Los Angeles Times
By Stuart Pfeifer
January 7, 2010

Launching a prosecutorial misconduct defense that was effective for Broadcom Corp. executives, former KB Home Chief Executive Bruce Karatz has accused federal prosecutors of manipulating witnesses in his upcoming option-backdating trial.

In a motion filed this week in federal court in Los Angeles, Karatz’s attorney said two former KB Home employees who once supported Karatz later changed their accounts after meeting with federal prosecutors and FBI agents. The attorney cited the change as an indication of prosecutorial misconduct.

The defense motion came three weeks after alleged prosecutorial misconduct prompted a federal judge in Orange County to throw out option-related prosecutions of Broadcom co-founders Henry Samueli and Henry T. Nicholas III as well as the company’s chief financial officer.

The judge said prosecutors had improperly pressured witnesses, impeding the executives’ ability to defend themselves.

“What happened in Broadcom will cause defense lawyers to pursue these misconduct allegations because for the first time there’s a possibility such arguments will be heard and acted upon by judges,” said Wayne Gross, former chief of the U.S. attorney’s office in Santa Ana, who now practices white-collar defense with the Irvine office of law firm Greenberg Traurig.

“Defense lawyers often assumed that coercive tactics by prosecutors and agents, though repugnant, would be overlooked by judges if ever brought to their attention. So defense lawyers let it go,” Gross said.

Karatz singled out two witnesses in the case: James Johnson, former chairman of the Westwood home builder’s compensation committee, and Gary Ray, the company’s former vice president of human resources. They have both told prosecutors that they believe the company inappropriately changed option dates to enrich employees, the motion said.

“Both firmly believed that the stock option grant practice was lawful and they were willing to say so,” Karatz’s attorney, John W. Keker, said in the motion filed Monday. “Once the prosecutors got ahold of them, that changed.”

Thom Mrozek, spokesman for the U.S. attorney’s office in Los Angeles, which is prosecuting the case, declined to comment. He said his office would file a response to the allegations in court.

Keker cited the Broadcom case in his motion, asking U.S. District Judge Otis D. Wright II to hold a hearing to determine whether “that same right has been deprived here.” The judge is scheduled to consider the defense request at a Feb. 8 hearing in Los Angeles.

Karatz, 64, who rode the housing boom to become one of the highest-paid executives in the country, is scheduled to stand trial Feb. 23 on 20 counts of fraud and making false statements related to an investigation of the company’s option grants. He has pleaded not guilty and denied any wrongdoing.

Prosecutors accused Karatz of backdating stock option grants to himself and employees from 1999 to 2006 without disclosing the practice in regulatory filings.

Stock option grants allow employees to purchase stock at a set price — usually the price on the date of the grant. If the stock price rises, employees can exercise their option to buy the stock at a low price and make risk-free profit. Backdating the options to a date when the price was lower can make them even more valuable.

Companies are allowed to backdate option grants as long as they account for it. In the KB Home case, the backdating was not disclosed to shareholders until nearly a decade after it began. The company ultimately adjusted its financial statements to account for $70 million in options-related expenses.

The two potential witnesses, Johnson and Ray, were each deeply involved in KB Home’s option grants.

In a 2006 interview with an outside law firm investigating KB Home’s option grants, Johnson said it was commonly understood that management was free to select option grant dates. Two years later, in a meeting with prosecutors and federal agents, Johnson said he did not believe it was proper for management to set the grant dates, the defense motion said.

“How and why Mr. Johnson made two such distinct sets of statements, going so far as to falsely deny having made the first set, is an issue of the utmost importance,” Keker said in the motion.

Federal authorities began investigating option practices in 2006 after academic studies showed that scores of companies, many of them technology firms, had dated option grants retroactively to make them more valuable to employees and, in some cases, to the executives who granted them.

By February 2007, the FBI said it had 61 active option-backdating investigations, and the Securities and Exchange Commission was looking at more than 100 firms for possible civil enforcement actions.

The cases have proved to be difficult for prosecutors.

In 2008, the former general counsel for computer security company McAfee Inc. was acquitted of option-backdating charges. Prosecutors won a conviction in the case of former Brocade Communications Systems Inc. Chief Executive Gregory Reyes, only to see the conviction overturned on appeal.

Then came the surprise decision in the Broadcom case. U.S. District Judge Cormac J. Carney threw out the charges after concluding that prosecutors’ heavy-handed interactions with witnesses had “distorted the truth-finding process and compromised the integrity of the trial.”

Samueli later returned to work at the Irvine chip designer as its chief technical officer. The fallout appears to have reached beyond Broadcom.

Gross, the former federal prosecutor, said he expected prosecutorial misconduct allegations to become commonplace: “Judge Carney’s ruling, by pulling the curtain on such abuse and doing something about it, will continue to embolden defense lawyers to take more aggressive action, as was done here by Karatz.”