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November 3, 2005

Mercury top brass quits under fire

In the wake of IT governance software vendor Mercury Interactive's announcement that it has a major governance problem of its own, the company's three top officials have quit. Although there are concerns over how customers will take this news, it is unlikely that key clients will bolt, and Mercury's share price has rebounded following the initial fallout, suggesting investors still have faith.

By CBR Staff Writer

Mercury said the trio of executives had been asked to leave in the aftermath of an US SEC-prompted internal report over questionable options practices between 1996 and 2002. The three officials, CEO Amnon Landan, CFO Douglas Smith and general counsel Susan Skaer were shown the door following the report, which claimed they had knowingly and unfairly profited from misstated stock options grants.

The problem stemmed from discrepancies in the dates that the three executives and other employees of the company exercised their options versus the dates reported on company financial statements.

An investigation of the options grants was initiated internally last June in response to an SEC inquiry, which began November 2004. The internal investigating committee identified 49 instances between January 1996 and April 2002 where it said options grant dates were misstated.

More damning were two findings. Firstly, on the date of the actual options grants, the stock prices were more favorable than on the dates formally reported. So the beneficiaries involved got a better deal than was reported on paper.

Secondly, the investigating team found that the three named executives were aware, and, to varying degrees, participated in the practices discussed. For instance, Mr Landon is said to have personally benefited on at least three of those occasions.

However, no accusations were made against the company’s compensation committee, which approved all the options grants.

Like previous cases at Informix and Computer Associates, the alleged transgressions involved allegedly criminal behavior on the part of executives. But there are huge differences. While CA, Informix and another instance involving Microstrategy centered largely on claims about the misstatement of revenues, the Mercury findings have nothing to do with the sales pipeline. They center primarily on executives allegedly understating their incomes.

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Consequently, while misstatement of options grants is likely to have some material effect on corporate revenues and income, their impact is likely to be trivial compared to cases of revenue acceleration or overstatement.

Nonetheless, Mercury is revisiting its financial reports through the period in question, and is delaying statement filing for Q3 2005. After the admission, Mercury stated expectations that revenues for Q3 will hover around $205 million – $210 million.

In fact, the biggest toll of announcements like this are on corporate reputation. In an analyst call, Mr Landon’s replacement Tony Zingale attributed uncertainties for upcoming Q4 to uncertainties over how customers will take the news.

For Mercury, the results are especially poignant because the company is one of the few niche software vendors that have managed to remain independent. Until this year, the firm’s track record for growth was well above average, having made astute decisions to grow beyond its core market, which is mature, and garnering good reviews for its new governance products.

As an independent vendor, Mercury could find itself in play if the new executive team is unable to convince customers that it has firmly broken with the past, or unable to generate sufficient momentum with the new governance products to offset declines in existing testing products, which still account for roughly 80-90% of revenues.

In reality, existing customers are not likely to bolt if they already have extensive investments. That’s only the case if a company’s viability is challenged. That’s hardly likely here. The company has a revenue stream that remains quite substantial, and its expenses are not hopelessly out of control.

The most severe consequence would be Nasdaq delisting if the company fails to submit amended statements by November 30, 2005. Such an outcome is unlikely as long as the scandal doesn’t reach any further.

New customers are another question, especially as Mercury ramps up governance options as part of a strategy to go upmarket from software testing tools to IT governance. The governance space is drawing growing competition, such as previously-governance challenged CA, which threw its hat in the ring when it acquired Mercury rival Niku earlier this year.

The latest announcement has capped a challenging year for Mercury, which laid off 5% of its workforce after disappointing Q2 results in July. After news of the executive firings broke, Mercury stock sunk 26% to $25.66, which is roughly half its 52-week high. However, the stock has since rebounded 5%.

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