by T. GormanPosted on Posted in SECActions

Over the last few months news about SEC enforcement has been dominated by the on-going option backdating scandals with a sprinkling of the usual financial fraud and insider trading cases.  By now, everyone had heard that the SEC has about 140 companies under investigation for backdating options and that a total of about 200 companies are conducting internal investigations into their option backdating expenses.  It is old news that a number of enforcement actions have been brought first against individuals claimed to have been involved and more recently against companies.  The real question about the scandal at this point is the standards that will be used going forward in decisions made by the SEC as to who to include in future enforcement actions. 

Now, however, a new wrinkle to the use of options has been added.  Yesterday, the SEC filed a settled administrative action against IBM Corp. over its options practices.  Big Blue was not accused, however, of backdating its options.  Rather, the crux of the actions seems to be that the company used the issuance by the SEC of its then-new guidance on options (SAB 107) as an excuse to mislead analysts about its earnings to soften the impact of missing guidance.  According to the Order For Proceedings, IBM violated the reporting provisions of the federal securities laws by filing a Form 8-K in April 2005 that “contained materially misleading information about the amount of IBM’s stock options expense and the impact it would have on IBM’s earnings per share.  The Form 8-K created the impression that IBM’s stock options expense would be greater than what IBM actually expected it to be for 1Q05 and FYO5.”  http://www.sec.gov/news/press/2007/2007-109.htm 

A review of IBM’s April 2005 Form 8-K cited in the Order For Proceedings shows precisely what the company did.  First, in the earnings call IBM told analysts that it was implementing SAB 107.  Second, the company told analysts to reset their 2004 numbers so that they would be comparable with 2005 numbers which would include the expense.  In this context, the company told analysts to include 55 cents for 2004 and 14 cents for 1Q04.  Third, IBM told the analysts to use similar adjustments for its 2005 projections.  Finally, a chart was included which listed analysts’ projections for 2004 and 2005 and made the 2004 adjustments, but not the 2005 adjustments.  Analysts were told, however, that for 1Q05, the option expense adjustment would be comparable to 1Q04 – that is, 14 cents.  At the time the SEC’s Order For Proceedings says, IBM knew that the actual number was 10 cents, not 14 cents. 

So what is the big deal?  It’s the impact.  At the time of the conference call, earnings per share projections for 1Q05 were $1.04 per share, according to the chart given analysts at the conference call, which is reproduced in the IBM 8-K.  If the option expense for 1Q05 was actually 14 cents, then the EPS number should be adjusted down to $0.90 for the quarter.  However, if the actual option expense of 10 cents had been provided, the EPS would have been adjusted downward to $0.94.  When IBM actually reported earnings per share of $0.85 in its Form 10Q for the quarter, its share price dropped 8% the next day.  That drop resulted because the company appeared to miss its projection by $0.05.  But, actually the company missed guidance by $0.09.  Since the actual difference between street expectations and reported results was almost twice as much, one would expect a more significant drop in share price — say 15%, rather than 8%.  

This sad saga appears to just be the latest difficulty with options and meeting Wall Street expectations.  In many cases where firms strive to meet those expectations, earnings get managed with improper accounting practices such as round trip transactions, channel stuffing and the like.  Here, rather than manage income, the expectations of Wall Street were managed.  IBM resolved the matter with the SEC by consenting to a Cease-and-Desist Order.  As Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “Information regarding a company’s earnings is one of the most important factors that many investors consider in making an investment decision, and it is essential that the information companies provide be clear and accurate.” 

All of this suggests that perhaps management should move away from earnings guidance and meeting Wall Street expectations to a more long term of managing the business for shareholder value.  

by T. GormanPosted on Posted in SECActions

Today the SEC began round two of its options backdating cases. Previously, the securities enforcement agency has brought civil law enforcement actions against individual corporate officers and directors alleging securities fraud centered on option backdating schemes. In some instances, those cases were filed in tandem with criminal charges brought by the local U.S. Attorney’s Office.

