In re Mercury Interactive Corp. – Option Backdating

A recent backdating case,In re Mercury Interactive Corp. Secs. Litig., 2007 U.S. Dist. LEXIS 59171 (D. Cal. 2007), provides some insights into the difficulties inherent in private suits under the antifraud provisions.

The Complaint that backdating of stock options by Mercury Interactive Corporation. Defendants include Mercury, Price Waterhouse Coopers (“PWC”), individual executive officers at Mercury, and individual members of the Mercury Compensation Committee. Specifically, the Complaint alleged that between 1994 and 2005, fifty-four separate stock options provided a grant date that differed from the actual date the option was granted.

Ultimately, the court dismissed the Complaint with leave to amend because of problems concerning the class of shareholders eligible to sue.  The court, however, used the opportunity to provide essentially an advisory opinion regarding plaintiffs’ Amended Complaint. The court focused on the Complaint’s failure to plead loss causation and scienter.

With respect to loss causation, the Complaint alleged that five separate instances of disclosure that resulted in economic loss.  For most of them, however, the court found problems with the alleged causation.  In one instance, the Complaint contained no allegeation of a price drop following the disclosure.  In two other instances, the drop was apparently not "statistically significant."  Plaintiffs also in at least one instance failed to show what portion, if any, of a decline, was related to the backdating.  Only in one instance, when share prices fell 27% following an announcement of the "full extent of the options backdating scandal," did the court conclude that loss causation had unequivocally been pled. 

The court spent the majority of its opinion addressing areas where the plaintiffs’ Complaint failed to plead scienter. Under the heightened pleading standards of the PSLRA, a private securities plaintiff “must plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.” In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970, 974 (9th Cir. 1999).

The Complaint alleged that the Compensation Committee Defendants knowingly signed incorrect financial statements and failed to recognize and pursue warning signs. The court concluded that these allegations were commensurate with negligence by the Compensation Committee Defendants. However, these allegations failed to evince “a strong inference of knowledge or deliberate recklessness as required by Silicon Graphics.”

The court opted not to address the question of scienter in regards to Mercury’s executive officers until the filing of an Amended Complaint. Because courts impute the scienter of executive officers to the corporation, the plaintiffs’ ability to plead scienter for Mercury’s executive officers is tantamount to its ability to plead scienter of Mercury. Accordingly, the court was unable to address the element of scienter regarding Mercury until plaintiffs file an Amended Complaint.

Finally, the Complaint argued that PWC’s failure to pursue “red flags” discovered in its audit of Mercury proves that PWC knew or should have known about Mercury’s misconduct, therefore, providing strong evidence of scienter. The court found that these allegations against PWC might show negligence, however, they do not rise to the level of deliberate recklessness, as required by the pleading standard for a violation of Section 10(b) against a public auditor. This standard is “an egregious refusal to see the obvious, or to investigate the doubtful.” In re Software Toolworks, Inc., 50 F.3d 615, 627 (9th Cir. 1994).

We will continue to follow this case when the plaintiffs file an Amended Complaint.