Cyberonicx CYBX:
Special report: Insiders made nearly $50M trading a money-losing company's stock
Cyberonics says 4.2 million Americans' lives could improve with a medical implant device the company makes to treat severe depression and epilepsy. The FDA approved its product. But federal investigators are probing Cyberonics' compensation practices. This USA TODAY Special Report examines one company caught up in the nation's expanding stock-options scandals. The report explains how a few Cyberonics executives and directors made nearly $50 million in stock-trading profits while selling a money-losing device that remains controversial.
By Elliot Blair Smith, USA TODAY
HOUSTON — Cyberonics (CYBX) said Monday that its chief executive and chief financial officer had resigned after an internal investigation found that unnamed insiders had incorrectly reported the dates of company stock options for years.
Cyberonics general counsel David Wise said in a filing to the Securities and Exchange Commission that the company had under-reported its executive compensation expense by about $10 million and would have to restate its financial statements going back to 1999.
STORY: SEC filings show new chairman got options 3 years before joining board
The company's disclosures came at a time when one of the biggest financial scandal in years is sweeping U.S. corporate boardrooms. Federal authorities are examining at least 130 companies to determine whether insiders manipulated options-award dates to illegally profit from market gains, principally by backdating the options to an earlier date than issued to give themselves a head start on rising prices. To date, dozens of companies have announced executive departures or restatements after internal investigations. Two criminal cases are pending.
In June, Cyberonics said that it was one of the companies under investigation by the SEC and by the U.S. Attorney's office in Manhattan. The company also faces several options-related lawsuits by shareholders and is embroiled in a proxy fight with a large investor demanding substantial changes in the board's makeup and governance practices.
During three interviews with USA TODAY in August, former CEO Robert "Skip" Cummins — who quit Friday — defended Cyberonics and denied any wrongdoing. "We have nothing to hide," Cummins said. But he deflected questions about the government and board probes. Company lawyer Wise said at the time that Cummins could not discuss the controversy. The company has declined to comment for this story.
Cummins had been directing Cyberonics' drive to win Medicare reimbursement for its medical devices to treat severe depression, a decision that he said could open up a $1 billion sales market for the company. Medicare's administrators have not yet ruled on the application.
Earlier, in June, former Cyberonics chief financial officer Pamela Westbrook, who resigned Sunday, told investors that "all stock options" issued by the company "are granted the day of approval and are priced at fair market value on the date of the grant." Westbrook said the company "fully followed securities and accounting regulations."
A USA TODAY investigation reveals that Cyberonics' board has engaged in a series of questionable practices to reward Cummins, certain directors and some executives with stock and options almost from its inception as a public company in February 1993. Among its practices, the company frequently issued stock options just before market-moving events that insiders participated in, including merger talks, regulatory milestones and earnings advisories. It also repeatedly issued options at the lowest or second-lowest monthly trading price, SEC filings show. On one occasion, management, including Cummins, and a director who serves on the compensation committee, bought company stock at a discounted price in which Cummins represented himself both as the CEO selling the shares and as an individual buying them.
Over the past year, academic research at several major universities has identified widespread problems in dating of stock options granted to company insiders. A joint study at Harvard and Cornell universities published last week estimated that about 850 CEOs at 720 companies benefited from opportunistic timing. The study, "Lucky CEOs," said the findings reflect widespread governance problems.
A stock option entitles the holder to buy a share at a fixed price. Options typically are issued at the stock's current market value. It is not illegal to issue options at below-market prices, but a company must charge the discount against earnings, and the recipient must report the gain as income. Most options mature over several years, meaning they cannot immediately be converted to cash. But if the stock rises, the value of the options rises.
Since Cyberonics' founding, Cummins and the company have raised $175 million from investors. The company's loss through January was $186 million. Despite the perennial cash drain, company officers and directors have reaped $49.4 million in stock-trading profits from 1999 to present, including $22.5 million for Cummins, according to Thomson Financial, a financial information company.
University of Michigan finance professor Nejat Seyhun, who analyzed all of Cyberonics' options grants since 2000 for USA TODAY, says the odds the award dates on some of the low-priced options occurred by chance range from one in 600 for Cummins to one in nearly 500,000 for the man who now replaces him as chairman: former U.S. congressman Tony Coelho, a longtime member of the board's compensation committee and a beneficiary of Cyberonics stock options.
