As Silicon Valley companies competed for top talent during the heady days of the dot-com boom - luring stars with plump signing bonuses and the most highly prized manna of all, stock options - Mercury Interactive , a highflying software concern, joined the fray with gusto.
Setting its sights on a prized technology sales manager named Jay Larson, Mercury lured him to the company in 2000 and granted him 300,000 options over the next year. But by the spring of 2001, the company's plummeting stock price had made it unlikely that Mr. Larson could cash in any of his options.
So, after Mercury's stock started to rebound, the company made things right for Mr. Larson. In the summer of 2001, the company awarded him a fresh clutch of options and backdated the grant to the previous spring, when its stock was trading at its lowest price of the year - ensuring that he had a good chance of hauling in at least $1.45 million when he cashed in his new options, according to four people in possession of or briefed on internal Mercury memos and who requested anonymity because of their involvement in investigations or litigation related to the company.
On July 6, 2001, Mercury's five-member board ratified Mr. Larson's options grant, according to people who have seen or were briefed on the meeting's minutes. To seal the deal, these people said, Mercury prepared documents backdating Mr. Larson's grant for three prominent Israeli businessmen who were the only members of Mercury's compensation committee as well as its audit committee. All three of the committee members signed off on the backdated options after the board meeting, according to people who reviewed Mr. Larson's grant.
In theory, directors are supposed to help keep wayward practices like options backdating in check at most companies, but at Mercury it was the directors themselves - who received a final seal of approval from the company's compensation committee - who kept the backdating ball rolling.
Now, as federal investigations of possible regulatory and accounting violations related to options backdating have expanded to include more than 80 companies. Mercury's pay practices - and the actions of the three outside directors on its compensation and audit committees - have come under scrutiny. In late June, the Securities and Exchange Commission advised the three men that it was considering filing a civil complaint against them in connection with dozens of manipulated options grants.
Even if the S.E.C. decides against taking further action against the directors, the fact that it has put the company's compensation committee on notice is unusual. Corporate governance experts say that it appears to be the first time that members of an entire compensation or audit committee could face civil charges in the wake of a financial scandal. That never happened in highly publicized corporate frauds like those at Adelphia, WorldCom or even Enron. While options investigations so far have largely focused on executives who might have enriched themselves or employees by awarding options at rigged prices, regulatory actions against Mercury indicate that the net is being cast more broadly, to possibly include other corporate gatekeepers like compensation committees and outside auditors.
"If the facts permit, and I want to emphasize that all our enforcement cases are very fact-specific, it wouldn't surprise me to see charges brought against outside directors," said Roel C. Campos, an S.E.C. commissioner, in a speech this month discussing the options investigations.
Lawyers for the Mercury compensation and audit committee members - Giora Yaron, Igal Kohavi and Yair Shamir, the son of a former Israeli prime minister - said in a joint statement that their clients were "not involved in any plan to backdate options at Mercury" and "acted reasonably under the circumstances."
While each has stepped down from the compensation and audit committees, each remains a director. Dr. Yaron is chairman of Mercury's board. Dave Peterson, a Mercury spokesman, declined to comment about its directors, executives and prior option grants.
Mercury, based in Mountain View, Calif., appears to have had years of practice backdating options it awarded employees. From 1994 to March 2005, there were 54 options grants - including 24 grants approved by Mercury's board or compensation committee - that were backdated, according to the company's earnings restatement in early July. In almost every instance, the company concluded, backdating the grants made the options more valuable. The maneuvers also let Mercury bolster its earnings and lower its taxes.
An internal report that Mercury released last November conceded that the company had inadequate accounting controls; the report laid its options problems largely at the feet of its chief executive, Amnon Landan, and two other officers of the company. All three executives resigned abruptly last fall. "While each of these officers asserts that he or she did not focus on the fact that the practices and their related accounting were improper each of them knew or should have known that the practices were contrary to the options plan and proper accounting," the report said.
Mercury's investigators were less critical of the three outside directors who served on its compensation committee during roughly the same time. Although the November report identified six options grants between 1995 and 2002 for which "questions should have been raised in the minds of the compensation committee members," the same report also exonerated the committee. It found that the "compensation committee members were focused on the substance of who received options and how many options they received" - not the "effective dates" listed on paperwork used to backdate the options. The compensation committee, the report said, "reasonably, but mistakenly, relied on management to draft the proper documentation for the option grants and to account for the options properly."
But information provided by people familiar with Mr. Larson's grants indicates that in that case, Mercury's compensation committee was more aware of backdating practices at the company than the firm's internal investigations suggest. And the federal investigation of the company appears to be broadening, despite the fact that Mercury agreed to be sold to Hewlett-Packard last month in a $4.5 billion deal.
