Stock options investigations hold potential for event-driven funds - analysis05 January 2007

Public companies under investigation for options backdating could represent an unexplored corner of the market for investors interested in profiting from short-term fluctuations in securities prices, according to conversations with several traders and hedge fund investors.
However, opportunities are somewhat limited and exist in reaction to specific events within individual investigations, they pointed out, since company valuations have been largely insulated from apparently negative news related to options probes.
To begin with, the market has repeatedly reacted to negative headlines with a short-lived drop in share price. “There are definitely opportunities there,” said one prop desk trader, noting Apple Computer as one such possibility. Last Wednesday after new disclosures were revealed in its internal probe, Apple dropped as low as USD 76.77 per share; then on Friday subsequent to the company’s public admission of having actually manipulated historical options, shares closed at USD 84.84 per share. Yesterday Apple closed at USD 83.80 per share.
Likewise, Minnesota health insurance giant UnitedHealth’s share price dipped numerous times on negative developments related to backdating investigations, including when it initially went public with the investigation, when it announced it would be unable to file its 10-Q on time, and when its CEO, William McGuire, stepped down in November 2006. After each dip, UnitedHealth’s share price recovered within days.
The key characteristic of companies like Apple and UnitedHealth, that repeatedly bounce back, is that they are fundamentally strong companies: “With Apple, we have a situation where the underpinnings are solid and the potential upside in 2007 is much better today than it was a year ago,” said analyst Jonathan Hoopes of ThinkEquity who covers Apple Computer and vocally maintained a positive outlook on the company throughout its risky headline exposure last week.
He said that in these types of situations, strong fundamentals and growth prospects trump investigations into what is often perceived as relatively inconsequential accounting errors. Most investors understand that options pricing is a non-cash, stock-based compensation line item on an income statement that has very little to do with potential near term outlook in revenue growth, he added.
On the other hand, in instances where the stock has taken an options-related plunge and failed to recover, particularly when it has lost key management in the process, the company could become an attractive acquisition target, pointed out the trader.
Rent-way, a rent-to-own retailer and one of the first companies to announce backdating investigations, was acquired by its rival, Rent-a-Center, last November. In the technology sector, software maker Mercury Interactive, which uncovered 49 instances of backdating within a 10-year period and endured the resignation of three top executives, was ultimately acquired by Hewlitt Packard last July, and RSA Security was acquired by EMC in September.
Currently, other companies that have weathered probes and lost executives are also rumored or known to be takeout targets, among them Comverse Technology and Affiliated Computer Services.
The tangible negative events that arise as a consequence of investigations also present opportunities for stock fluctuation that investors can take advantage of, pointed out a trader and a hedge fund investor. The biggest threat to a company’s stock is not legal or tax liabilities, but the danger that key management will be removed from their positions, particularly if one or more of those executives are intimately tied to the company’s success, said Richard Marmaro, West Coast head of white collar defense at Skadden Arps.
The investor said if that happens, valuations will most likely suffer. With Apple, for example, the stock’s decline was mostly related to uncertainty that CEO Steve Jobs could depart the company, said Hoopes.
The SEC and DoJ have been much more likely to pursue individuals than whole companies for damages, said Skadden partner Marmaro. In July 2006, the SEC filed civil charges against Brocade Communications’ former CEO and former VP of human resources, and in August followed up with charges against the former CEO, CFO and general counsel at Comverse Technology.
He added that when they face charges, companies mostly elect to settle and that up to this point, settlements have been nominal compared to companies’ market caps. This is because often damages to shareholders are scarcely quantifiable, particularly if there hasn’t been a drop in share price.
In cases where valuations don’t suffer, the situation lacks the typical measure of damage that exists in traditional class action cases. “This area is unlike any other securities fraud that has ever been prosecuted. In the classic securities fraud case, it’s the drop in stock price when the fraud is discovered [that constitutes the measure of damage],” said Marmaro. As a consequence, shareholder derivative suits will likely be much more common than class actions, since derivative suits directly address management’s fiduciary duty, even outside the context of a quantifiable loss of market value, he said. Still, damage claims may not be significant at all: “Shareholders can cobble together a damage claim, but it’s very difficult if there is no drop in share price. So the settlement is often pretty small,” said Marmaro.
Another event ripe for taking advantage of occurs when a company cannot file its financial statements on time. Many debt covenants hold issuers in default if they do not file on time, and consequently the issuer may owe a heavier burden to debtholders than just the interest payment. In many cases issuers will have to pay a consent fee to have debt holders waive its default, or even offer to repurchase the bonds at par or higher, noted one hedge fund investor. Mercury Interactive’s convertible noteholders benefited significantly when Mercury was unable to file financials on time. In October, Mercury agreed to pay holders of its 4.75% convertible notes of 2007 a consent fee of USD 25 for each USD 1000 in principal amount held, in order to obtain a waiver of default. Secondly, Mercury offered to repurchase its zero coupon senior convertible notes of 2008 at a repurchase price of 107.25% of the principal amount. Similarly, software maker Novell also executed a consent solicitation in November in which it ultimately agreed to pay an additional 7.33% per year in special interest on its 0.50% convertible senior notes of 2024.

by Kate Laughlin

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