After disclosing the government investigations, the board hired outside law firm Morgan Lewis & Bockius to probe its options practices. The Houston company, which employs more than 600, said Monday that neither its management nor auditors had closely reviewed the law firm's findings. But it installed Coelho as chairman and one of the company's founders, Reese Terry, as interim CEO. They declined to comment for this story.
In an interview, former SEC chairman Harvey Pitt, who reviewed some of Cyberonics' stock transactions described in this story, said, "There is something incredibly wrong with this picture even if one assumes no laws were broken.
"What you have here, it seems to me, is a system of granting options that are opportunistically timed with ultimately almost a $50 million payout to insiders from a company that hasn't earned a penny," Pitt said. "The picture looks, on its face, rather tawdry."
'Tough son of a gun'
Cyberonics' triumph at bringing its medical technology to market, and Wall Street's rousing response, seemed to affirm its use of stock options to reward management for a job well done.
At a development-stage company such as Cyberonics, where revenue and profit were hard to come by, stock options enabled the market to set a large component of CEO pay without draining the corporate treasury. But for years, another debate has swirled around the company: about the safety and effectiveness of its medical implants.
The small, battery-powered device — surgically inserted in the chest at a cost of about $25,000 — sends electrical current to the brain through a nerve in the neck. Some medical researchers believe the electric stimulation wards off depression and seizures. But nobody knows for sure how Cyberonics' vagus nerve stimulation device affects the brain, and there are conflicting views among physicians, patients and regulators about how effective it might be.
In July 1997, the FDA approved Cyberonics' implants to treat a form of epilepsy. To date, that product has been implanted in more than 40,000 epilepsy patients. In July 2005, agency administrators overruled the objections of their own staff investigators to approve the implants to treat depression, as well. The device has been implanted in about 1,600 depression patients, many of them during company-paid clinical trials.
Cyberonics estimates as many as 4 million severely depressed Americans could benefit from the product, a U.S. patient base 20 times larger than its potential U.S. epilepsy patient base. First, the company must persuade Medicare to pay for the procedure for depression, as it does for epilepsy.
How Cyberonics proceeds without Cummins remains to be seen.
On Monday, Karen Finerman, president of Metropolitan Capital Advisors, an investment group that owns 7.3% of Cyberonics stock, acknowledged "we don't know" what effect Cummins' departure will have on the company's Medicare application. But Finerman welcomed Cummins' departure, saying, "This is a step in the right direction of very necessary corporate governance changes that we've been asking for. It is a step. There is more to do." Metropolitan is leading a proxy fight to shake up the board.
Investors bid up company shares by 12% to $24.17 at the close of trading Monday.
For Cummins, the personal setback is only the latest in a history of large challenges. In the small Pennsylvania town of Grove City, where he grew up, his parents married and divorced each other three times. To distance himself from the domestic discord, Cummins said during an interview, he lived with his paternal grandmother.
Jeff Lumley, Cummins' best friend during high school, says now, "He knew there was a better way of life than what he had, and I think that was a motivating force for him to work hard and achieve his goals — his success — always pushing hard to be better."
An athletic scholarship to Dartmouth College was Cummins' ticket out of town. The two-time All-Ivy-League linebacker repaid his tuition by punishing opponents. "Skip was one tough son of a gun," says Dartmouth coach Buddy Teevens, a freshman quarterback during Cummins' senior year. "He was extremely competitive."
Cummins earned an MBA at the University of Illinois and took jobs in venture capital that carried him from Chicago to New Canaan, Conn., where a firm he joined, Vista Partners, invested in Cyberonics at its founding. Cummins joined Cyberonics' board in June 1988.
But less than two years after taking the company public, Cyberonics' founders realized they did not have the resources required to get through the legal and regulatory obstacles ahead of them. Over several months, the company approached 70 potential investors with hardly a nibble of interest, according to its SEC filings. By June 1995, $100 invested in the company's IPO was worth $33. The board fired its CEO and hired Cummins.
"He was aggressive. He was a hardworking guy. And suddenly he comes up through the ranks and sees this opportunity and steps in, never having had the benefit of that formal training (in managing a company that) you really need," says venture capitalist Bill Mullaney, one of Cyberonics' early investors. "I saw him as a guy who would step in on an interim basis."
In taking the job, Cummins' mission was to complete the sale of Cyberonics to St. Jude Medical, a big medical device manufacturer with which the board had launched merger talks in June 1995. But the new CEO and board also initiated a practice that would prove troublesome in the future: granting attractive options on fortunate dates.
