In his last three years as chief executive officer of KB Home, Bruce Karatz made $232 million, most of it from stock options of the high-flying homebuilder.

But many more options were backdated so that Karatz could pocket millions of dollars in undisclosed compensation, say federal prosecutors in Los Angeles, who go to trial on Tuesday against Karatz.

With the KB Home case, prosecutors are looking to improve upon their dismal trial record in stock-options backdating cases. Of the five cases that have gone to trial, three have resulted in convictions, but one was reversed last year due to findings that prosecutors had misstated facts to the jury during closing arguments. A fourth ended in acquittal, while another case collapsed near the end of trial after the judge found that prosecutors had inappropriately influenced and intimidated witnesses.

This time around, the government appears to be shifting strategies.

Most important, prosecutors are focusing the case on Karatz’s profit from the backdated options. It’s a relatively new strategy that emerged last month in the government’s retrial of former Brocade Communications Systems Inc. CEO Gregory Reyes, whose prior conviction was reversed on appeal.

By making the case about personal gain, prosecutors are looking to establish a motive for the crime, something that had been lacking in past backdating cases. The strategy is also meant to defeat the defense’s main argument: that the practice of backdating couldn’t be criminal since everybody was aware of it, or that the defendants relied on their accountants and lawyers to advise them about a murky accounting rule.

“That makes for a more attractive case in front of a jury if you can show the defendant getting money in his pocket as a result of the crime,” said Evan Barr, a partner at Steptoe & Johnson LLP‘s New York office. Barr represented James Treacy, the former chief operating officer of Monster Worldwide Inc., who was convicted in a backdating case last year after the government accused him of making more than $13 million from backdated options. “Otherwise, it’s a very abstract crime.”

The government started out strong in its backdating cases with two significant successes, the 2007 convictions of Reyes and Stephanie Jensen, the former vice president of human resources at Brocade. Reyes was sentenced to 21 months in prison, while Jensen faced four months. Prosecutors have also secured several guilty pleas.

APPELLATE REVERSAL

But on Aug. 18, the 9th U.S. Circuit Court of Appeals reversed Reyes’ conviction because of prosecutorial misconduct. Specifically, the appeals panel found that prosecutors told the jury during closing arguments that Brocade’s finance department was left in the dark about the backdating, even though prosecutors knew that several executives in that department had admitted to the backdating in FBI interviews. Those executives did not testify during the trial. The 9th Circuit affirmed Jensen’s conviction but sent her case back to the lower court for resentencing. Her sentence was reduced to two months.

In October 2008, the government lost its backdating case against Kent Roberts, the former general counsel of what is now McAfee Inc., a security software firm in Santa Clara, Calif. In December 2009, a federal judge threw out the government’s backdating case against two former executives of Broadcom Corp., a technology firm in Irvine, Calif., concluding that prosecutors had committed misconduct by inappropriately influencing and intimidating witnesses in the case.

The main defense argument in most cases has been consistent. Defendants assert that backdating was an accepted practice they believed to be legitimate and legal, said James Sanders, a former federal prosecutor who is now a partner in the Los Angeles office of Reed Smith. Defendants frequently point out that hundreds of other companies were forced to restate their earnings due to the same conduct. “And that’s not the kind of conduct that should result in criminal sanctions,” he said.

The KB Home case is especially important for the U.S. Attorney’s Office for the Central District of California, which is trying to recover from the failed Broadcom case that was run out of the Santa Ana office. In that case, U.S. District Judge Cormac Carney of the Central District of California found that prosecutors had “distorted the truth-finding process” and made a “mockery” of the defendants’ due process rights.

Karatz’s trial is being handled by two prosecutors from the Los Angeles office: Alex Bustamante and Paul Stern. In 2007, Bustamante received the Justice Department’s highest award for obtaining the convictions of four gang members who were targeting blacks in the Highland Park neighborhood of Los Angeles. The case was the first to use the federal hate-crime statutes to charge street gangs with racial violence.

Stern declined to comment, and Bustamante did not return calls for comment.

