KLA-Tencor Charged with Backdating

Swift, comprehensive action helped the high-tech company avoid fraud charges linked to an alleged options backdating scheme.
Stephen TaubJuly 26, 2007

The Securities and Exchange Commission has charged that KLA-Tencor Corp., and its former chief executive officer, were involved in an illegal scheme to backdate stock option grants. The company agreed to settle the charges.

The SEC charged that since 1997, the semiconductor equipment company concealed more than $200 million in stock option compensation by providing employees and executives with potentially lucrative “in-the-money” options while secretly backdating the grants to avoid reporting the expenses to investors. The regulator also charged that Kenneth L. Schroeder, the former CEO, repeatedly backdated options between 1999 and 2002, and once in 2005, even after he received advice from corporation counsel that retroactively selecting grant dates without adequate disclosure was improper.

“KLA dramatically overstated its reported financial results, depriving investors of accurate information about the company’s compensation costs and financial performance,” said Linda Chatman Thomsen, the SEC’s Director of Enforcement. “It is especially troubling for a public company to engage in such misconduct even after being cautioned that these practices were impermissible.”

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In laying out its case, the commission alleged that former company executives routinely used hindsight to issue options to employees priced at or near KLA’s lowest stock price of the preceding weeks. Although pricing the options below current prices required the company to report a compensation charge under “well-settled” accounting principles, former KLA officials avoided reporting the charges by falsely documenting that the options had been granted on an earlier date, according to the complaint.

The backdated grants “resulted in materially misleading disclosures,” the SEC asserted. It claimed that the company overstated net earnings in fiscal years 1998 through 2005 by as much as 156 percent.

In a separate complaint, the SEC charged that Schroeder repeatedly engaged in backdating after becoming CEO in 1999, including pricing millions of dollars worth of in-the-money options awards to himself. The regulator characterized Schroeder’s actions as “a potential windfall never disclosed to KLA-Tencor’s shareholders.”

What’s more, the complaint alleged that Schroeder received a legal memorandum in March 2001 cautioning that “the [b]oard and its committees are limited in their ability to grant options at a retroactive price without exposing the company to risk of an accounting charge. “The memo further warned that “[a]ny attempt to set a price before such a grant is made raises substantial risks under securities and tax laws [and] accounting rules and gives rise to disclosure obligations.” Nevertheless, Schroeder continued to backdate options, according to the SEC.

KLA-Tencor, without admitting or denying the allegations in the commission’s complaint, agreed to settle the matter by consenting to a permanent injunction against violations of the reporting, books and records, and internal controls provisions of federal securities laws. SEC officials stressed that the commission chose not to charge the company with fraud or seek a monetary penalty, based in part on the company’s “swift, extensive, and extraordinary cooperation” in the federal investigation, as well as its “far-reaching remedial measures.”

The company’s cooperation included an independent internal investigation and the sharing of the results of that investigation with the government. It also took significant remedial actions in response to the findings of its internal probe, including the implementation of new controls designed to prevent the recurrence of fraudulent conduct, removal of certain senior executives and board members, and the re-pricing and cancellation of retroactively-priced options held by several individuals, the SEC noted. “KLA-Tencor went to great lengths to clean house after discovering the fraud, and [its] cooperation greatly facilitated the government’s investigation,” noted Marc J. Fagel, associate regional director of the SEC’s San Francisco Regional Office.

The SEC alleged that Schroeder violated, or aided and abetted, violations of the antifraud, record-keeping, financial reporting, internal controls, lying to auditors, equity transaction reporting and proxy provisions of the federal securities laws. The complaint also charged Schroeder with signing false certifications, which are documents required by Section 302 of the Sarbanes-Oxley Act of 2002.

The regulator said it is seeking injunctive relief, disgorgement of ill-gotten gains, and monetary penalties against Schroeder, in addition to an order barring him from serving as an officer or director of a public company. In addition, the complaint seeks reimbursement of bonuses and profits from stock sales under Section 304 of the Sarbanes-Oxley Act.

In January, KLA-Tencor recorded $370 million in charges to correct its past accounting for stock options. The company took a $348 million pre-tax, non-cash expense for the period from July 1, 1994, to June 30, 2005, and $22 million for the year ended June 30, 2006.

Last October, the company announced that Kenneth Levy, founder and chairman of the board, had retired as a director and employee. He had served on the board since 1975, was chairman of the board since 1999, and CEO from 1975 to 1997, and from mid-1998 to mid-1999. In addition, general counsel Stuart J. Nichols resigned. The company also said it terminated all aspects of its employment relationship with Schroeder. He was president and chief operating officer from 1991 to 1999, and CEO and a member of the board of directors from 1999 through 2005.