Don’t Worry, Ben, It’s a Long Way to San Quentin

Photographer: Wittelsbach Bernd

Prison? Don’t worry, CEOs: It’s almost as hard to get sent in as to get out.

Pity the poor chief executive. Stooped with worry, deprived of true confidants, bound to the office via smartphone 24 hours a day, and all the while petrified of the cops banging down the door and hauling him off to jail for some tiny misunderstanding of the law.

Wait. Stop. Roll that tape back. CEOs worried about jail? For real?

Last week Ben Horowitz, a venture capitalist and partner at Andreessen Horowitz, published a post on his blog titled, “Why I Did Not Go to Jail,” about how he narrowly avoided falling seriously afoul of the law in an options back-dating scandal. In the post, Horowitz tells the story of “Michelle,” his chief financial officer at a software company, who’d advised him that it was okay to backdate options grants, something she’d done at her previous company with (according to Horowitz) her auditors’ approval.

In Horowitz’s telling, the only thing that kept him from following the advice of “Michelle,” whom he thought of as honest and straightforward, was running it by an excellent general counsel, who nixed it. Later, “Michelle’s” previous company was charged with accounting fraud, and “Michelle” wound up going to jail for three and a half months in what Horowitz calls an “arbitrary” handing out of prison terms. “In retrospect,” Horowitz writes, “the only thing that kept me out of jail was some good luck and an outstanding General Counsel, and the right organizational design.”

The point of Horowitz’s post is that every chief executive should make sure to hire a great general counsel and make sure that general counsel reports directly to the CEO. I certainly won’t argue that one; every media organization should have a great lawyer, too. By all means, let this song go out to all the attorneys we love.

Still, with many folks under the impression that startlingly few non-Enron connected white collar defendants go to jail, it’s funny that a top technologist and investor would feel so nervous that a mistake could send him to the slammer. So I decided to look back at the history a bit to figure out just what Horowitz’s CFO might have done. It turns out that it takes quite a few slip-ups.

Tracking down the real “Michelle” case wasn’t hard (the New York Times did it, too), because Horowitz is quite scrupulous with his facts. Horowitz’s company did in fact have a chief financial officer who went to jail over stock option improprieties at her previous employer. Her name is Sharlene Abrams.

When I reached Abrams on the phone last week, she said she hadn’t read Horowitz’s post and wouldn’t comment on his post or on her options backdating case. “I’ve been away from [Silicon Valley] for years,” Abrams told me. So we don’t have Abrams’ version of the story — but there’s a lot we can reconstruct from the public record.

Abrams, together with her boss, Amnon Landan, were sued by the Securities and Exchange Commission over backdating options in the late 1990s and early 2000s. As Horowitz says, that kind of backdating — setting a lower stock price for options to effectively guarantee employees a profit — was a common practice in Silicon Valley. At the time, many folks in Silicon Valley saw it as a practice with no losers. Accounting rules would have required a company that issued below-market-price options to report many millions in compensation expenses. But that “expense” didn’t involve spending actual money. So it seemed easy enough to backdate the options, giving free money to employees and not really harming anyone.

Now, you can argue about how sensible or stupid the accounting rules were, but even if you thought they were stupid (and let’s repeat: a lot of people in the technology industry thought they were stupid) it seems that something might have struck you as strange about more or less giving away money. And we’re talking about major numbers here. On one day in 2000, at the height of the dotcom frenzy, Abrams’ company backdated options on close to 2.493 million shares, cutting the price by more than $20 a share. So that’s $50 million in free money.

SEC chart of backdated options

Source: U.S. District Court, Northern District of California

Part of a chart of options grants that the SEC alleged were backdated at Mercury Interactive, where Sharlene Abrams was CFO.

Again, accounting rules are complicated. So let’s add another wrinkle that might make you skeptical. Horowitz says that “Michelle” told him that backdating options was an important retention technique. That may be true, but some of the folks benefiting from this retention technique were, well, the CEOs and CFOs doing the backdating. You might think that when you’re handing out options to yourself you’d be extra careful (Caesar’s wife etc. etc.) about just how aggressive your interpretation of the rules was. According to the SEC’s complaint, Abrams’ boss at Mercury Interactive made more than $3 million on one backdated options grant.

Now that still doesn’t really settle things. Just because you’ve taken an interpretation of the rules that seems to be markedly in your own favor, that doesn’t mean it’s wrong. And in fact all the charges that I sketched so far did not send Abrams to jail. Both Abrams and her boss settled with the SEC by paying fines and restitution, without admitting or denying guilt. Which, you may notice, is pretty much how most of the white collar impropriety you read about is resolved.

To get from that to jail you need to add another chapter to the story: Once you backdate options, you’re confronted with a whole new set of choices. Like, if you backdate the options grant date, why not also backdate the exercise date? What if changing the exercise date can help your employees save money on their taxes? And while we’re talking about those employees, well, what about your own taxes, too? And by the way, what do you put on your year-end tax forms? Start with one legally iffy interpretation of the rules, and you invite a cascade of related questions.

Abrams did not actually go to jail for backdating stock options. What she pleaded guilty to in a criminal case was listing a false exercise date for her options on her tax returns. That meant more of her profits got taxed as capital gains (at a lower rate), less as ordinary income. Lowering your marginal tax rate is a silly reason to risk jail, but that’s a separate question. In his post, Horowitz says, “Michelle ultimately served 3 1/2 months in jail for her part in [her old employer’s] stock option practice — the same practice that we nearly implemented at Opsware.” Well, sort of. Certainly the charges against Abrams were a consequence of the backdating investigation.

It’s safe to guess, though, that backdating company loans to executives (something else that happened at Abrams’ earlier company) and switching around exercise dates to cut his own taxes weren’t practices Horowitz was planning to implement. You don’t need a great general counsel to steer clear of this. Just following the instructions on TurboTax would probably do it.

That isn’t quite the end of the story. Presumably there are accountants with a more intricate understanding of tax law than Intuit’s instructions. Problem is, it’s not clear that the accountants at Abrams’ old firm were as accepting of all that options backdating as Horowitz’s narrative says. On the contrary, the SEC’s specifically alleged that Abrams misled the companies auditors, and to back it up sought to introduce the auditors’ notes as evidence. So getting things straight with your accountants may be another way to head off this kind of unfortunate legal entanglement. And, again, that’s before we get to the tax issues that actually sent Abrams to jail.

Horowitz, whom in our short conversation Abrams called  “a very smart guy,” seems to have had at least some inkling that there was an issue with Abrams’ advice from the beginning. He was leery enough of it to run it by his general counsel, right? And the answer he got from his excellent general counsel — “Ben, I’ve gone over the law six times and there’s no way that this practice is strictly within the bounds of the law” — doesn’t make it sound like this was a close call.

Ben Horowitz seems to have done everything right here. He did basic some basic due diligence, found that an idea that sounded suspect in fact was, and decided not to do it. So give him all appropriate credit here. But Horowitz didn’t have to do everything right in this scenario to stay out of jail. He just had to do something right — any bit of common sense or due diligence along the way would have been enough.

As Horowitz tells the story, Abrams’ plan would have yielded “a more favorable result for employees.” Worth repeating: one of the employees it yielded favorable results for was herself. So there’s a revised lesson for you: If you’re about to stretch the boundaries of common sense and basic good corporate governance in ways that are extremely favorable to your own finances, check with a good attorney first. It’s a little bit sad to think that there are corporate executives who would benefit from even that pallid advice.

Update/disclosure: Bloomberg LP is an investor in Andreessen Horowitz.

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