Imagine my surprise when Ben Horowitz, one half of the venture capital team of Andreessen Horowitz, wrote a blog post about dodging a jail term for stock option backdating that also implicated PwC.
Michelle (note: her name has been changed) comprehensively understood software accounting, business models, and best practices, and she was beloved by Wall Street in no small part due to her honest and straightforward reporting of her previous company’s business. In my reference checking, at least a dozen investors told me that they made far more money when the numbers disappointed than when the company outperformed, because they trusted Michelle when she said that things were not worse than they appeared and bought on the dips.
Once she came on board, Michelle rapidly reviewed all of our practices and processes to make sure we were both compliant and competitive. One area where she thought we were less than competitive was our stock option granting process. She reported that her previous company’s practice of setting the stock option price at the low during the month it was granted yielded a far more favorable result for employees than ours. She also said that since it had been designed by the company’s outside legal counsel and approved by their auditors, it was fully compliant with the law.
I’m not sure why Horowitz bothered to change the name of the CFO. It’s public knowledge. Sharlene Abrams was CFO of Opsware and her previous employer was Mercury Interactive.
The New York Times Dealbook’s William Alden picks up on Horowitz’s hero story and gives us more details.
The S.E.C. claimed in 2007 that Ms. Abrams and three other former officers committed fraud by backdating stock option grants and failing to record hundreds of millions of dollars of compensation expenses. As part of a settlement with the agency in 2009, Ms. Abrams was barred from serving as an officer or a director of a public company.
She later pleaded guilty to tax evasion after a Justice Department inquiry into the stock options scheme.
Sharlene P. Abrams, the chief financial officer of Opsware at that time, was forced to resign in 2006 after it emerged that the S.E.C. was planning an enforcement action against her in connection to her previous employment at Mercury Interactive, an enterprise software company.
No one talks about stock options backdating much anymore. Certainly auditors are rarely mentioned even when someone actually does. Of all the parties who could have been seriously singed in the options back dating law enforcement conflagration ignited by Iowa academic Erik Lie, auditors were left pretty much unscathed.
How did Horowitz, according to his account, avoid jail? He asked his General Counsel to review an Abrams proposal to advantageously date options.
According to Horowitz:
I told “Michelle” that a better stock granting process sounded great, but I needed Jordan Breslow, my General Counsel, to review it before making a decision. Jordan lived in my hometown of Berkeley and he certainly belonged there. With hippie sensibilities, Jordan was nearly allergic to corporate politics, showmanship, or any behavior that covered the truth. As a result, I knew that what he said was 100% what he believed and had nothing to do with anything else. I could trust it.
“Michelle” was surprised, as her previous company had run this practice for years with full approval from PricewaterhouseCoopers, its accounting firm. I said: “That’s all fine and good, but I still need Jordan to review it first.”
Jordan came back with an answer that I did not expect: “Ben, I’ve gone over the law six times and there’s no way that this practice is strictly within the bounds of the law. I’m not sure how PwC justified it, but I recommend against it.” I told “Michelle” that we were not going to implement the policy and that was that.
Here’s what Mercury Interactive said Sharlene Abrams did when they sued her and the other executives:
Abrams was also prosecuted by the SEC and went to jail for the criminal charges related to tax evasion brought by the Department of Justice. (Bloomberg’s Mark Gimein fleshes it out a bit more and seems skeptical of Horowitz’s “holier than thou” tone regarding his near brush with incarceration.)
Sharlene Abrams’ prior company, Mercury Interactive, was audited by PricewaterhouseCoopers. Why did Sharlene Abrams trust Mercury Interactive auditor PwC’s judgment so much, to her profound detriment?
PwC was also named as a defendant when Mercury Interactive executives were prosecuted for the backdating issues. Judge Jeremy Fogel dismissed the case against PwC contending that the plaintiffs had not provided proof supporting a “strong inference of knowledge or recklessness” on PwC’s part.
The complaint also targeted Mercury’s auditor, PricewaterhouseCoopers, claiming it knew or should have known about Mercury’s alleged backdated options.
Fogel again stated that the plaintiffs had not pled facts supporting a strong inference of knowledge or recklessness on the auditor’s part.
“The allegations against PWC amount to a series of allegations about improprieties at Mercury and a conjecture that PWC must have known about it,” Fogel said.
That, sort of, flies in the face of Sharlene Abrams’ claims, according to Horowitz, that outside counsel had designed the program, and PwC was fully aware of it and had approved it.
