If anyone knows where I might find the world's smallest violin, I would love to borrow it so I could play a tune in sympathy for the latest "woe is me" declaration by an executive who feels persecuted by the SEC's investigation into options backdating.
Network Appliance [NTAP] CEO Daniel Warmenhoven gave a very candid interview to BusinessWeek's Peter Burrows. I'll tip my cap to Warmenhoven for his candor at a time when most executives don't want to go on record about the options backdating scandal. That said, some of his comments reinforced exactly why this IS a big issue and something we outside investors have the right to want further clarity on.
I encourage everyone to read the interview in its entirety before drawing your own conclusions, but I want to highlight a few of the more glaring rationalizations I found particularly disconcerting.
...They're penalizing today's shareholders for events that occurred five years ago. But who is this protecting, exactly? With Enron, every shareholder in the company lost money. The same with Qwest, and with MCI-Worldcom. But I don't know who the injured party is here...
My reaction: The injured party was any shareholder that presumed these companies were operating to the letter of the law and that insiders interests were aligned with outside stakeholders. It's this callous and dismissive attitude which is, in and of itself, a major problem. {Credit to BW's Burrows who answers the question perfectly)
...First of all, backdating options wasn't illegal. You just had to make sure you disclosed it and properly expensed them. And the laws have changed since [then]. Now, [because new regulations compel companies to expense all options, not just special cases like backdated "in the money"options], the basic fraud issue has by definition gone away. And let's not forget that most companies' options vest over four years, so most of the guys who got these grants in 1999 and 2000 never got a chance to cash out anyway (since most tech stocks are trading far below even the backdated prices).
My reaction: If I pull a gun out and fire a shot at someone but it misses the mark, I'm still guilty of attempted murder. It's the intent to defraud that's the crime, regardless of whether the executives were successful in their attempts at ill gotten gains.
This is going to sound weird, but what difference did it make [if the options expense was recorded on company's official financial records using generally accepted accounting principles, or GAAP]? It was going to be removed for the pro forma reports anyway, and that's all the investment community cared about. And there was no rigor around the enforcement of this [by the SEC]. I'm not trying to defend the practice. But [properly disclosing and expensing in-the-money options] just wasn't viewed as a high priority by anyone. It generally wasn't even audited by the audit firms. The view was that close enough is close enough, which is why some people crossed over the line.
My reaction: Ah...so "close enough" is the new benchmark for meeting your fiduciary responsibilities? So the next time a software company books $11.5 million in license revenues when they guided to $12 million; it would be OK if they reported the $12 million to appease investors since, after all, it's CLOSE ENOUGH!?!?!
At the end of the day, I think you'll find almost every company has some impaired records like this. I'd bet there will be 10 cases of egregious behavior for every 1,000 cases of clerical mistakes.
My reaction: There are approximately 8,000 listed domestic equities so by using Warmenhoven's math, we should have no more than 80 cases of fraud if EVERY listed company committed some measure of improper backdating. Obviously we've already blown through that assumption. I will say this, if 1000s of companies and their auditors blame an inability to meet the legal reporting standards on clerical errors, the state of our country's financial controls is far more dire than most believe. If he's right (and he's not, in my opinion), Sarbox costs start to make a heck of a lot more sense, no?
...Almost anything I did would have more impact on the company—calling on customers, driving down cost of goods sold to get the gross margins up, signing up a partner. Fiddling with stock options didn't return much in the way of a business result.
And stock options don't vest for at least a year, so we're talking about a form of long-term compensation. To take such a short-term view [such as cooking the books to avoid options-related expense] would have struck me as, well, like the millionaire that clips coupons. If I can't make the stock move more than that by the time the options vest, I'm not being very effective.
My reaction: On this point we agree, but again, it doesn't obviate the problem, it makes it more egregious in my estimation. Most of this backdating was being done at a time when technology equities were soaring, most of these executives were already becoming wealthy beyond their wildest expectations and yet, in the face of that, some felt the need to eke out more than the system was fruitfully allowing.
It's like this. Did you ever drive the speed limit on 280 (a highway in Silicon Valley where traffic typically moves along at 80 mph or more)? Of course not. Nobody does. Does that make you a bad person? That's what this feels like. It's like the police come to you in 2006 and say,"Hey, it turns out we have videotapes of everyone from 2000, and we have video of you speeding 18 times. Here are your tickets." On the other hand, I don't think [the SEC] has much of a choice. When academics start publishing their data (on all the companies that issued options at suspiciously low prices), what are they supposed to do? Ignore it? They have to do something with it. And the more rocks they turn over, the more snakes they find. The trouble is that there are people who I think have high integrity who are going to go through a period of duress. They're going to go through hell.
My reaction: Any company that had no wrong-doing is going to be able to prove that in reasonably short order. Many companies, Network Appliance included, appear to have been diligent in their internal investigations and have cleared themselves. If people have high integrity, this will amount ot an ANNOYANCE, but HELL? I know Dante's Inferno had a lot of levels but somehow I don't think being asked to produce documentation by the SEC or other governing bodies qualifies...that is, unless you did something wrong in which case they would fail to qualify under Warmenhoven's definition of "high integrity" I presume.
As I said in Et Tu? Apple, the options backdating scandal IS something that needs to be taken seriously. Ironically, I think Warmenhoven's portrayal of the "damage" it's causing is uncorrelated with the efficiency of the public markets. Take a look at the price action of some of the most notable companies under investigation. A great many have rebounded as the investigations proceed. And the most notable culprit (to date), Mercury Interactive [MERQ], is being acquired by HP for $4.5 billion dollars and a substantial premium. Investors will look past this issue particularly if the current management team wasn't culpable; but it would be blind foolishness for we investors to think that such broad-based lack of fiduciary responsiblity on this issue didn't raise questions about further misalignment between outside investors and internal stakeholders.
Related Posts:
Note: At the time of this writing I, and/or funds I maintain discretionary control over, maintained a long equity position in MERQ but did not maintain a position (long or short) in NTAP. We may also, at times, carry derivative options on underlying equity positions as a hedge.
options backdating shareholder interests warmenhoven ntap businessweek software woodrow investing
Jason, I am torn
Ethically I cannot disagree with you.
But I do not feel that sorry for investors if you read my post here. I feel sorry for the rank and file employees for whom options make a fair bit of income and can do little to influence that in spite of their contributions.
http://dealarchitect.typepad.com/deal_architect/2006/07/options_backdat.html
also, I think the SEC loves to go after s/w companies - revenue rec, now this. They are high profile targets. I doubt any other vertical gets as much scrutiny...and then it misses big ones in the industrials and financial svcs.
Posted by: viinnie mirchandani | August 17, 2006 at 11:13 AM