Off the record


Among the mansions and box stores popuutf8g Silicon Valley are several major tech firms at the heart of a stock option backdating scandal that has metastasized through corporate America over the last two years.

The hall of shame includes Juniper Networks, McAfee, Nvidia, Brocade Communications Systems, and most notably for this story, a Mountain View–based firm called Mercury Interactive, which came under scrutiny in late 2004, making it one of the earliest companies identified for allegedly tampering with the lucrative stock options given to employees.

While some of the half-billion-dollar backdating mess at Mercury has appeared in the business press already, additional details contained in a civil lawsuit filed by investors are under seal in Santa Clara County Superior Court, and three news outlets want them opened up by a judge.

"These companies fleeced investors, and the public has a right to know," Karl Olson, an attorney for the outlets, told Judge James Kleinberg during a hearing Jan 5. Olson is representing the San Francisco Chronicle, Bloomberg News, and the Recorder legal newspaper. He added the defendants have "not shown an overriding interest that supports sealing any of these records."

Attorneys for the company and its fallen former executives have not cited trade secrets or proprietary information — commonly used excuses in corporate litigation — as reasons for keeping the filings sealed. Instead, they seem to be worried the documents will paint an even more sordid picture of executive misdeeds than what’s already come out, and they want to block the press from telling the full story.

But there is an interesting irony to the Chronicle insisting it is entitled to access this information. The newspaper’s parent company, the Hearst Corp., asked a federal judge to withhold from the public some of its own company records unearthed amid a federal civil suit leveled against it and other media giants over the summer.

San Francisco real estate mogul Clint Reilly filed an antitrust claim against Hearst and its rival–cum–business partner, Denver-based MediaNews Group, owner of several Bay Area newspapers, arguing that a bid between the companies to share business expenses was illegal. The Guardian has joined an effort with the nonprofit Media Alliance to unseal records related to Reilly’s suit.

But in the Mercury case, attorneys for the company and its former executives complain individuals not listed as defendants "would have their identities revealed and be implicated in alleged misconduct."

Mercury certainly would like to forget its troublesome past. Computer giant Hewlett-Packard is closing out its purchase of the company for $4.5 billion, taking on Mercury’s liabilities and obviously hoping to put the backdating matter to bed.

Nationwide, somewhere between 150 and 200 companies (reports vary) are internally investigating options problems or have received inquiries from the Securities and Exchange Commission (SEC), the federal agency charged with ensuring publicly traded firms reveal essentially every major move they make.

Mercury was founded in 1989 and produces business software for companies worldwide. In another bit of irony, Mercury specializes in making a group of applications designed to help corporate clients fully comply with the new federal financial disclosure rules passed by Congress as part of the Sarbanes-Oxley Act following Enron’s implosion.

Amnon Landan, the former Mercury CEO who resigned in November 2005 under pressure following an internal probe, is said to have exercised $5.5 million worth of options and sold 1.04 million company shares for a total of $73.6 million "during the period of wrongdoing," according to another suit filed by investors in federal court last spring.

Two additional executives resigned at the same time as Landan. The list of plaintiffs in the federal suit, which charges that Mercury’s backdating imbroglio greatly damaged the company’s market value, includes the retirement system for New Orleans municipal employees.

The value of a stock option is determined by its closing price per share on the day the option is granted. Instead of listing that particular date when the options are later exercised, backdating an option generally involves picking a spot earlier on the calendar. That way, employees of companies that make it big can reap huge windfall profits far bigger than they were entitled to receive. As Duke law professor James Cox somewhat famously described backdating, it’s like betting on a race and knowing who the winner will be.

Silicon Valley’s start-ups during the tech boom relied on hopes and dreams more than directly available cash assets to flashpoint their growth. To attract the best executive talent around, they offered stock options in exchange for hefty salaries. If the top suits performed well from the beginning, when the stock price was low, they could sell the shares much later when their value had climbed sky-high.

But some of the still relatively young companies that dot the fringes of Highway 101 where it weaves toward downtown San Jose are today being charged with failing to inform investors and government regulators just how many zeros were involved in those enriching IOUs.

Defense attorney James Kramer made an important point about backdating, however, to Judge Kleinberg during last week’s hearing. "There is nothing about backdating that is illegal," he said. "The issue is whether you properly account for it."