Jump-start
On Oct. 11, 1995, Cyberonics' board awarded Cummins options on 50,000 shares at $4.70 a share, lower than all but one price the stock closed at that month, and near a six-month low. As investors anticipated a merger agreement with St. Jude, the stock quickly rose 54% from the grant price to $7.25 in November 1995, before the deal unraveled. Had the merger gone through, Cummins' options would have vested immediately. At $7.25 a share, he would have pocketed $127,500 on the options issued in October, company filings show.
Timing options grants to profit from future events is called "spring loading." Spring loading "is not illegal," says Mark Poerio, co-chairman of the Paul Hastings law firm's executive compensation practice and a member of the firm's Stock Option Task Force. But, he says, the practice is "viewed poorly" by regulators and shareholders "as an unfair form of executive enrichment."
Cyberonics and St. Jude renewed their courtship a few months later. On June 1, 1996, six weeks before shareholders convened to vote on the revised merger at $7 a share, the board awarded each non-employee member options on 2,000 shares at $4 a share. That was a 26% discount from the market price and a 43% discount from the merger price. The prospective gain on the options amounted to $6,000 for each director. Cummins' prospective gain on his options issued in October 1995 was now $115,000.
Cyberonics' shareholders approved the proposed merger. But St. Jude walked away again.
In early 1997, Cummins said in an interview, he visited Coelho near Washington to offer him a seat on Cyberonics' board.
The onetime House Democratic party whip had resigned from Congress in June 1989 after failing to disclose on his congressional financial statement a "junk" bond investment he obtained on favorable terms. But he remained a power broker. And he had epilepsy, an illness Cyberonics sought to treat.
Coelho accepted Cummins' invitation, though he was busy leading the upcoming U.S. delegation to the 1998 world's fair in Portugal. On March 7, 1997, Coelho was granted options on 35,000 shares at $4.63 a share but missed two of Cyberonics' next four board meetings, SEC filings show. By year's end, the stock more than tripled to $15.25 a share.
Coelho's stewardship at Expo '98 met with scathing criticism by the State Department's inspector general, which, in a September 1999 report, held him responsible for "questionable payments" on a luxury hotel, car and driver for himself and for a $300,000 personal loan from a Portuguese bank under terms for which the U.S. government feared it was liable. The inspector general referred its findings to the Justice Department, which brought no charges.
Meanwhile, Coelho became a member of the board's compensation committee, which oversees the company's stock-option plans and sets the CEO's compensation. He continues to hold that job, along with being the board's lead director, serving as the primary liaison between directors and the CEO. Coelho did not respond to requests for comment for this story.
Insurance reimbursement specialist Michael Strauss joined the board a few weeks after Coelho and was appointed to lead the audit committee that has been investigating the company's options.
About the same time, a firm Strauss founded, Covance Health Economics, began collecting $1.6 million in consulting fees from Cyberonics over three years, including $511,459 the first year. Cyberonics did not disclose the related-party transaction — involving dealings between insiders — to the SEC for 2½ years. Strauss had no comment.
Also in March 1997, Cyberonics sold stock at the discounted price of $4.44 a share — lower than any price the stock closed at in the month — to an investment group led by New York investment firm Clark Estates. One of Cummins' Dartmouth classmates, Kevin Moore, was senior vice president of Clark Estates. Its $6.8 million investment gave it a 9.2% stake in the company.
Cyberonics described the private placement as having been based on "arm's-length negotiations between the company and the lead investor." It is not unusual for a company to give a large institutional investor a discount when buying stock during a recapitalization of the company. But Cummins, two vice presidents and another new board director, Baylor College of Medicine neurologist Stanley Appel, participated in the investment as individuals. They bought 82,627 shares at the discounted price. Cummins signed the sale agreement on behalf of Cyberonics as CEO and himself as a buyer of the shares, according to an SEC filing the company made in April 1997.
Former SEC attorney Ronald Mueller, an expert on securities law and disclosure, says the transaction "raises a potential conflict of interest."
Former SEC chairman Pitt says, "If Cummins is on both sides of the transaction, it's not a potential conflict of interest. It's just a conflict."
Moore, now a director, did not respond to requests for comment. Appel, who was about to join Cyberonics' compensation committee at the time of the investment and who remains a director and compensation committee member, declined to comment.
