Tech Probes Cost Twice

There’s a sinking feeling among technology stock investors this summer -- a feeling of history repeating.

At the start of 2002, the bear market of that era had been raging for nearly two years. Then came a wave of corporate scandals that showed the Enron Corp. debacle of late 2001 was no one-off affair.

As shares of Tyco International, Adelphia Communications Corp. and WorldCom Inc. all collapsed in the first half of 2002 amid allegations of massive financial fraud by their executives, demoralized investors wondered whether they could trust any number on corporate balance sheets and income statements.

The scandals helped fuel one last burst of panicked selling, driving the Standard & Poor’s 500 index down nearly 30% in the first nine months of 2002. The tech-dominated Nasdaq composite index plunged 40% in that period.

Now, investors’ faith in corporate accounting again is under siege. Over the last few months, more than 50 companies -- most of them technology firms -- have disclosed that they were under investigation by federal authorities for possibly manipulating executives’ stock option grants to boost the potential payoffs.

It’s early in this scandal, if that’s what it indeed turns out to be. No charges have been filed, and we may well find that what some companies did with options was unethical but not illegal. It seems unlikely that this will amount to fraud on the scale of Enron and WorldCom.

Even so, stocks of many tech firms have taken steep hits in recent months as the probes have been reported. With memories of 2002 still fresh, some investors appear to be selling first and asking questions later.

A Nasdaq index of 575 computer-related shares is down 9.3% year to date. Although the stock market as a whole fell in May and early June on interest-rate worries, nearly all other major U.S. market indexes still are positive on the year. Tech is the glaring exception.

Ann Yerger, executive director of the Council of Institutional Investors, a Washington-based group of major pension funds, said her members were blindsided by the large number of companies that have admitted they’re under investigation.

“I think everyone has been surprised by how this has snowballed,” she said. “It’s another black eye for the corporate community.”

The technology industry is at the center of this, of course, because stock options long have been the preferred type of compensation for tech executives. In the 1990s shareholders were told, over and over, that even though their stakes in tech companies faced continual dilution because of the huge volume of options granted to executives, the awards were necessary to keep the industry’s entrepreneurial spirit alive.

What’s more, Silicon Valley leaders fought like mad for a decade to prevent accounting regulators from forcing companies to formally record options granted as a business expense. They finally lost in 2004.

If option grants were manipulated on a large scale, it would confirm for suspicious investors that tech companies had something to hide in trying to keep Wall Street’s focus away from option-program details.

At a time when excessive corporate compensation is a driving issue for shareholder activists, the option investigations also feed investors’ simmering anger about what some call wanton executive greed.

“There’s something so fundamental about this,” said Kevin Cameron, president of Glass, Lewis & Co., a shareholder advisory firm. Enron’s book cooking, he said, was so complex that most on Wall Street admitted it was beyond their comprehension.

But in the case of option manipulation, “this is so straightforward and so wrong that every investor can understand it,” Cameron said.

A principal focus of the probes is whether the companies routinely backdated option awards in the late 1990s and early in this decade so that executives were able to buy shares at the lowest possible prices in a given period. (A change in disclosure rules in 2002 made such practices more difficult after that.)

Generally, the purchase, or exercise, price of an option is supposed to be the stock price on the date of the grant. By backdating option awards -- in effect, cherry-picking prices after the fact -- companies could turn options into guaranteed income for company officers. That would take a large chunk of market risk out of the executives’ options.

Another focus: whether companies timed option grants to precede good news that would be expected to lift the share price.

The possibility of widespread backdating of option awards was proposed by Erik Lie, an associate professor with the University of Iowa’s college of business, in a May 2005 research paper. He looked at nearly 6,000 option awards from 1992 through 2002, using company disclosure reports filed with the Securities and Exchange Commission.

What he found, Lie said, was a pattern of abnormally large stock price gains immediately after unscheduled option grants -- those that weren’t awarded at the same time each year.

Unless companies and executives possessed uncanny luck in deciding option award dates, Lie said in his report, the “results indicate that at least some of the official grant dates must have been set retroactively” to take advantage of a dip in the market price.

In an interview, Lie said he believed that many more companies were likely to be probed for backdating. “I’m quite confident we’re talking about hundreds of companies that have done this,” he said.

Investors’ concern isn’t merely moralistic, of course. They also fear what the investigations ultimately will cost the companies involved, and therefore shareholders.

Indeed, the bitter pill for investors is that they often lose twice when their companies are caught doing something wrong. The first hit is the slide in the stock on the disclosure. Later, the stocks may suffer again -- or at least be held back -- if the companies face heavy financial or regulatory penalties that impede their business prospects.

Paul Wick, a veteran technology investor who manages the $3.5-billion Seligman Communications and Information stock mutual fund, illustrates the uncomfortable position in which shareowners of many implicated tech companies now find themselves.

“On the one hand, most institutional investors are disgusted that management of these companies would have been so brazen and unethical to undertake some of these practices,” Wick said.

At the same time, he said, the possibility of earnings restatements, fines, executive firings and management’s distraction from running the business could “end up hurting the people who were hurt the first time around: shareholders.”

Wick said his fund has been, and remains, the largest shareholder of one of the companies first implicated in the option investigations: Mercury Interactive Corp., a Mountain View, Calif.-based developer of software testing programs.

In November, Mercury said three of its top executives quit after an internal probe concluded that they had manipulated options grants from 1996 to 2002. The company last week restated results from 1992 through 2004, reducing profit before taxes by a stunning $567 million after accounting for what its true compensation expenses had been, factoring in manipulated option contracts.

On the day Mercury announced the executives’ departure in November, the stock plunged from $35 to $25.66. “We thought that was ridiculous,” Wick said. That turned out to be the worst of it for the shares. The price has recovered since November, ending Friday at $37.51.

Wick said he believed that investors were judging Mercury correctly -- not its previous option practices, but what the cleaned-up company itself is worth as an ongoing business.

“It’s not like the fundamentals of these companies are going to be different post-restatement,” he said.

As during the tail end of the last bear market, knee-jerk selling of tech stocks caught up in the option investigations may well wind up producing bargains for patient investors.

The damage this affair does to long-term investor confidence, however, is a cost that may be beyond measure.

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit: latimes.com/petruno.