Yet Mercury didn’t properly account for more than $567 million in compensation expenses over a 12-year period in its SEC filings. And that’s what is illegal. The IRS heavily taxes earnings from backdated stock options, which are akin to tax-free bonuses that aren’t reported to the SEC. Investors say the failure to disclose the backdating exposed the company to heavy tax penalties, money that came from shareholders.

"Throughout the development of the options scandal, Mercury Interactive has been one of the most significant companies for the public to watch, due to both the primacy and seriousness of its options problems," Recorder reporter Justin Scheck wrote in a declaration to the judge last week. The Recorder, which serves about 20,000 readers in the state’s legal community, asked Jan. 5 for Kleinberg to open the records.

Recorder attorney Olson, who regularly represents the Chronicle in such open-records cases, argued in a memo to the court that the desire to shield top Mercury execs from "adverse publicity" and "potentially embarrassing corporate documents" doesn’t justify withholding up to 17 exhibits that Mercury wants to keep away from the press and the public. Petitions submitted to the court regarding the sealed portions of the case are public and were obtained by the Guardian last week.

The defendants’ attorneys said the investors signed a confidentiality agreement early in the suit so that evidence could be more freely exchanged with Mercury during discovery, and they want that promise kept.

"The plaintiffs in the [Santa Clara] suit are not roving attorneys general who are tasked with pursing every defendant who they believe has done something wrong or caused harm to someone else," Brandon Wisoff, a defense attorney in the case, said in a phone interview. "The purpose of a derivative suit is for a shareholder to recover on behalf of a corporation in which he or she owns stock, because he or she is indirectly impacted by any harm that allegedly occurred to the corporation."

The Santa Clara suit’s status as a derivative claim could lead Judge Kleinberg to toss it out, since HP has purchased Mercury. For that reason, Wisoff says, documents produced before the sale aren’t going to be used in court and so shouldn’t be accessible to the public.

"Non-defendant third parties also would have their identities revealed and be implicated in the alleged misconduct" if the records were opened, attorney Thomas Martin wrote in a declaration to the court. In other words, the documents could suggest how much was known about the problems with backdating at Mercury. And that might be of concern to more than just the company’s investors.

Martin, who declined to comment over the phone for us, is representing Kenneth Klein, a former Mercury chief operating officer who left the company in 2003 and has not officially been linked by Mercury to backdating problems but is nonetheless listed as a defendant in the Santa Clara suit.

Thomas and the other defense attorneys argue the investors’ court filings openly cite sealed discovery material, which presumably includes references to Klein’s alleged involvement in or knowledge of backdating, given his status as a defendant, as well as the names of others possibly listed in the documents. They’re arguing Mercury and its executive defendants could not publicly rebut suggestions made by the media about their involvement.

While Kleinberg seemed sympathetic to the notion that the press doesn’t always do the best job reporting on civil allegations, he said it’s a fact of life that most civil complaints — even ones that say "very outrageous things about people and institutions" — fall into the public domain.

But Amber Eck, an attorney for the investors who are now advocating for the filings to be opened, says the complaints made in the suit are far from frivolous and the company’s own board investigation identified who had participated in the misconduct and who knew about it. She said the whole story hasn’t been told.

"There’s a lot saying there was backdating and the amount of the [SEC financial] restatements," Eck said in a phone interview. "But what I was explaining to the judge was that as far as the details on the manner and the process in which it happened … that isn’t really out there yet, and that’s contained in our complaint and the exhibits."

Janet Guyon, an editor at Bloomberg News in New York who has watched the options backdating scandal unfold, told the judge in a declaration that the public deserves a "window into this litigation" to ensure fairness for investors who are expected to trust promises of transparency made by public companies.

"More than 80 companies have announced earnings restatements totaling over $8.8 billion, including $84 million most recently by Apple Computer, which admitted it forged documents recording a directors’ meeting to award its CEO backdated options," Guyon stated. "At least 65 executives or directors have resigned and 300 lawsuits have been filed against 100 companies. Yet little light has been shed on how this practice got started and why it continued." *

Declaration by Bloomberg News editor Janet Guyon to judge Kleinberg on why the Mercury records should be unsealed.

Declaration by local reporter Justin Scheck on why the Mercury records should be unsealed.

Application by attorney Jared Kopel for defendant Kenneth Klein on why the records should continue to be sealed.

Declaration by attorney Thomas Martin for defendant Kenneth Klein on why the records should continue to be sealed.