Options Pricing Scandal Could Hit Tech Vendors' Customers

Mercury Interactive, McAfee, CA, Affiliated Computer Services, Quest Software, and Comverse Technology all have something in common--and it's not good. They've all admitted to problems related to stock option pricing, but they're only a handful of some 60 companies, most of them IT vendors, caught up in this latest American corporate scandal.

For some of those 60, it's just allegations or investigations. In most cases, it involves inappropriate "backdating," where executives and sometimes rank-and-file employees exercise stock options based on an earlier, lower stock price than the day of the grant, resulting in inflated returns. This practice becomes illegal if it isn't properly reflected in earnings or taxes. The Sarbanes-Oxley Act of 2002 has brought even tighter controls, requiring companies to disclose stock option grants within two days.

By themselves, these options scandals won't mortally wound any IT vendor. But they're a huge distraction, as top executives focus on keeping their jobs amid falling stock prices, rather than on product innovation and customer satisfaction.

"If they're cooking the books there, then what else are they not doing?" asks Bruce Woods, manager of software quality at Burlington Coat Factory Warehouse, which uses Mercury Interactive's LoadRunner and WinRunner software for testing IT loads. Mercury last week said it would erase $567 million in profits from 1992 through 2004--dunking the entire 2003 fiscal year into the red--and will spend $70 million to clean up the accounting mess related to backdated options.

Woods says the whole thing stinks of dishonesty, and he wonders if the distraction explains why his engineers aren't seeing expected fixes and enhancements to Mercury software. Mercury is deeply ingrained in Burlington's IT environment, but Woods says he's more open to alternatives. Mercury officials declined to be interviewed.

Culture Of Greed
SEC chairman Christopher Cox last month called the "apparently widespread" practice of covert backdating "of serious concern." The tech industry has been the worst offender, particularly in the dot-com boom years. "There was a culture in the United States where greed had gotten ahold of a lot of people in the technology industry," says Steven Ashley, a financial analyst with R.W. Baird.

Mercury's case has brought some of the toughest reactions. The company's still reporting strong sales of its IT management software, but the one-time Silicon Valley highflier was delisted from Nasdaq in March for delays in filing financial reports because of accounting problems, which also led to the earlier firings of CEO Amnon Landan, CFO Douglas Smith, and general counsel Susan Skaer.

Here's an example of backdating: As of Jan. 6, 2000, Mercury's stock had dropped 20% in 10 trading days to close at $81.44. Eleven days after that, it was up to $136.25 a share. The company granted former CEO Amnon Landan 350,000 options based on the Jan. 6 price, which earned him an incredible $19 million paper gain in just a few weeks. It wasn't just fortuitous timing. Mercury last month canceled those options and then last week said it has found 54 instances of improperly dated stock options since 1992.

Mercury and other companies face Securities and Exchange Commission investigations, and in some cases, Justice Department and criminal prosecutors are investigating, too. Shareholders are filing lawsuits; Apple recently became a defendant after announcing that an internal investigation found irregularities in stock option grants. Just last week, the SEC turned up the temperature by telling Mercury it might file civil charges against three company directors and the former CFO.

The stock market hasn't punished offenders across the board. Mercury's stock price fell 27% after it first disclosed stock option irregularities last fall, but it has since recovered and last week was trading higher than it was just before the disclosure. Shares of application management vendor Quest dropped 10% in a four-day period last week on news it would restate earnings, and shares of Marvell Technology Group, which just got an SEC inquiry and a grand jury subpoena from the U.S. Attorney's Office regarding stock option practices, dropped 8% in that time period. Like Mercury, those stocks could rebound. But chip company Altera has lost 22% of its value since announcing its discovery of stock option irregularities in May.

While the full impact on Mercury hasn't yet been determined, CA provides an example of what can go wrong for a tech company riddled by accounting problems. CA has replaced at least 10 top executives since late 2003, paid $225 million in fines, and watched as its former CEO and CFO plead guilty to fraud. Though the company has tried to focus on keeping customers happy, some aren't, claiming excessive account-director turnover. New customers require a lot of convincing that CA is on the right track, and at least one company that left during the peak of the turmoil, Burlington Coat Factory, hasn't returned. CA continues to stumble: It recently announced it will restate hundreds of millions of dollars in earnings because of improper reporting of sales commissions and subscription revenue, as well as stock option irregularities.

