.

The company also relieved Mr. Reyes of his CEO duties and eventually terminated him.

Mr. Reyes was a tough manager who was known for firing questions at any employee who passed him by without making eye contact. Intensely competitive, he could make crude remarks about Brocade's competitors, referring to the main one, McData Corp., as "McDoodoo."

In a Halloween ritual at the company, employees would gather in a courtyard while Mr. Reyes stood on a chair, made a speech about the need to smash the competition, then took a baseball bat and shattered a pumpkin with "McData" carved on it. Another Reyes specialty: He sometimes startled staffers by chewing tobacco during meetings and spitting into a Styrofoam cup or empty mineral water bottle.

Mr. Reyes's lawyer says his client never personally benefited from options practices that have been questioned. "Financial gain is always the motive in securities fraud cases, and here, there was none," said the lawyer, Richard Marmaro. "There is not even an allegation of self-enrichment. Nor is there any evidence of criminal intent."

Mr. Reyes received several of his own options grants on highly favorable days, raising a question whether the dates might have been manipulated. One grant was dated Oct. 1, 2001, when Brocade closed at its lowest point of the year, after the Sept. 11 terror attacks had hurt the entire market. Two other awards to Mr. Reyes came at monthly stock lows.

Mr. Reyes said the board's compensation committee chose the dates, not him. Two members of the committee in that period, Neal Dempsey and Seth D. Neiman, didn't return calls. Records show Mr. Reyes never exercised any options he received after the company went public in 1999, though he sold hundreds of millions of dollars worth of shares received before the Brocade initial public offering.

Mr. Reyes spent much of his boyhood in Silicon Valley in a family of high-tech entrepreneurs. His father, Gregorio Reyes, had left Cuba in 1958 to study engineering in the U.S. and became a highly successful tech executive. An uncle, George Reyes, is Google Inc.'s chief financial officer.

The younger Mr. Reyes arrived at Brocade in mid-1998 as its new 35-year-old CEO. It was a small private company with only about 120 employees at the time.

He set out to expand Brocade fast. By 2000, the goal was to recruit 200 new employees every quarter. Not in a position to pay big salaries, Brocade instead held out the lure of stock options, offering even low-level employees a possibility of riches if the share price rose enough. It did: From a stock-split-adjusted price of $2.375 at the IPO in May 1999 it hit $133 on Oct. 23, 2000 -- a rise of roughly 56-fold.

Stories spread of Brocade employees making millions from stock options. "You had a lot of candidates very interested in Brocade because they knew Brocade from the stock," said Aleina McCarver, a former Brocade recruiter.

The process of granting stock options was cumbersome because the compensation committee met only every three months. Mr. Reyes said he wanted to speed it up so he could recruit better in those hectic days in Silicon Valley. The board gave him authority to approve options by himself, including their exercise prices.

He said the idea was supported by Larry W. Sonsini, one of the most prominent attorneys in Silicon Valley, who was then a Brocade director. A spokeswoman for his law firm, Wilson, Sonsini, Goodrich & Rosati in Palo Alto, said that one-person stock-option committees are legal under the laws of Delaware. That's where Brocade is incorporated. "One-person stock-option committees were adopted during a time of intense competition for hiring and retaining employees and the ability to act quickly was critical," said the spokeswoman for the law firm.

New hires were often granted options on the day they signed an "offer letter," even though they couldn't start for weeks because of the need to give notice to a current employer. But in October 1999, then-Chief Financial Officer Michael Byrd told Mr. Reyes that draft changes in accounting rules meant that new hires had to be working at a company to get options, according to internal email reviewed by The Wall Street Journal.

Part-Timers

Mr. Byrd recommended that new hires who couldn't start at once be given a chance to work up to four hours a week to qualify. Mr. Reyes said executives believed the part-time status also would help deter recruits from jumping to rivals before they had even started full-time.

An attorney for Mr. Byrd, who's no longer at Brocade, said, "Mike Byrd has been characterized as a witness in the government's investigation and has never been designated as a subject or target of that investigation. As the matter is the subject of ongoing civil litigation, Mr. Byrd does not believe it would be appropriate for him to comment on the allegations surrounding Mr. Reyes."

This process didn't always work out quite as planned. Mr. Canova's offer letter from Brocade, for instance, indicated that the future chief financial officer would get a batch of options as soon as he signed on. He agreed to become a part-time worker on Nov. 13, 2000. In the letter, he indicated that he would move to full-time status on Dec. 11, by which time the stock was up nearly 9%.

However, Brocade's stock sank in mid-December, erasing any potential gain for any options that would have been issued on either of those two dates. Records indicate that Brocade eventually resolved this problem by pricing the options for Mr. Canova not on Nov. 13 and not on Dec. 11 but on Dec. 21. The price that day was the bottom of the sharp price drop, and the lowest close of the second half of the year.

The difference between a Brocade option granted on his full-time start date of Dec. 11 and one on Dec. 21 would have meant $15.9 million more in profit for Mr. Canova had Brocade's stock price recovered and stayed up long enough for the options to "vest," or become exercisable. Instead, it stumbled, and Mr. Canova didn't reap any gain from the grant, according to securities filings.