The actions today name the company as a defendant for the first time. One case was brought against Mercury Interactive, LLC (Formerly Mercury Interactive, Inc.) and four of its former directors and/or officers. A second was brought against Brocade Communications Systems, Inc. These are the first options backdating cases brought against a company. As in the past, both cases are based on allegations which depict intentional, fraudulent conduct. In both cases, the company settled with the SEC.

First, the SEC filed securities fraud charges against Mercury Interactive, its former Chairman and CEO Amnon Landan, former CEOs Sharlene Abrams and Douglas Smith and former General Counsel Susan Skaer. http://www.sec.gov/news/press/2007/2007-108.htm. According to the SEC’s complaint, the former officer defendants engaged in a scheme from 1997 to 2005 to award themselves and others undisclosed, secret compensation by backdating stock option grants. As part of the scheme, $258 million dollars in compensation expenses were not recorded in the books and records of the company. During one period from 1997 to 2002, the company backdated 45 stock option grants, representing every grant made during that time period, according to the complaint.

In addition, from 1997 to 2001 Amnon Landan, Sharlene Abrams and others managed Mercury’s reported earning per share, according to the complaint, through a “stop-shipment” scheme under which customer shipments were halted when financial targets were met and held to the next period. Using this practice, the company shifted from between $35 million to approximately $182 million in revenues. According to the complaint, the scheme was documented in a power point presentation presented by Sharlene Abrams to Amnon Landon which stated in part: “Our Hidden Backlog … What Any Analyst Would Love to Get Their Hands On!”

Mercury, which has since merged and is no longer a public company, settled by consenting to the entry of a statutory injunction prohibiting future violations of the antifraud, reporting and proxy rules. The company also agreed to pay a $28 million civil penalty.

The claims against the former Mercury officers are pending. In those claims, the SEC is seeking statutory injunctions, disgorgement and prejudgment interest and civil penalties. In addition, the complaint seeks an officer/director bar against the four individual defendants and an order directing Defendants Landan and Smith to repay bonuses and stock profits under Section 304 of the Sarbanes-Oxley Act of 2002. Under that provision, certain officers can be required to repay bonuses and profits when a restatement results. This is the first action in which the SEC has invoked Section 304.

Second, the SEC filed a civil injunctive action against Brocade Communications. http://www.sec.gov/news/press/2007/2007-107.htm. In that action, the SEC alleged that the company falsified its reported income from 1999 to 2004 as a result of an options backdating scheme. The SEC previously brought civil securities fraud charges against the former CEO and other former executives of the company. The U.S. Attorney’s Office also brought criminal charges against former officers of the company. Both of those actions are presently in litigation.

Brocade agreed to settle the SEC’s action by consenting to the entry of a statutory injunction which prohibits future violations of the antifraud and books and records provisions of the securities laws. In addition, the company agreed to pay a civil monetary penalty of $7 million.

These two cases represent the next phase in the SEC’s investigations into option backdating practices. Although the Commission reportedly has about 140 companies under investigation and about 200 issuers have disclosed inquiries into their option backdating practices, to date, only a few cases have been brought against individuals alleged to have been directly involved in the backdating process and are based on conduct alleged to be fraudulent. The SEC’s investigations may, however, include others involved in the option issuance process or who may have reviewed the process such as the company, the board of directors, board committees, outside counsel and outside auditors.

The actions today suggest that in the next round of cases the SEC will focus on the company involved. Based on the cases against Mercury and Brocade, issuers may be charged in the future using the same type of intentional fraud allegations in the past. These cases also suggest that the SEC will be seeking substantial financial penalties from the companies involved. Notably, however, no criminal charges were filed in conjunction with the actions brought today.

Going forward, the question will be how wide the SEC casts its enforcement net? If the cases brought to date are a guide, that net may be focused only on the company and those directly involved. At the same time there are indications that net could expand. The SEC releases concerning Mercury notes that its investigation is continuing, at least offering the possibility that more actions may be brought based on that inquiry. In contrast, the SEC release concerning Brocade does not state that the inquiry is continuing. At a minimum, it appears that when Chairman Cox recently noted that the agency was prepared to move forward with its option cases (blog post, May 1, 2007) he was suggesting at least actions against company’s like those brought today.