Last month, on the eve of a scheduled trial, the accounting firm of Deloitte & Touche quietly settled a malpractice suit that accused it of having approved a stock option pricing program that amounted to backdating.
The plaintiff in the case, San Jose semiconductor maker Micrel Inc., disclosed the fact of the settlement — though none of its terms — last week in its 10-K filing with the SEC. In an interview, Micrel general counsel Vince Tortolano declined to give any additional information about the deal, but suggested that some clues about its size might be discernable from the company’s 10-Q for the first quarter of 2007, which will be filed in April or May.
“Deloitte & Touche has denied, and continues to deny, any responsibility for the claims in the lawsuit brought by Micrel,” a spokesperson for the accounting firm said in an e-mail Monday. “The lawsuit has been settled to avoid the substantial expense and inconvenience of continued litigation.”
I had been hoping it would go to trial, because it would have finally shed some light on how Silicon Valley accountants were analyzing options backdating issues in the late 1990s. (Many of the court filings in the case were lodged under seal, and are consequently unavailable.)
The case was also intriguing because it was one of only two I know of so far — the other being Microsoft — where a company is believed to have actually secured the blessing of some outside “gatekeeper” ( i.e., an accounting firm or law firm) for a “backdating” scheme. At the outset of the options backdating scandal, there was much speculation that such gatekeepers had to be at fault, given how widespread backdating was prior to passage of the Sarbanes-Oxley law in 2002, but that theory has not yet borne much fruit.
What allegedly happened at Microsoft (according to Microsoft’s SEC filings and a June 16, 2006 Wall Street Journal article by Charles Forelle and James Bandler [behind a paying firewall]) and at Micrel (according to the complaint Micrel filed against Deloitte in April 2003) sound startlingly similar. Here is the chronology of the intertwined events at the two companies.
In 1992, Microsoft instituted an options pricing policy that seems to have aimed at solving a problem many tech companies were then facing — one that only grew more intense during the dot-com bubble years. Due to extremely volatile prices, new employees often complained about receiving options with dramatically different strike prices from those of similarly situated colleagues who had joined the company just a few days earlier or later. Under Microsoft’s program, new employees were granted options that, at first, conformed to the norm: they had an exercise price equal to the price of a share of Microsoft at the market close the day before. But for the next 30 days, if the stock price fell, the option price would be “reset” to the lower price. In the end, new employees would get their options at the lowest trading price for the 30-day period following their date of hire. Using a similar mechanism, existing employees regularly received additional options priced at the lowest price for the month of July. An unidentified Microsoft official told the Journal that Microsoft’s accountants at Deloitte had approved the programs, evidently opining that such options grants could be considered “at-the-money” grants — options priced at fair market value as of the day of the grant. Such options would not need to be expensed at all under the accounting rules of that time. (A Deloitte spokesperson says in an email that the firm “can’t comment on advice the firm has given to a client.”)
In 1996, Micrel, in San Jose, began using a nearly identical 30-day pricing program, also allegedly blessed by its lead outside accountant at Deloitte, according to Micrel’s complaint.
Then, in mid-1999 Microsoft, for reasons that are not clear, decided that its program did not comport with generally accepted accounting principles after all. Since the pricing process did not really conclude until 30-days after it started, the company apparently concluded, the strike prices were effectively being backdated to the lowest price during that 30-day period. (Duh.) Accordingly, they were in-the-money options, which needed to be expensed. Microsoft then discontinued the program and took a $217 million charge against earnings.
Meanwhile, Micrel kept using its own 30-day pricing policy for two more years, until November 2001. By that time, however, according to Micrel’s complaint, the lead Deloitte partner on the Micrel account had changed. The second Deloitte partner then allegedly disavowed his predecessor’s opinion, and advised Micrel to discontinue the policy and make a restatement, which the company did. (The revisions added more than $50 million in expenses to its financial statements.) In 2003 Micrel sued Deloitte for malpractice, seeking reimbursement for all the costs that resulted from the first Deloitte partner’s allegedly bad advice.
It’s a tantalizing set of facts, isn’t it? But, alas, due to the settlement, that’s all we know.