KB Home ex-CEO tried to keep stock option scheme secret, an executive testifies

Former KB Home chief Bruce Karatz engineered a massive stock option scheme that made him millions of dollars and then fought to keep it secret from investigators, a longtime company executive testified Wednesday.

Gary Ray, who served as KB’s human resources director from 1996 to 2006, told a federal jury in Los Angeles that he and Karatz backdated stock options to make them more valuable to themselves and employees and then concealed it from company shareholders and the Securities and Exchange Commission.

When the company launched an internal investigation in 2006, he said Karatz told him “to put the best interests of the company ahead of the truth,” and deny that they had carefully selected dates when the stock price was low to make options more valuable. The scheme had enabled Karatz to make more than $6 million in additional profit from his options, prosecutors say.

Ray, 52, is at the center of the government’s prosecution of Karatz, who faces 20 felony charges including securities fraud and making false statements about the stock option program to regulators. Ray pleaded guilty last year to conspiring to obstruct justice and agreed to testify against Karatz. In exchange for his testimony, prosecutors have agreed to recommend leniency when Ray is sentenced.

Ray said Karatz instructed him to backdate employee stock options from 1999 to 2005, carefully choosing dates when the stock price was low so that the options would be more valuable. He said Karatz lied to the company’s chief legal officer about the backdating in the hopes they could fend off regulators.

“He specifically said, ‘We don’t look back. We’ve never looked back. It’s not something we do in this company,’ ” Ray said. “It was Mr. Karatz’s belief we had to make sure we keep this within the company.”

Ray said Karatz was so concerned about avoiding scrutiny of the company’s options plan that he asked him to fire a company lawyer who had questioned the backdating. KB did not fire the lawyer because of concern he might be protected as a whistle-blower, Ray said.

Karatz, who is free on bond, has pleaded not guilty and denied any wrongdoing. Defense lawyer John Keker told jurors in his opening statement that neither Karatz nor Ray knowingly broke any laws, saying they handled options the same way that many other companies did. He said Ray had agreed to plead guilty because he was afraid of a possible prison sentence.

The defense lawyer also said Ray changed his story about the way the company handled options during 17 meetings with prosecutors before the trial, initially denying wrongdoing and now describing a scheme that he said violated federal law. Keker is scheduled to begin cross-examination of Ray on Thursday morning.

Despite his insistence that he did nothing improper, Karatz paid $7.2 million in 2008 to settle a lawsuit filed against him by the SEC. Of that amount, more than $6 million was returned to KB for what the SEC determined were ill-gotten profits from the backdated options.

By taking the witness stand, Ray completed a surprising transformation from being one of Karatz’s top confidants to his chief accuser. Karatz recruited Ray from PepsiCo Inc., put him in charge of the company’s stock option plan and invited him to exclusive employee compensation meetings in California at resort hotels in Pebble Beach and Carlsbad.

Stock options are a form of compensation that allows employees to buy a set amount of stock at a set price -- usually the closing price on the date they’re granted. If the stock price increases over time, employees can exercise their option to buy at the lower price and sell at the higher price for a profit.

If a company handpicks an option date when the stock price was low, employees can make even bigger profits.

Backdating is not illegal as long as companies account for it in public filings. KB Home did not acknowledge the practice until 2007, when it acknowledged $70 million in previously unreported option liabilities from 1998 through 2005.

Karatz, indicted by a grand jury last year, was one of several high-priced executives the government accused of options-related malfeasance. By that time, Ray had already pleaded guilty and agreed to testify as a prosecution witness.

Under questioning from Assistant U.S. Atty. Alexander A. Bustamante, Ray said he had made “the biggest mistake of my career, if not the biggest mistake of my life,” by trying to conceal the backdating of stock options.

“I have not forgiven myself for that mistake,” Ray said, his voice trembling. “It caused a great deal of pain for my family.”

Ray, who is due to be sentenced July 12, has paid $1 million to settle a lawsuit KB filed against him about the backdating scheme. He also agreed to give up retirement and deferred compensation benefits.

stuart.pfeifer@latimes.com