In addition to the S.E.C., the Justice Department is investigating Mercury's stock option practices for possible fraud, and the Internal Revenue Service is examining the company's books for millions of dollars in possibly unpaid taxes, according to recent corporate filings. Plaintiffs' lawyers, meanwhile, have filed lawsuits against the company, its board, its outside auditor and former executives. On Friday, the Senate Finance Committee said it plans to hold a hearing on Sept. 6 that will examine executive compensation and options backdating; representatives from the Justice Department, the S.E.C. and the I.R.S. are all scheduled to testify.
The legal actions already leveled against Mercury are "clearly a warning shot to the director community," said Charles M. Elson, who oversees the Weinberg Center for Corporate Governance at the University of Delaware . "It suggests that you not only have the private plaintiffs' bar to fear if you do a questionable job, but now a governmental agency where the consequences reputationally and professionally are far more severe."
In many ways, Mercury's rise and fall mirrors that of Mr. Landan, its 48-year-old former chairman and chief executive who was among its first employees. In the late 1980's, Mr. Landan was an engineer manually testing software for Daisy Systems, a company that eventually collapsed. Determined to find ways to automate testing, Daisy's founder asked Mr. Landan to develop technology that would let software test software - an idea that gave birth to Mercury in 1989. Within a few years, the company was growing strong. Mercury turned its first profit in 1993; that same year, it went public. But it was not until Mr. Landan became chief executive in September 1997 that Mercury's stock price began to soar.
BY 2000, at the height of the technology boom, Mercury's sales had tripled, to $300 million, and the stock market valued the company at $12 billion. Mr. Landan rallied his executive team around the goal of joining the likes of Oracle and Microsoft as a major player in the software industry. While the little company benefited from the dot-com frenzy, its software was a real product, not Silicon Valley snake oil. Analysts considered Mercury well run, and those who worked with Mr. Landan, a former Israeli Defense Force paratrooper, said he led them the same way he led his platoon: with intensity, perspicacity and great calm.
"He had a very good way of analyzing what the market needed and then methodically coming to a solution," said Barry Crist, a former Mercury senior executive. "He was not the most charismatic executive but he was still able to - and very successfully - motivate his people; he was a guy that walks the walk, not talks the talk."
There was also a heavy emphasis on transparency, Mr. Crist and other former managers recalled. Mr. Landan directed his executives to avoid such aggressive accounting practices as booking revenue the company had not yet collected, even though it was common in Silicon Valley to do so at the time. And when a Mercury manager presented a growth chart, whose scale had been manipulated to make its results appear rosier, the usually reserved Mr. Landan stopped the meeting to publicly rebuke him, Mr. Crist said.
But company documents tell another story about Mercury's inner workings. The findings of Mercury's two internal investigations - one led by the Los Angeles law firm O'Melveny & Myers in response to the S.E.C.'s initial inquiry and released in November; another led by Munger, Tolles & Olson, also of Los Angeles, in response to shareholder lawsuits and released in July - cite instances of backdating, improper loans, and inadequate corporate controls. Company documents, interviews with nearly a dozen former employees and others familiar with the company, and disclosures in securities filings also paint a vivid picture of Mercury's permissive culture and freewheeling compensation practices.
Exhibit A: the grants to Mr. Landan himself. From 1995 to 2002, Mercury awarded him more than four million options, adjusted for stock splits. Every one of those grants occurred when the company's stock price was in a deep trough, according to a review of his option grants, a red flag for regulators examining whether the grants may have been backdated. From 1998 to 2001, Mr. Landan cashed out options worth more than $14.6 million, according to public filings.
Mercury also lent Mr. Landan $2.4 million so he could exercise his stock options on the company's dime. The company lent him an additional $1 million in September 1999 that Mercury has "not yet been able to ascertain the purpose or use of," according to its November report. Directors had not approved the $1 million loan and Mr. Landan did not disclose it in a company questionnaire, according to the report.
Jonathan M. Cohen, a lawyer for Mr. Landan, declined to comment on the record about Mr. Landan's tenure or compensation at Mercury. The company recently voided Mr. Landan's remaining stock options, which had a market value of about $61.7 million. He has repaid the $3.4 million in loans he received from the company, according to corporate filings.
Mr. Landan was not the only Mercury employee who benefited from the company's pay practices. Even by Silicon Valley standards, Mercury was extremely liberal with its stock option grants in good times and in bad. It routinely told employees that their options would be granted at the lowest price within a certain period, according to a person briefed on the company's practices.
When Mercury first established its option plan in 1989, it gave the board or compensation committee the right to set the number and strike price for all grants, in keeping with normal practice in corporate America. But it also gave directors the right to reprice options more favorably if the stock price declined after a grant, according to company filings - a less common practice in the corporate world, experts say, but one that smaller Silicon Valley companies sometimes deployed during the boom years to quickly nab star executives. When Mercury revamped its option plan in 1999, it ended the repricing provision and barred the granting of options at below-market prices. Yet the company continued to dole out - and backdate - reams of options, according to corporate records.