Pitt says that Coelho's initial failure to attend board meetings for which he was compensated also raises governance concerns: "If you have a director who doesn't attend meetings, you don't really have a director. You have a face and a name but no substance."
And Pitt says the fact that Strauss, the audit committee's chief, received business benefits and stock options from Cyberonics could have compromised the board's investigation. "How is he going to be able to blow the whistle, if that's required, without blowing the whistle on himself?" Pitt says. "What you've got is somebody who may have an economic incentive in the outcome."
Driven by FDA approval of the vagus nerve stimulation device for epilepsy treatment in July, the Clark Estates shares more than tripled in value by year's end, closing 1997 at $15.25 a share. The 40,000 shares Appel purchased at a discount rose by $432,400 by year's end, a calculation of his investment shows. Cummins' 35,500 shares bought at a discount rose by $383,755.
The beat goes on
Among the lucrative options grants overseen by Coelho and Appel's compensation committee, according to Cyberonics' annual proxy filings:
•In March 1999, Cummins received options on 100,000 shares at $8, the stock's second-lowest closing price that month. The stock rose 99% by year's end and nearly tripled in two years. Cummins did not report receiving these options for two years, according to Equity Incentive Analytics, a stock-tracking service.
•In June 1999, when independent business consultant Alan Olsen joined the board, he was awarded options on 50,000 shares at $11.63, the stock's lowest closing price that month. By year's end, the stock had risen 37%. Olsen is a member of the audit committee that investigated the options grants. He had no comment.
•In January 2000, new manufacturing Vice President Richard Kuntz received options on 150,000 shares at a price lower than all but one closing price that month. In July 2001, new marketing Vice President Michael Cheney got options on 150,000 shares at the stock's lowest closing price that month. In August 2001, new chief medical officer Richard Rudolph got options on 150,000 shares at the lowest closing price that month. And in October 2001, new sales Vice President David Erinakes got options on 50,000 shares at the lowest price that month.
•In June 2001, Cummins got options on 150,000 shares at $12.80, the month's low and the lowest price it traded at for the rest of the year. CFO Westbrook got 15,000 options at the same price, the same date. By year's end, the shares rose 107% in value to $26.53 a share.
University of Michigan finance professor Seyhun has developed a statistical program to assess the likelihood that multiple grants of low-priced options were awarded randomly. Seyhun says the chances Cyberonics' options grants to Coelho were random range from one in 2,000 to one in 492,000; for Appel, the chances are from one in 4,000 to one in 42,000; and for Cummins, from one in 600 to one in 2,796.
"None of this proves that they are backdating," Seyhun says. "What it shows is that it is extremely unlikely to get these on a random basis."
Bill Coleman, an executive compensation consultant at Salary.com, says, "It could be coincidence, it could not be coincidence. Many coincidences make one tend to believe it's not a coincidence at all."
Even after Congress reduced insiders' ability to manipulate options dates under the Sarbanes-Oxley Act of 2002 — the new law required options grants to be reported within two business days, rather than up to a year previously — some Cyberonics executives and directors continued to get options at dips in the stock price.
In June 2, 2003, a week after Cyberonics provided Wall Street analysts with an earnings forecast at the low end of analysts' expectations, the board awarded Cummins options on 250,000 shares at $18.94 a share, the previous Friday's closing price. That was the lowest price the stock closed at for the rest of the year.
Then, in August 2003, the company issued new guidance to Wall Street, saying its earnings were exceeding expectations, driving up its stock price. On Aug. 21, Cummins cashed in 100,000 options he'd been awarded years earlier and reaped $2.5 million in a cash profit.
A big payday
On June 15, 2004, the Holiday Inn at Gaithersburg, Md., filled with Cyberonics executives, lobbyists, medical researchers, depression patients and Wall Street securities analysts. It was a pivotal day in Cyberonics' history.
An FDA advisory panel would hear the company's arguments for approving the vagus nerve stimulation device to treat depression and vote whether to recommend it. The FDA almost always accepts its advisory panel decisions.
Six medical patients who had participated in Cyberonics-sponsored clinical trials spoke about their ordeals with depression and about the dramatic effect that the company's battery-powered electronic device appeared to have on their recoveries, according to an official transcript.
Patients who participated in the trials were not told whether their implant device was turned on. Despite encouraging accounts from some patients, the trials provided scant statistical evidence that the implanted devices worked much better than placebos. "The study failed to demonstrate a statistically significant difference" between a group of implant patients whose devices were turned on and those whose devices were not, testified Carlos Pena, an FDA staff medical device reviewer.
