As Fools, we're generally unconcerned with what the market says at any particular moment. Some days, Mr. Market is happy and bids our shares up; other days, he's in a dour mood and bids them down. Sometimes, though, you have to wonder whether the market is actually onto something.
In the past three months, the stock of global e-commerce outsource provider Digital River (NASDAQ:DRIV) has fallen about 16%. Digital River provides e-commerce strategy, site development and hosting, order and transaction management, product fulfillment and returns, and customer service to companies such as Symantec (NASDAQ:SYMC) and Novell (NASDAQ:NOVL).
Over the trailing 12 months, revenues have grown by more than 38%; compounded over the past five years, they've grown by more than 41% annually. Clearly, it's not the business side of things that's got me worried. Nope -- Digital River's got a compliance problem.
Digital River runs off course
Back in October, proxy advisory firm Glass Lewis published a report entitled "The Backdating Scandal's Second Act." It reviewed hundreds of thousands of insider transactions between 2004 and 2006, pinpointing some 6,000 stock-option grants that seem questionably timed and were reported late to shareholders.
As I've covered here, here, and here, backdating is an attempt by companies to give executives additional unearned compensation by changing the dates on which stock options were issued. An option gives a person the right to buy a stock in the future, at a price set when it's initially granted. Backdating generally involves moving the grant date further into the past, usually to some point where the share price is lower, giving the executive owning the option an immediate additional profit.
Not only is backdating unethical, it can also run afoul of securities laws, because companies are required to record an expense for the options when they are issued. However, if an option is already "in the money," which happens when they're backdated, no expense needs to be recorded. So companies have been evading expenses on their financial statements only to restate them when caught, costing shareholders millions of dollars in earnings.
The cure that wasn't
When executives buy and sell shares in their companies, they are required by the SEC to file a Form 4 with the regulatory body within two days of the option exercise date. Before, they had months after the transaction to report it, giving them oodles of time to play with the grant dates. It's one of the reasons why backdating was rampant before 2002, when SOX went into effect, but has been virtually nonexistent afterwards. With just a two-day window, there's little opportunity for hanky-panky. Alas, "little" doesn't mean "none."
The SEC is constrained by limited staffing and resources. It can't go after every violation; it must focus its resources where they'll make the biggest impact. A few companies, it seems, are taking advantage of that weakness, failing to file their Form 4s within the required two-day period. According to Glass Lewis, that may include hundreds of companies it identified, including Hansen Natural (NASDAQ:HANS), Websense (NASDAQ:WBSN), and O'Reilly Automotive (NASDAQ:ORLY). Digital River's problem is that it consistently files its forms late.
The SEC wakes up
Glass Lewis didn't say that any of the companies it identified had actually engaged in backdating, only that their behavior increased the likelihood of backdating, and raised concerns about the companies' internal controls for financial reporting. But according to a Digital River shareholder lawsuit filed in November, there's a 99.5% chance that the dates on which options were granted to the CEO and 11 other executives weren't random. The SEC subsequently notified Digital River it is investigating its stock-option practices.
That's what's got me thinking Mr. Market may be onto something, perhaps explaining the stock's slow sag. The discovery of backdating by Digital River could push shares down hard, even if the drop is temporary.
Foolish final thoughts
If there are instances of backdating going on, the people responsible, including CEO Joel Ronning, should be dealt with accordingly. Unlike Apple (NASDAQ:AAPL) shareholders, some of whom are willing to excuse any transgression by a CEO who's brought both the company and the stock back from the dead, I'm not willing to go so easy on the executives running the companies I own.
Over the past few years, I've enjoyed the leadership that Ronning has provided Digital River, and my investment in the company has grown several times over. That still wouldn't excuse him for using the company as a personal piggybank, nor for flouting SEC rules and regulations. In both cases, if there was indeed subterfuge, it ought to be dealt with in a manner proportional to its severity.
Digital River remains one of the premier e-commerce outsourcing providers, and its business should continue to flourish. Yet it needs to do so by playing by the rules -- all of them.
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Fool contributor Rich Duprey owns shares of Digital River, but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