She also said that since it had been designed by the company’s outside legal counsel and approved by their auditors, it was fully compliant with the law.
Abrams was not the only one saying auditors were an important part of the design, approval and implementation of the stock option backdating plans. Here’s law firm McDermott Will & Emery in August 2006:
Potential Claims Against Auditors
Auditing firms are faced with a similar dilemma. Often, it is the auditing firms that provide advice concerning issuance of stock options and related tax ramifications. Moreover, auditors review and opine on the financial statements of public companies quarterly and annually. Did the auditors miss any of these issues, give incorrect advice or otherwise permit the wrongful backdating activity to occur? These questions inevitably will be posed.
MWE also advised auditors to steer clear of involvement in internal investigations of the backdating issues if firms had any part in designing, approving or implementing stock option granting plans in question.
Auditing firms have similar concerns. To the extent the firm is asked to analyze or assist in the defense of a stock options program concerning which it provided advice, the conflicts may be insurmountable.
I wrote extensively about the options backdating when I first started this blog. Options backdating was the hottest issue potentially affecting auditors in 2006 and 2007 before the subprime crisis morphed into the credit crisis and then the financial crisis. These are a few of my posts:
Aug 18th, 2007 Brocade And Backdating – Gatekeepers Fail
Mar 11th, 2007 Deloitte Settles Again – Options Truth Remains Buried
Dec 18th, 2006 Backdating – Now It’s The Directors’ Turn
Nov 29th, 2006 The Auditors and Options Backdating
In one case the CEO actually blamed PwC for the backdating scheme:
From a news account of the case in CFO.com:
In a motion to dismiss the criminal case against Gary Gerhardt, the former CFO of Engineered Support Systems, his lawyers say the fact that PricewaterhouseCoopers accountants were aware that stock options had been granted “in the money” proves that Gerhardt hadn’t concealed the erroneous grant dates. Hence, “there was no attempt to avoid detection by the public, no attempt to deprive investors or the public of accurate information, and no attempt to defraud investors,” the lawyers wrote in the motion filed with a U.S. District Court in Missouri earlier this week.
The attorneys claim that since the executives shared information about the options dating with PwC, ESSI executives can’t be charged with trying to hide the backdating, as the indictment alleges. Further, because the grand jury was unaware that PwC knew that ESSI had backdated and repriced stock options, its indictment of Gerhardt is invalid, the lawyers added.
Gerhardt eventually pleaded guilty to the charges. PwC was named as a defendant in a shareholder case related to ESSI, Nickell et al. v. PricewaterhouseCoopers LLP, but the case against the firm was later dismissed.
Earlier this year Don Whalen, General Counsel & Director of Research for research firm Audit Analytics, prepared a report, The Stock-Option Backdating Scandal and its Minor Implication of Audit Firms: An Overview.
By his count there were 181 total Stock-Option Backdating Cases (consolidated from 206).
- Specifically Asserting Backdating: 158
- Cases Resulting in a Financial Restatement Addressing Backdating and/or Deferred Stock-Based Issues: 23
- Subset of the 181 Cases Filed by the SEC: 32 (16 naming only individuals)
- Subset of the 181 Cases Filed as Derivative Actions: 74
How many cases named an auditor as a defendant?
Only 13 or 7% of his count of total cases. (PwC was named as a defendant in four, KPMG in five, EY in three and Arthur Andersen in one according to data provided by Audit Analytics.)
“Only four auditor settlements (shown below) exceeded one million dollars and in three of these cases, the stock-option backdating allegations were secondary to much more egregious conduct resulting in criminal prosecution of executives.”
Source: Audit Analytics
(Detail on the four settlements is shown below as footnotes. These notes were prepared by Don Whalen.)
This is another case of auditors walking barefoot over hot coals and walking away with no injuries. The audit firms were there, fanning the flames at the behest of clients, but judges refused to see that it was the auditors who had started the fires and stoked them with illegal advice.
It’s interesting to note that audit firms made big money on the backdating issue even though they neither highlighted nor called out the illegal acts based on their audits, before and especially after Sarbanes-Oxley was passed. Every Big 4 audit firm was actively involved as a hired gun for the law firms called in to investigate stock option backdating activities. Audit firms should have only investigated companies they did not audit, but I suspect this independence conflict was ignored given the number of investigations and the shortage of accounting firms that knew how the programs worked. It’s a great competitive advantage to be the one who designed the crime when someone later needs help investigating it, or covering it up.