As of December 2003, Mercury had handed out or allocated for stock grants so many options that it had diluted the stake of existing investors by about 40 percent, according to an estimate by Institutional Shareholder Services, a proxy advisory firm. That compared with a median dilution level of only 21 percent for Mercury's peers.
Mercury's internal investigators found that from January 1996 to April 2002, a vast majority of option grants to all employees - from entry-level hires to the company's top five officers - had been intentionally backdated. With few exceptions, they concluded, the backdating subsided after April 2002, when the company established fixed option grant dates.
Still, Mercury's top five executives, who held an average of 22 percent of all the company's options from 2000 to 2004, appear to have received the most, according to The Analyst's Accounting Observer, a trade publication.
Mr. Landan and Mercury's former chief financial officer, Douglas P. Smith, and its former general counsel, Susan J. Skaer, were each aware of and benefited from backdating practices, the November report concluded. All three stepped down after the findings of Mercury's investigators were released last fall, and the S.E.C has advised them that it is considering filing a civil complaint against them in connection with backdated options, according to people familiar with the S.E.C.'s actions.
In public filings, Mr. Smith has denied any wrongdoing; his lawyer, Patrick D. Robbins, declined to comment on the S.E.C.'s actions, but said his client plans to contest a class-action lawsuit filed against him and others on behalf of Mercury.
Melinda Haag, a lawyer for Ms. Skaer, declined to comment on the S.E.C.'s actions against Ms. Skaer or on any criticisms of her client in Mercury's internal investigations. In an e-mail message, Ms. Haag said that Mercury's compensation committee awarded options "following a practice that was reportedly in place for many years before Susan became Mercury's general counsel in 2000, which gave her reason to believe there was nothing wrong with the practice.'' She added: "Susan would have had no reason to believe that the company would not correctly account for the compensation committee's decisions, if in fact there were any issues with the accounting.''
Sharlene Abrams was Mercury's chief financial officer from 1994 until 2001, when Mr. Smith took over her job. Mercury granted the bulk of its backdated options during Ms. Abrams' tenure, and the S.E.C. recently notified her that it might file a civil complaint against her in connection with backdating options. Mercury's internal report issued last November did not mention Ms. Abrams; its July restatement cited her role in helping manage Mercury's earnings, but said nothing about possible involvement in backdating options. Her lawyer, Douglas R. Young, was unavailable for comment.
IN addition to Mr. Landan, Mercury's board consisted of the three Israeli advisers and Kenneth R. Klein, the company's chief operating officer. Mr. Klein, who left the company in 2003 and never served on the compensation committee, has not been charged with any wrongdoing but is a defendant in a class-action suit against the company. Jared Kopel, a lawyer for Mr. Klein, declined to comment.
Theoretically, a corporation relies on its board for advice and for help in appropriately governing its affairs. And, theoretically, board committees need to function independently of one another in order to carry out their oversight responsibilities most effectively. Corporate governance experts say that having audit and compensation committees made up of the same members raises the possibility of serious conflicts of interest.
Mercury, of course, had audit and compensation committees that mirrored each other. The same three men - Dr. Yaron, Mr. Kohavi and Mr. Shamir - were the only members of both committees from October 1996 to July 2002. They were Mercury's only outside directors at that time.
While virtually unknown to most American investors, the three directors represented a Who's Who of the Israeli technology industry. Dr. Yaron, 57, and Mr. Kohavi, 66, are venture capitalists and serve as chairman or chief executive of several companies in Israel. Mr. Shamir, 60, has been the head of some of Israel's biggest businesses; his career has included a stint as chairman of the Israeli airline El Al.
The circumstances surrounding options that Mercury awarded Jay Larson, the star technology salesman, illustrate how the company - with the knowledge of its three compensation committee members - appears to have used backdating to line employees' wallets.
When Mercury's sinking stock price pushed Mr. Larson's initial block of options out of the money, the company's top executives became concerned. On July 9, 2001, a Monday, Ms. Skaer faxed all three members of the compensation committee, urging them to "approve Jay Larson's stock options as we discussed at the meeting Friday," according to two people who have seen the documents. Soon after, those people said, the directors had given their approval by signing off on the backdated grants.
If Mercury's overlapping committee structures raised the possibility of conflicts of interest on the company's board, some governance experts also say that the structure gave audit and compensation committee members plenty of information to help them monitor potential wrongdoing at the company - if they chose to do so.
"Obviously, they should have had a lot more information about the grants and how that ties into financial reporting," said Lynn E. Turner, the former chief accountant of the S.E.C. "If you knew those grants were being awarded on a backdated basis and you didn't say anything about it when you are sitting on the audit committee, it would be most appropriate for the S.E.C. to take you out and hang you high from the oak tree."