Bradley Morgan, a former Brocade director of systems engineering, said she disagreed with the policy of making new hires part-time employees for options reasons. She said she hired 81 people for her department and didn't let any start part-time and get options early. "I just didn't think that was ethical," she said. "Some of the people had already been there through the start-up procedure and had given their body and soul, and I just didn't think people should come on and get the benefit of that."

Mr. Reyes said that he didn't recall ever having been made aware of her concerns and that he wasn't involved in details of how the part-time program was implemented.

At some point, former human-resources employees say, Brocade shifted to a procedure where a compensation committee determined a common grant date and exercise price for a whole group of new employees. The committee, however, consisted solely of Mr. Reyes.

One ex-employee said that a list of about 65 new hires would be submitted to the committee via Stephanie Jensen, then vice president of human resources. She would return with a printout, initialed by Mr. Reyes, listing closing prices for every day since the previous grant date. One date -- often close to the lowest, and several weeks in the past -- would be highlighted in yellow and be used as the grant date for the group, the ex-employee said.

Mr. Reyes said that he didn't pick grant dates based on the lowest share prices on any printouts, but rather selected dates when he believed the share price was relatively low. Ms. Jensen couldn't be reached for comment.

The fizzling of the tech boom kept many employees from benefiting from stock options. Though insiders sold more than $1.2 billion of Brocade stock from August 1999 to the end of 2000, according to Thomson Financial, hardly any came from options granted after the IPO. Only one top official exercised options after Brocade went public.

By February 2001, with the Internet boom fading fast, Brocade shares began falling sharply. Employees who hadn't exercised stock options or hadn't been there long enough for them to vest began to grumble. Brocade had given some employees large loans secured by stock options that were now worthless.

Offer Letters

It was around mid-2002 when a small group of staffers in human resources was asked to push forward the "start dates" of about five executives, several former employees said. One said Ms. Jensen inquired about how the company's database systems and backup tapes stored employee data. This former worker told of later being given folders, one at a time, containing revised offer letters of jobs for these executives. The new letters were dated several months after the original ones, so that options given when the executives came aboard could carry later dates, when the price was lower.

The former worker said he agreed to change the dates for two or three executives but then declined to change any more. He said Ms. Jensen told him he didn't have to continue. According to another person with knowledge of the episode, a supervisor changed the remaining records.

Mr. Reyes said he had no knowledge of such an incident. The company said it had "no comment related to the question of improprieties."

The unraveling of the options-granting practices began in late October 2004 with a call to Mark Cochran, then Brocade's general counsel. According to people familiar with the matter, the call was from an attorney for Dan Cudgma, a former Brocade sales executive who left in 2002.

Mr. Cudgma had received a $1.2 million loan from Brocade that was secured by his house in Needham, Mass., and never repaid. In April 2004, Brocade began court proceedings to foreclose on the house. Mr. Cudgma's attorney suggested in the October phone call that if Brocade did so, Mr. Cudgma would complain to the SEC that his stock options had been backdated, say people familiar with the situation. Mr. Cudgma didn't return calls seeking comment. Mr. Cochran declined to comment.

According to the people familiar with the matter, Mr. Cochran reported the conversation to the Palo Alto law firm where Mr. Sonsini, the director, was a partner. It contacted the board's audit committee, which brought in another law firm and a team of forensic accountants. After nine weeks, in January 2005, Brocade said the probe had determined that options granted under the part-time program were "incorrectly accounted for."

Brocade also said that it expected to restate some financial results because of its stock-option granting practices, including giving grants to employees who hadn't started working yet or were on a part-time basis.

Mr. Reyes prepared a short speech to defend himself to the board. "My actions as they relate to the issues at hand were always based on attracting and retaining top talent, which is one of the most important aspects of a CEO's job," he said in the speech on Jan. 7, 2005. "The majority of the issues ... deal with a period of time where hiring and retaining the best people was perhaps the most important thing I could do for the company." He went on to blame two high-level subordinates for "making many administrative errors with an embarrassing level of sloppiness" that he said he had not known about.

Brocade restated results on Jan. 24, 2005, and then again later. Buried in the January announcement was the disclosure that after six years, Mr. Reyes was stepping down as chief executive, but would remain as a consultant. "They never asked me to do a single thing" as a consultant, he said. Last July, the company terminated him.

Though Mr. Reyes never exercised any options, he sold at least $380 million of shares received before Brocade's IPO. Over time he bought a 12,000-acre California ranch and hunting grounds, an Alaskan fishing lodge, a stake in the San Jose Sharks hockey team, a 10,000-square-foot home in Saratoga, Calif., and more than a half-dozen cars including a Porsche and a Ferrari.

Mr. Reyes and Brocade are defendants in a suit by the Arkansas Public Employees Retirement System, filed in federal court in San Francisco by Bradley E. Beckworth of the law firm of Nix, Patterson & Roach LLP in Daingerfield, Texas. The pension fund says it lost nearly $2 million on Brocade stock and the suit alleges that Brocade defrauded investors through its options-granting practices. Mr. Reyes denies the allegations. Brocade has filed a motion to dismiss the suit.

--Charles Forelle contributed to this article.