Karatz’s lawyer, John Keker, founding partner of San Francisco’s Keker & Van Nest, is a formidable foe, having handled some of the Central District of California’s biggest cases in recent years. He represented Carter Bryant, the former Mattel Inc. employee whose designs sparked a high-profile copyright dispute between the Barbie manufacturer and the company that makes Bratz dolls, as well as Univision Communications Inc. in its bet-the-company trial last year with Mexican media giant Grupo Televisa S.A. Keker also represented William Lerach in the government’s kickback case against his former firm, Milberg Weiss Bershad & Schulman, now called Milberg. Another partner at Keker’s firm, Jan Little, represented Jensen in her backdating trial in San Francisco.

Keker declined to comment, but in court papers filed last week he wrote: “In 2006, in the face of considerable confusion about what was and what was not ‘backdating’ as the term began to be used, Bruce Karatz made plain that he favored a thorough investigation by independent counsel of past practices. At no time did he ‘scheme to defraud’ or act with criminal intent.”

NEW OPTIONS

Karatz was indicted last year on seven counts of mail fraud, five counts of wire fraud, three counts of securities fraud, four counts of making false statements in filings with the U.S. Securities and Exchange Commission and one count of lying to accountants. If convicted of all the charges, he faces a maximum sentence of 415 years in federal prison. In its March 2 trial memorandum, the government puts the profit motive up front. “Defendant was himself the principal beneficiary of this fraud, typically receiving between 250,000 to 600,000 stock options annually, which was roughly one-half of the total number of annual options awarded to KB’s corporate officers,” the memo states.

Barr, who represented Monster executive Treacy, said prosecutors pushed the profit motive in the case against his client. Treacy was alleged to have made more than $13 million in compensation from backdated options, a large chunk of the $23 million he received during his four years as an executive at the company.

“That was a big, big part of their case,” Barr said. “Obviously, it was an important reason why they prevailed.”

During Reyes’ retrial last month, prosecutors told the judge that they plan to introduce — for the first time — evidence of options that the defendant personally received.

In the first trial of Reyes, prosecutors attempted to prove criminal intent by telling the jury that the finance department didn’t know about the backdating — a statement that landed the government in hot water before the 9th Circuit.

“The fact that prosecutors were pushed to make those representations to the jury indicates how important the prosecutors recognized they were to suggest there was evidence of mens rea,” or a guilty state of mind, said Larry Ribstein, a professor at the University of Illinois College of Law.

Alleging personal profit also steers the government’s case away from a debate about the accounting rule at issue, which has served as a common defense in many backdating cases, Barr said. In general, the accounting rule, referred to as Accounting Principles Board Opinion No. 25, required that companies disclose in public filings the expenses they incurred when granting options that were “in the money,” or below the current market value. Option grants that were “at the money,” meaning at the current share price, didn’t need to be disclosed. In the KB Home indictment, the government avoided all mention of the accounting rule.

But prosecutors must still prove that the backdating was knowing and intentional, Barr said. In his trial memorandum, filed on March 3, Karatz said that the evidence in trial will show that he never thought he had committed a crime when he set grant dates. Instead, he and KB Home’s former human resources chief, Gary Ray, who pleaded guilty to obstruction of justice and is serving as a government witness, “believed they were playing by the rules as they existed then. Ray thought the stock option process was proper and legal, as did Karatz, as did the legal staff who were informed of it, as did the accountants who looked at it.” In the KB Home indictment, the government doesn’t even specify the amount of compensation Karatz allegedly earned from the backdating, simply stating “millions.”

And then there’s the elephant in the room: prosecutorial misconduct. Last month, U.S. District Court Judge Otis Wright of the Central District of California rejected Keker’s request to hold an evidentiary hearing regarding potential misconduct in the case. Keker had questioned the reliability of two government witnesses, drawing parallels to the Broadcom case. Wright denied the motion, calling Keker’s argument “astonishing,” given that he had no evidence beyond that “little matter in Santa Ana” to assert misconduct.

For prosecutors, it’s a small but significant victory. “Basically, almost nothing has worked for the government,” Ribstein said. “Prosecutors are going to face these problems, these troubles, in almost every backdating case.”

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