The SEC’s settlements of options backdating civil enforcement actions against Brocade Communications and Mercury Interactive received extensive coverage in the financial press last week (refer here and here). But there are several features of these settlements and the underlying civil actions that merit closer attention, particularly with respect to the Mercury Interactive action and settlement. The SEC’s Mercury Interactive litigation release and complaint can be found here and here The SEC’s Brocade Communications litigation release can be found here.
One aspect of the Mercury Interactive civil enforcement action that is particularly noteworthy is the sheer accumulation of numeric detail. The complaint alleges that all 45 of the company’s stock option grants made to executives and employees during the period 1997 to April 2002 were backdated, some by as much as four months, causing “Mercury to fail to record over $258 million in compensation.”
This apparently comprehensive program of options backdating stands in odd contrast to the option plan arrangement that Mercury’s shareholders approved. According to the complaint, not only did the shareholder approved plan specifically require all options grants to be priced at 100% of fair market value at the date of the grant, but the shareholders had earlier rejected an option grant plan that would have permitted the stock options to be granted at less than fair market value. In order to create the appearance that the backdated grants (which were in the money when they were actually awarded) were priced at 100% of the fair market value, the Company’s former general counsel allegedly created falsified written consents and meeting minutes, and other false reports to create the appearance that the approvals had taken place at the earlier date. (Law.com has a June 1, 2007 article entitled “SEC Says Former Mercury GC Falsified Records” (here) that examines in greater detail the SEC’s specific allegations against the Mercury’s former general counsel.)
But perhaps even more interesting that the options grant backdating allegations are the allegations in the complaint relating to options exercise backdating. Through this process, several corporate officials were able to report that they had exercised their options earlier than the actual exercise date. The company’s stock was trading lower at the selected earlier date, which reduced the apparent spread between the strike price and the market value on the reported exercise date. Because the amount of this spread is taxed as ordinary income, the use of the earlier date with the lower market price permitted the officials to minimize the gain that would have to be reported as ordinary income. The underreporting reduced the tax deduction benefit to the company as well. The backdated exercise date also shortened the period the officials had to hold the stock in order for gain on any stock sales to be taxed at the lower capital gains rate.
One official’s tax benefit from the exercise backdating was as much as $17.7 million, and another official’s benefit was as much as $2.2 million. In some instances, these officials allegedly were backdating their exercise on backdated options. (Refer here for my prior post on exercise backdating.)
The complaint also contains other allegations not directly related to backdating. For example, the complaint also alleges that the defendants manipulated its revenue recognition in order to manage the company’s reported earnings per share. The complaints also alleges that the defendants fraudulently structured loans for overseas employees’ options exercises to conceal the loans’ accounting consequences, causing the company to fail to report $24 million in related compensation expense.
All in all, it is difficult to disagree with the assessment of Peter Henning, the Wayne State law professor who maintains the White Collar Crime Prof blog, in the Law.com article (here), that the company had a “widespread culture of fraud.”
Yet there are nevertheless a couple of things that trouble me. It had been discussed in the press for some time that the SEC Commissioners were struggling with the question whether or not to impose civil fines directly on the companies involved in the backdating scandal. (Refer here for a Bloomberg.com article discussing the Commission’s debate about whether or not to approve the $7 million Brocade settlement). There is an awkward question about the imposition of civil penalties on corporations for past violations, since the financial burden falls on current shareholders.
The Mercury civil penalty put this question in sharp focus since Hewlett Packard acquired Mercury on November 8, 2006, and Mercury is now a non-trading subsidiary of HP. The burden of Mercury’s civil penalty falls on HP’s shareholders, who of course have nothing to do with what happened at Mercury. And while it may be surmised that the acquisition price that HP paid for Mercury was discounted due to the uncertainty surrounding the SEC’s investigation, that does not eliminate the question surrounding the purpose of the corporate civil penalty.
With the Brocade and Mercury Interactive settlements, it is clear that the SEC has resolved its internal debate and is now committed to pursuing civil penalties against at least some of the companies involved in the options backdating scandal. The imposition of corporate civil penalties to be borne by current shareholders for past misconduct does raise questions about the punitive or deterrent value of the penalties; it is hard not to wonder whether the penalties are misplaced. And why was Mercury Interactive’s settlement $28 million and Brocade’s $7 million?
To be sure, the SEC’s civil enforcement actions against the individual officials at Brocade and Mercury Interactive are continuing. It remains to be seen what penalties (if any) these individuals will face. Along those lines, however, one very interesting omission from the Mercury Interactive civil enforcement complaint is the absence of any reference in the civil complaint to Mercury’s former outside directors. As Mercury disclosed prior to the HP merger (here), three individual Mercury Interactive outside directors had been served with Wells Notices in connection with the SEC’s investigation. However, the only individuals named in the SEC’s civil enforcement complaint were former Mercury officers; no former outside directors were named. UPDATE: Alert reader Uri Ronen points out that the SEC’s press release (here)announcing the Mercury Interactive enforcement action specifically states that “The Commission’s investigation is continuing.” As the SEC Actions blog notes (here), the Brocade Communications release does not mention that the investigation is continuing. The statement in the Mercury Release about the continuing investigation suggests at least the possibility that there could be further actions brought in the future.
One final note– the SEC, in its civil complaint, could not resist adding the following detail when describing Mercury’s software business: “One of the product solutions [Mercury] sold was marketed as a means to implement best practices frameworks for Sarbanes-Oxley compliance.”
Special thanks to alert reader Lauren Murphy Pringle for providing several links relating to the Mercury Interactive settlement.
Lerach Status: As I noted in a prior post (here), rumors continue to circulate about Bill Lerach’s possible retirement from the Lerach Coughlin law firm and a possible link between his supposed impending retirement and developments in the Milberg Weiss criminal investigation. Perhaps the most provocative article the rumor mill has produced it the Los Angeles Times’ June 1, 2007 article (here), relating to Lerach’s possible retirement, entitled “Class-Action Lawyer Could Face Charges.” The WSJ.com Law Blog has a good summary (here) of the various stories currently in circulation.
According to a separate WSJ.com Law Blog post (here), the Lerach Coughlin firm has issued a press release acknowledging that Lerach is “considering retirement.” The release notes that the firm itself has never been the subject of the investigation – which by negative inference certainly suggests that developments in the investigation have something to do with Lerach’s retirement considerations. (The complete text of the press release can be found on the Legal Pad blog, here.) The WSJ.com Law Blog post also notes that the prosecutors and criminal defendants filed a sealed agreement last week postponing all motions in the criminal case for two weeks, which is consistent with the notion that there are active plea negotiations underway.
There will clearly be some interesting developments in the story in the next few days.
401(k) Fee Suits: A May 31, 2007 Law.Com article entitled “401(k) Suits Over High Costs to Employees on the Rise” (here) takes a look at the growing number of lawsuits against companies, and in some cases their directors or 401(k) plan trustees, alleging that the defendants breached their fiduciary duties by allowing third parties to charge undisclosed or excessive fees to employees who participate in the plan. One law firm, St. Louis-based Schlichter, Bogard and Denton, has filed 13 of these cases, some of which have already survived preliminary motions to dismiss. However, other cases have been dismissed, including one case against Grumman that had named the Grumman board of directors as defendants.
The several plaintiffs’ lawyers quoted in the article all indicate that they expect to be filing more of these excessive fees suits in the future. As one defense lawyer quoted in the article put it, the claims for excessive 401(k) fees are like the “new toy in the toy box” for plaintiffs’ lawyers.