Wednesday, March 14, 2007

Options Backdating: Sue the Gatekeeper?

Photo Sharing and Video Hosting at Photobucket Way back in 2003, long before any of the rest of us had ever heard of options backdating, Micrel sued its former auditor, Deloitte and Touche, alleging that the accounting firm had given the company faulty advice regarding its options grant practices. In its recently filed 2006 10-K (here), Micrel dislosed that on February 23, 2007, it settled the lawsuit, the first of its kind against an outside professional of which The D & O Diary is aware.

Micrel first disclosed its lawsuit against Deloitte in an April 23, 2003 8-K filing (here). The lawsuit didn’t attract much attention at the time, but it gained notoriety after the options backdating scandal broke almost exactly a year ago. On June 19, 2006, the New York Times ran an article about the case entitled “Inquiry Into Stock Options Pricing Casts a Wide Net” (here). The article can also be found on the International Herald Tribune’s website (here).

According to the Times article, Micrel was having a problem in the mid-90’s due to the volatility of its share price. It was providing new hires with stock option grants, with the exercise price set at the closing price on the new employee’s first day. Because the exercise price was so variable, a “fairness problem” emerged. Micrel wanted to make its option grants “a little more equitable.”

According to the allegations in the subsequent lawsuit, Deloitte proposed that Micrel set the exercise price at the lowest point in the 30-day period from when the grant was approved. The lawsuit also alleged that Deloitte advised Micrel that this 30-day pricing method followed the rules and would not have adverse accounting consequences. The 30-day pricing method was originally used for just new employees, but was subsequently extended across the company. According to the Times article, “Morrison and Foerster, the San Francisco law firm hired as Micrel’s outside counsel, affirmed the terms of the plan in an opinion letter.” Senior management also signed off on the plan, as did three members of the board.

In December 2001, Deloitte decided to reverse its view regarding the 30-day pricing method. (According to the Legal Pad blog, here, Deloitte’s reversal came when a new audit partner replaced the audit partner who approved the plan.) According to the Times, Deloitte urged Micrel to restate its prior financial reports. Micrel subsequently restated its financial statements for 1998, 1999, 2000 and the first three quarters of 2001 (refer here). Micrel claimed that the total cost to the company of the flawed options plan was $58.6 million. In its 2003 lawsuit, Micrel sought to recover, among other things, the additional professional fees incurred to “address the impact on Micrel’s financial statements and other effects”; changes to earnings that would not have occurred but for the advice; and liability and potential liability for taxes that would not have been due but for the advice.

According to Micrel’s 2006 10-K (here, refer to footnote 15 of the financial statements), “Deloitte agreed to pay Micrel a settlement amount of $15.5 million.” The Company expects to record the settlement as other income during the first quarter of 2007.

Micrel was not the only company with which Deloitte was entangled over the 30-day pricing method. According to a June 16, 2006 Wall Street Journal article entitled “During 1990’s, Microsoft Practiced a Variation of Options Backdating” (here, subscription required), Microsoft also awarded options at monthly lows, each July, from 1992 to 1999. During that period, Microsoft issued options “covering what would now amount to about three billion shares, adjusting for stock splits,” according to the Journal. The article also states that the July-low practice was “approved by Microsoft’s longtime auditor – Deloitte and Touche.”

Microsoft voluntarily stopped the practice, and on July 19, 1999, announced that it was ending the practice and took a $217 million charge. According to the Journal article, “Microsoft and Deloitte consulted about the practice before making the 1999 change.”

All of this makes me wonder a couple of things: why did it take Deloitte more than two years after Microsoft had taken a $217 million charge to earnings to discontinue the practice at Micrel? And were Micrel and Microsoft the only two companies who received Deloitte’s counsel regarding this specific options grant practice?

More generally, the sequence of events involving these two companies make me wonder whether outside gatekeepers may have spread these and other kinds of options grant practices among companies?

And finally, I wonder whether we will be seeing more lawsuits against outside professionals for their options grant related advice, or for negligent oversight regarding options backdating?

The Legal Pad blog discusses these issues further, here. Special thanks to a loyal reader (who prefers anonymity) for the link regarding this settlement.

The D & O Diary’s prior post about the Micrel case can be found here.

Now This: Before you fly, read these important messages (here).

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