Mercury Interactive: Less Murky But No More Forgivable (MERQ)

| About: Mercury Interactive (MERQ)

Mercury Interactive (MERQ), the grand-daddy of the companies being investigated for options backdating, finally filed its restated 10-K for 2004 yesterday. It lifted some of the clouds of mystery surrounding the options transactions that got the company into hot water. At least we now know what they did, and what the corrections amounted to. What will become of the managers who conducted themselves so badly remains to be seen, however.

How did they misrepresent options transactions to shareholders? Let’s count the ways:

From 1994 through the quarter ended March 31, 2005, fifty-four instances of backdating - “in which the exercise price of stock options was established based on a stated grant date that was different from the actual grant date” - occurred.

Compounding their fault: some of these backdatings involved Incentive Stock Options (ISOs), where there cannot be option grants with prices less than market value, and recognizing that the backdating occurred disqualified these options for ISO treatment. Thus, they became treated as Non-qualifying Stock Options (NSOs) but that resulted in the deduction limits for those kinds of options being exceeded. Bottom line: Mercury now bears exposure for additional withholding taxes - a cash consequence of the misdating.

From 1998 through the quarter ended March 31, 2005, the company incorrectly accounted for the stock options exercisable or exercised with promissory notes. They stuck with the legal form of the notes and didn’t even do that consistently. Had the proper accounting been followed, the awards would have been shown under “variable plan accounting,” with adjustment to the accrued compensation recognized each quarter for changes in the stock price.

The correction of the accounting affected the basic and diluted share count. More striking was the indifference of the firm regarding the collection of the notes: “We have numerous instances of a lack by former senior management (including our then CEO) of adherence of to the legal terms of the notes, evidenced by: 1) interest and principal forgiveness, 2) subsequent modifications to the length and collateral of the notes, and 3) additional principal added to the note without additional collateral. Additionally, these notes were secured only by the stock issued without any evidence that the Company would exercise its rights to enforce collection of amounts due under the note against other assets of the borrowers…”

From 1997 through the quarter ended March 31, 2005, the firm didn’t keep accurate records of options issued to or modified for “certain individuals who held consulting, transition or advisory roles with us either preceding or following their full-time employment with us.”

The corrected financials showed an increase in stock-based compensation expense for these transactions.

On several occasions between 1998 and 2001, “exercise dates for options exercised by certain executives appear to have been incorrectly reported. In each case, the price of our common stock was substantially lower on the reported exercise date than on the date the option was actually exercised. The reporting of such incorrect dates ordinarily would have the effect of significantly reducing the individuals’ taxable income…”

Thus, Mercury underreported withholding tax liabilities associated for these officers - another cash consequence.

There was an error relating to the price used for certain Employee Stock Purchase Plan [ESPP] stock purchases between August 2002 and August 2004. There was a 15% gap in the purchase price used for two classes of employees, when they should have both used the same price.

The correction resulted in an increase in the stock-based compensation expense.

All told, the corrections chopped $30.8 million out of 2004’s stated earnings; decreased 2003’s stated income by $104.1 million; and 2002’s earnings were decreased by $28.1 million.

But wait, there’s more. Mercury was an APB Opinion 25 disciple, meaning that the restatements didn’t capture the fair value of the option grants to employees. Those adjustments above for the misdated options were capturing only the intrinsic, in-the-money value of the options granted. Investors still had to look at the footnotes for the various years to get a glimpse of what Statement 123 would have wrought - and those footnotes were improperly stated, too.

Mercury was one of those companies that needed the APB 25 beauty treatment to avoid showing losses caused by unsightly fair-valued stock compensation: it would have shown losses in the years 2002 through 2004 had it adopted Statement 123. Those losses ballooned in the restated 123 footnotes: from $21.5 million in 2004 to $57.5 million, post-restatement; from $94.2 million to $178.9 million in 2003; and from $55.8 million in 2002 to $122.7 million.

Certainly a bundle of issues, and certainly destined to make a lot of companies look inward to see if they’ve done any of the same things. So will the fact that the SEC has issued “Wells notices” to “directors Igal Kohavi, Yair Shamir and Giora Yaron that the SEC Staff is considering recommending that the Commission file a civil enforcement proceeding against each of these directors under applicable provisions of the federal securities laws.” At some time in the period under restatement, all of these directors had served on the audit committee.

What is the SEC’s endgame? Is it going to make an example of a few companies at a time in the hopes that others get the message? Or is it going to issue some comprehensive dictum that will enlist the auditing profession for cleaning up debacles like this one? One would hope that it’s the latter. If the Commission saw fit to get comparatively minor lease accounting issues in line last year, they should be jumping all over this issue in the same sweeping way. That would truly be acting as “the investor’s advocate.”

MERQ 4-yr chart:

MERQ 4-yr chart