Horowitz implies everyone knew the auditors’ role in the stock option backdating crimes. Law firms worked arm in arm with the auditors.
Why didn’t judges see that and hold auditors accountable?
A spokesperson for Ben Horowitz did not respond to my email request for comment.
Details on the four auditor settlement courtesy of Don Whalen of Audit Analytics.
There were some smaller settlements by auditors, too:
Total settlement Auditor portion
Juniper Networks, Inc 07/17/2006 EY 169,500,000 500,000
Comverse Technology, Inc. 04/19/2006 DT 227,350,000 275,000
Blue Coat Systems, Inc. 04/11/2005 EY 6,551,395 225,000
1. Vitesse. In the operative complaint in the private securities class action (available at http://securities.stanford.edu/1036/VTSS_01/2007104_r01c_062639.pdf), the nature of the lawsuit is described in paragraphs 1 through 22. After a few paragraphs of nonspecific allegations, fraudulent revenue recognition, and concealment of fraudulent revenue recognition, is alleged in paragraphs 5 through 20. Almost as an afterthought, stock option backdating is alleged in paragraph 21. The SEC, in its enforcement action complaint (available at http://www.sec.gov/litigation/complaints/2010/comp21769.pdf), first charged four executives with fraudulent revenue recognition, and later in the complaint charged them with stock option backdating. All four were also criminally prosecuted. In sum, examination of the litigation documents indicates that fraudulent revenue recognition was overwhelmingly the focus of the allegations.
(fm Note: I wrote about Vitesse here.)
2. Peregrine Systems. In the operative complaint in the private securities class action (available at http://securities.stanford.edu/1024/PRGN02-01/200445_r01c_02870.pdf) stock option backdating does not begin to be discussed until page 49. In contrast, the complaint focuses on alleged fraudulent revenue recognition and other accounting issues. The complaint in the SEC enforcement action (available at http://www.sec.gov/litigation/complaints/comp18205.htm) is similarly focused on revenue recognition (especially fraudulently characterizing contingency transactions as GAAP sales) than on stock option backdating. Not until paragraph 29 is stock option backdating discussed. In Peregrine, in addition to criminal prosecutions of the executives, the Andersen engagement partner, Daniel Stulac, was criminally prosecuted.
(fm note: I wrote about how Dan Stulac successfully beat the criminal charges by “pretending” to be stupid.)
3. Symbol Technologies. There was an operative complaint in the main part of the litigation and a second operative complaint against the auditor, NYED04-621. In the NYED04-621 operative complaint in the private securities class action (available at http://securities.stanford.edu/1036/SBL04_01/2004212_f01c_0400621.pdf), the focus of the complaint is on fraudulent revenue recognition and related improper accounting for inventory. Stock option backdating begins to be discussed on page 25. Only 3 paragraphs are devoted to a discussion of stock option backdating. In the SEC enforcement action (AAER No. 2029, available at http://www.sec.gov/litigation/litreleases/lr18734.htm) the revenue recognition fraud, and related improper accounting for inventory, are first and more prominently discussed before the discussion of stock option backdating. The senior executives were criminally prosecuted.
4. Broadcom. The Broadcom operative complaint in the securities class action (available at http://securities.stanford.edu/1036/BRCM_01/2008421_r01c_065036.pdf) is dramatically different, compared to Vitesse, Peregrine and Symbol, in three respects. First, it substantively focuses almost entirely on stock option backdating (although page after page of fluff boilerplate discussion of GAAP theory and certifications and ICFR inflate the length of the complaint). Second, it alleges that the auditor specifically knew of the extent of the stock option backdating, but did not resign or blow the whistle in any way. Third, it alleges on page 1 that as of the filing of the complaint (April 21, 2008), this was the largest restatement ever specifically due to stock option backdating ($2.2 billion). This third allegation appears likely true. It is backed up by a March 2007 report by Glass Lewis at http://www.corporatecrimereporter.com/documents/glasslewis.pdf. Similarly, the SEC enforcement action complaint (available at http://www.sec.gov/litigation/complaints/2008/comp20574.pdf), is entirely devoted to stock option backdating. The executives were criminally prosecuted.
NOTE: Broadcom is In Re Sonam Bakshi v. Henry Samueli et al (Case ID 7412).