Tech Companies The Worst
At least 10% of all stock option grants from 1996 to 2002 were covertly backdated, concludes recent research by Erik Lie, associate professor of finance at the University of Iowa, and Randall Heron, associate professor of finance at Indiana University. They think the actual percentage was even higher. "I don't think we will ever see the entire iceberg," Lie says.

Besides causing companies to restate earnings and shake up management, improper backdating hides compensation from shareholders and uncouples performance and compensation. When disclosed, that leads to all the restatements and stock hits we're seeing today. Those who cash in on covertly backdated options could face tax penalties.

The SEC and prosecutors don't seem interested in staff-level employees who weren't involved in designing such schemes. "I don't see any evidence that anybody out there is calling for remedies here that are going to hurt innocent parties," says Donald Langevoort, a Georgetown University securities law professor. In one case of possible backdating, storage area network vendor Brocade Communication Systems offered to replace some options for employees with ones that had higher exercise prices and paid the difference in cash.

Customer Beware
It's too early to tell how extensively backdating will affect customers. In general, problems of corporate governance and integrity don't cause major problems for buyers unless the company becomes unstable, R.W. Baird's Ashley says. "If you think that they're going to have some issues that distract or otherwise affect them externally, that could affect purchasing decisions," says Cindy Shaw, an analyst with Moors & Cabot Capital Markets. "However, that's going to be the extreme case."

IT buyers could even turn backdating into a bargaining chip. "You can say, 'OK, the company's going to have a bad quarter, so it might be more likely that they can give me concessions,'" says Ditka Reiner, president of Reiner Associates, which helps companies negotiate contracts with IT vendors. "You want to make sure to get some advantage in the negotiations."

At the University of Florida, Mercury's revelations haven't done a thing to change the school's relationship with the software vendor. "If it got bigger, there would come a time, but that time has not yet come," says Mike Conlon, director of data infrastructure.

Because of Sarbanes-Oxley, businesses are less likely to see their IT vendors hit by post-2002 stock option problems. Once in effect, backdating instances dropped almost 80% overnight, says Iowa U.'s Heron. Now, companies must report all stock options as expenses on earnings reports. Credit Suisse First Boston says expensing options could cut earnings per share 3% and finds that companies expensing options tend to offer fewer options than those that don't.

Microsoft has acknowledged it routinely priced options at monthly lows from 1992 to 1999, when it ended the practice and took a $217 million charge against earnings. The company has said setting strike prices at monthly lows is perfectly legal. But that approach also appears to weaken the link between performance and reward.

Three years ago, Microsoft stopped awarding stock options altogether, instead granting restricted Microsoft shares to a wide range of employees. CEO Steve Ballmer said the move would boost morale and retention at a time when many employees' options were underwater. Microsoft also began treating the cost of stock awards as expenses on its books.

Intel also has ended stock option grants and moved to restricted stock, which employees don't pay for and doesn't carry as much risk--or as much high-growth potential.

Still, it's nowhere near the death of the stock option. Barbara Baksa, executive director of the National Association of Stock Plan Professionals, says companies are cutting back on the size of awards, and employees receiving restricted stock probably receive fewer shares. She suggests other companies might move to stock plans that let employees cash in only if the stock appreciates, to performance-based stock grants, or to cash in lieu of stock options. She adds that although Microsoft and Intel have gone with alternatives, don't expect the entire industry to follow. Even Mercury continues to give out stock options.

There's a rough road ahead. The widening probe and the SEC's suggestions of civil prosecution will intensify the scrutiny and renew the debate about out-of-control executive compensation. Stock compensation at IT companies won't disappear, but it may come in different forms and be subject to more regulations. Since it involves years-old actions, there's nothing customers can do to avoid vendors that might face problems. Their best bet is to watch for distractions--and keep their own options open.

-- With Aaron Ricadela

This story was updated on July 10.