Chipmaker Vitesse Has More Than Its Shares of SEC Trouble

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The federal probe into stock option practices at Vitesse Semiconductor Corp. has forced the chipmaker into a serious liquidity crisis.


Camarillo-based Vitesse is among nearly 30 companies being investigated in a multi-agency probe by the U.S. Attorney for the Southern District of New York, the Securities and Exchange Commission and the Internal Revenue Service.


Though another Camarillo-based chipmaker, Semtech Corp., has received a formal letter of inquiry from the SEC regarding its stock option practices, Semtech’s stock has rebounded after taking an initial hit from investors.


By contrast, Vitesse’s problems go much deeper than the alleged improper backdating of stock options.


An internal investigation in April uncovered questionable accounting practices at Vitesse related to revenue recognition errors, primarily for returned products. Revenue recognition is the most common source of financial restatements from errors or fraud, and typically results in a loss of investor confidence.


The company’s problems began when Vitesse announced that it had to restate its financial statements for the past three years. Combined with the stock option probe, the accounting problems led to the firing of Vitesse’s founder and longtime chief executive Louis Tomasetta, as well as its chief financial officer and an executive vice president.


To calm nervous investors, Vitesse named former chief operating officer Chris Gardner, a Tomasetta rival, as its acting chief executive. The chipmaker also hired turnaround management firm Alvarez & Marsal LLC, of New York, which named Shawn Hassel, a managing director in Arizona, as acting chief financial officer.


Tim Kellis, an analyst at Stanford Group Co., speculated that a liquidity crisis could force Vitesse to put itself on the block or sell itself to a competitor.


“The issue right now that’s causing the greatest concern is the revenue recognition issue, which the company has been opaque and non-communicative about,” said Kellis, who had been on the verge of upgrading Vitesse before the stock option probe came to light. “We really don’t know the impact of this on the company’s financials.”


Shares of Vitesse, which traded at nearly $30 a share five years ago, plummeted to $1.56 a share on June 8, from a high of $3.79 a share in late March.


Kellis said the backdating of stock options raises “questions of integrity” at the company.


Some options backdating is legal, though regulators are trying to draw the line between negligence and fraud.


Since 2002, the Sarbanes-Oxley Act has required that companies report option grants to executives to the SEC within two business days. That requirement makes it much harder to manipulate the options price.


A stock option gives the holder the right to buy shares in the future at a price that is typically fixed on the date the options are granted. Backdating options involves retroactively dating the grant before a rally in the shares, which maximizes profits for executives.


Officials at Vitesse did not return repeated calls seeking comment.



High interest


As if the accounting irregularities weren’t enough, Vitesse received a warning from the Nasdaq Stock Market that it faced being delisted. In addition, Vitesse’s main lender, Silicon Valley Bank, told the company that it could be in default on its loans because it breached covenants by not having sufficient internal financial controls in place.


The possibility of a default forced Vitesse into the arms of Santa Monica-based mezzanine lender Tennenbaum Capital Partners, which arranged a $24 million loan, with the option to secure another $30 million in financing.


But terms of the loan were so disadvantageous with interest rates of 15 percent or more that Stanford Group analyst Kellis cut his rating on Vitesse last week to “sell,” which sent the stock into a tailspin.


Kellis said the financing simply highlighted the deterioration of the company’s financial situation.


Tom Paccioretti, a principal at Los Angeles-based turnaround firm Broadway Advisors LLC, said companies that are placed in a liquidity crunch often run out of options and are forced to borrow at high rates.


“While the distraction caused by restating financials is never a good thing, the real pain often comes from the impact it has on the company’s liquidity,” said Paccioretti. “Reduced liquidity can create a cash crunch that starts the company on a downward spiral.”


Though most companies caught up in the stock option scandal are taking a wait-and-see approach, Vitesse is in a far more precarious position because of its underlying accounting irregularities.


Ian Campbell, managing director of the Western region for Abernathy MacGregor, said investors are interested in two issues.


“There’s a difference between taking a short-term hit to your stock, and having the underlying market value of the company fundamentally damaged,” he said. “Investors want to know if the business model is going to be impaired some by legal or regulatory action, and if there is going to be a capable management team in place to run the company.”


Not surprisingly, the probe into stock options has expanded to include a look at the role played by the Big Four accounting firms in creating stock option programs that tested the legal limits.


Federal prosecutors first became aware of stock option backdating in 2002, during an IRS audit of Silicon Valley tech firm Micrel Inc.


Micrel ultimately sued its accounting firm, Deloitte & Touche, for setting up a stock option package that aimed to take the volatility of options out of the equation. The company began dating options at the lowest price during a 30-day period following their approval, a practice that later was determined to be illegal.


Micrel ended up paying more than $50 million in back taxes and was forced to restate its financial results during a three-year period from 1998 to 2000.


Clifford Hyatt, a partner at Pillsbury Winthrop Shaw Pittman, said it could take months for federal investigators to conclude the probe into stock options.


“It’s a pretty serious investigation,” said Hyatt, who said he believes that federal prosecutors will crack down on executives who are found to have cherry-picked their own stock option dates.