"Witch Hunt" in the Silicon Valley

Network Appliance CEO Daniel Warmenhoven says the government's search for backdated options among tech companies is going too far

At the start of this year, word began to spread around Silicon Valley that the Securities & Exchange Commission was on the prowl for companies that improperly accounted for stock options grants during the Internet boom. For a while, executives whispered about which companies were most at risk. But now, many executives are surprised by the breadth of the government's probe, which has resulted in SEC investigations into 80 companies and criminal indictments against former executives at Brocade Communications (BRCD) and Comverse Technology (CMVT). In the latest development, on Aug. 14, Sanmina-SCI (SANM) and PMC-Sierra (PMCS) revealed potential problems related to their stock option grants.

Already, most tech companies have launched their own investigations of their books, to spot irregularities before the feds or the press does it for them. But many tech executives are now beginning to use the phrase "witch hunt" to describe the growing scandal. While few doubt there were cases of outright fraud that should be punished, they fear that the widening probe has now reached a counterproductive level. Rather than just catching scofflaws, well-meaning companies and executives are being wrongly impugned by the scandal, in their view.


  This view is as common in Silicon Valley as startups and circuit boards, but few executives have expressed it publicly, given the legal exposure and intense political and media pressure. But Daniel Warmenhoven, who has been CEO of storage gear maker Network Appliance (NTAP) for the past 12 years, agreed to speak publicly about his views—in large part because his company has already done a comprehensive review of its books. NetApp commissioned an independent investigation of its accounting to head off any problems. The SEC has asked for information on NetApp's options program, but has not expressed any concerns, he says. Here are edited excerpts from three recent phone interviews with Peter Burrows, the Computers editor in BusinessWeek's Silicon Valley bureau.

What's your overall sense of the stock options scandal?

I think it's become a witch hunt. I think the government is looking to find some egregious examples [of wrongdoing] and to publicly hang people for them. That's fine. But where does it stop? I'm not saying the past practices were all good. But I thought the SEC's role was to build investor confidence. What they're doing right now is destroying it, and I don't see the purpose.

They're penalizing today's shareholders for events that occurred five years ago. But who is this protecting, exactly? With Enron, every shareholder in the company lost money. The same with Qwest, and with MCI-Worldcom. But I don't know who the injured party is here.

The victim was the investor, who was not getting accurate information about the options their companies were doling out. And in the case of backdating (in which shares are granted at prices below the market price on the day of the grant, guaranteeing the recipient paper profits), insiders were getting a better deal on shares than the company's public investors could get.

First of all, backdating options wasn't illegal. You just had to make sure you disclosed it and properly expensed them. And the laws have changed since [then]. Now, [because new regulations compel companies to expense all options, not just special cases like backdated "in the money"options], the basic fraud issue has by definition gone away. And let's not forget that most companies' options vest over four years, so most of the guys who got these grants in 1999 and 2000 never got a chance to cash out anyway (since most tech stocks are trading far below even the backdated prices).

So backdating isn't illegal if it's fully disclosed to the public and properly accounted for. But an awful lot of tech companies are admitting now that they didn't properly disclose and account for them. Why was this so common?

This is going to sound weird, but what difference did it make [if the options expense was recorded on company's official financial records using generally accepted accounting principles, or GAAP]? It was going to be removed for the pro forma reports anyway, and that's all the investment community cared about. And there was no rigor around the enforcement of this [by the SEC]. I'm not trying to defend the practice. But [properly disclosing and expensing in-the-money options] just wasn't viewed as a high priority by anyone. It generally wasn't even audited by the audit firms. The view was that close enough is close enough, which is why some people crossed over the line.

So do you think we'll see lots of companies found guilty, and see executives go to jail?

I think so. It's pretty clear that the SEC wouldn't prosecute cases if they didn't think there were egregious actions at the most senior management levels that were tantamount to fraud. I think they will bring many cases, and probably prevail on many of them.

Putting aside cases of outright fraud, explain why so many other companies are getting caught up in this scandal.

I think it falls into three buckets. First, there were companies who were very aggressive about using options on the recruiting front, who used a very loose interpretation of the rules, and didn't pay attention to disclosure like they should have.

Then there were the opportunists, who would take advantage of the fact that they had information the public didn't have [to time grants ahead of good news so recipients would get an immediate bump in the value of the underlying shares]. For example, we used to grant options to executives on the day our compensation committee did the annual executive performance reviews. This meeting took place a week or so before we announced earnings. Now, if we knew we were going to stink it up that quarter, you could ask yourself: Should we wait two weeks [to grant the options, after the stock had crashed]? We never did this, but it would have been legal.

Finally, there were companies that made administrative mistakes. For example, we do an audit at the end of each quarter just to make sure all our options paperwork is complete. At the end of the April quarter in 2003, we found that we didn't have the faxed signature from one of the members of the compensation committee for a grant we'd made to one of our executives. The director said he had sent it, but we couldn't find the paperwork. So we got him to send a new signature, and we closed the books on the transaction the following quarter. Officially, there was no problem. We had obtained all the proper approvals from the compensation committee to grant the options. But then there's that last administrative step: getting the sign-off on the grant itself, and having the documentation to prove it. And that last step is where a lot of the SEC focus seems to be now, and it's where there was a lot less rigor on the administrative side back then.

What would you guess is the ratio between outright fraud and honest process mistakes like this one?

At the end of the day, I think you'll find almost every company has some impaired records like this. I'd bet there will be 10 cases of egregious behavior for every 1,000 cases of clerical mistakes.

Even if tech companies didn't think the price of an option was a big deal, it doesn't prove they were, in fact, being careful to make sure options programs didn't unfairly benefit insiders. If not price, what were you and your fellow CEOs focused on to make sure you did right by shareholders?

There was a lot more focus on the number of shares we granted than on the price. The number of shares is what creates dilution, and we manage the number of shares being granted every year within a dilution cap. Every year, I talked to my big shareholders and asked for their support [for the year's options program], and explained to them in great detail what the options will be used for—to attract new hires, for executives, whatever.

Many of the allegations in this scandal center on overaggressive use of options to hire and retain employees. To what extent can the trend be blamed not on corporate greed, but on the necessity to recruit talented employees in a very competitive market?

I never thought it was necessary to do those things to attract people. If someone we were trying to recruit said: 'I won't join unless you give me a discounted option', my answer was 'I don't think you belong here.' After all, our stock price back then was generally up and to the right. That little differential [between the price of the option a few days or weeks before, rather than on the person's hire date] shouldn't affect someone's decision to come and make a career with us.

Some executives I've spoken with say it's preposterous to think that so many executives were so focused on options accounting fraud—if only because there were so many more powerful legal ways to pump up their stocks.

Absolutely. Almost anything I did would have more impact on the company—calling on customers, driving down cost of goods sold to get the gross margins up, signing up a partner. Fiddling with stock options didn't return much in the way of a business result.

And stock options don't vest for at least a year, so we're talking about a form of long-term compensation. To take such a short-term view [such as cooking the books to avoid options-related expense] would have struck me as, well, like the millionaire that clips coupons. If I can't make the stock move more than that by the time the options vest, I'm not being very effective.

How is this scandal affecting you personally, and your friends who are executives? Does it make you want to retire sooner than you might have?This is one more straw on the camel's back, but not the one that would singularly cause someone to change their career path. A few years ago [before the options scandal], my CFO walked into my office and quit. He said "I'm just tired of being a CFO," and he's as pure as the driven snow. He said, "I'm tired of going to conferences and speaking with investors and always feeling like I'm guilty of something." He said all the fun was gone. So I put him on the board. He used to work for me. Now I work for him.

Are you resentful of the government's treatment of tech?

It's like this. Did you ever drive the speed limit on 280 (a highway in Silicon Valley where traffic typically moves along at 80 mph or more)? Of course not. Nobody does. Does that make you a bad person? That's what this feels like. It's like the police come to you in 2006 and say,"Hey, it turns out we have videotapes of everyone from 2000, and we have video of you speeding 18 times. Here are your tickets."On the other hand, I don't think [the SEC] has much of a choice. When academics start publishing their data (on all the companies that issued options at suspiciously low prices), what are they supposed to do? Ignore it? They have to do something with it. And the more rocks they turn over, the more snakes they find. The trouble is that there are people who I think have high integrity who are going to go through a period of duress. They're going to go through hell.

Are you surprised by anything else about this scandal so far?

I'm surprised that companies like Yahoo! (YHOO) and Google (GOOG) and eBay (EBAY) haven't been mentioned. They were all really aggressive hirers at the time, but they haven't shown up in the press. Maybe [the SEC] hasn't gotten to the Y's yet, but they're past the E's.

What impact do you think the scandal is having on tech stocks?

The more airtime it gets, it creates real issues of investor confidence. We're all being tarred with the same brush right now. Tech stocks aren't just down because Dell (DELL) or EMC (EMC) or whoever missed a quarter. I really think there's something in the water. If you're an investor, what tech stock can you buy that you're sure won't be a target next week?

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