Late in the day, the panel's chairwoman, Kyra Becker of the University of Washington School of Medicine, told Cyberonics that "it's unclear" whether the depression treatment should be approved. At 4:10 p.m., the panel took a break.
A few minutes later, Cyberonics' chief regulatory liaison, Vice President Alan Totah, delivered the company's closing argument in "an unusually confrontational tone," according to Lazard Capital Markets securities analyst Alexander Arrow, who attended the proceeding.
Totah, speaking in "a slightly caustic, slightly indignant Southern drawl," according to Arrow, said depression patients in Cyberonics' clinical trials appeared to do better after more extended treatment than originally envisioned. He interpreted that as a promising sign. Totah quoted from FDA statutes to remind the panel that clinical trial standards for medical devices are more flexible than for drugs, based on the agency's "least burdensome" approval guidelines. A few minutes later, the panel voted 5-2 to recommend Cyberonics' depression therapy.
Nasdaq had halted trading in Cyberonics shares that day, pending the advisory panel's decision. That night, the board rewarded Cummins with options on 150,000 shares of stock — and Totah with options on 10,000 shares — at the previous day's closing price of $19.58 a share. The next day, Cyberonics' share price soared 78% to $34.81, delivering a $2.3 million overnight paper gain for Cummins and $152,300 for Totah.
The Financial Accounting Standards Board, which sets U.S. accounting standards, was already concerned at the time of the after-hours grant that U.S. companies were not appropriately disclosing the costs and benefits of executives' options.
In December 2004, FASB revised its options-reporting rule. Under the guidelines, all public companies had to begin reporting the "fair market value" of new options grants on their financial statements, whether they were issued at, above or below the stock's market price. "Fair market" is a technical valuation that incorporates the options' likely value over time, not just at the date issued.
For Cyberonics, the new rule did not take effect until this fiscal year, beginning in April. That same month, the company said it was unable to file its financial statements until it had reviewed its options practices. As a result, Nasdaq is threatening to delist Cyberonics stock.
In June, SunTrust Robinson Humphrey securities analyst Amit Hazan, who recently left the firm, issued a critical note to investors about Cummins' after-hours grant in June 2004, writing: "We feel this management knowingly abused" the principle of aligning management's interests with that of shareholders.
In an interview, Hazan said Cummins and the board were "trading on information that nobody else had, and the stock clearly was worth more than he got it for."
University of Michigan finance professor M.P. Narayanan calls the after-hours grant "clearly an end run around insider-trading laws."
Even so, the options would not vest for years, and the men would have to wait for their money.
'The only way out'
Unexpectedly, the FDA ruled on Aug. 11, 2004, that it would not accept its advisory panel's recommendation, amid an internal debate at the agency over Cyberonics' implant devices. In what is known as a "not approvable" letter, the agency's Center for Devices and Radiological Health, which evaluates new medical devices for use by the public, informed Cyberonics: "There are safety concerns associated with the use of your device. ... In addition to known safety concerns, worsening depression was reported as a serious adverse event during" one of the clinical trials.
Cyberonics' stock, which had been trading at $23.95 a share, fell to $14.36 the next day.
On Aug. 26, 2004, Cummins wrote a passionate, 10-page reply to the same FDA office. He described himself "as an American citizen whose mother and grandfather suffered from treatment-resistant depression, and committed suicide because it was their only remaining option."
He wrote that the FDA's decision against Cyberonics "insures that millions of Americans living today with chronic or recurrent treatment-resistant depression have only the same way out chosen by my mother and grandfather."
"After finding my mother's body in her small apartment an estimated two weeks after her suicide," Cummins wrote, "I can assure you that I know the sights, smells, tastes and despair that accompany the hopelessness of treatment-resistant depression and the only real way out."
On Feb. 2, 2005, the FDA signaled in a letter to the company that it would approve Cyberonics' depression treatment after all. Over the next week, investors bid up the company's stock by 58% to a record $43.36 a share. And on Feb. 10, 2005 — his 51st birthday — Cummins' cashed out $14.7 million in stock options, netting $10.3 million after his trading costs.
Sharing his good fortune were nine other insiders, including CFO Westbrook and board compensation committee members Coelho and Appel. Cyberonics officials cashed out $19.9 million in trading profits that February, in the largest sale of stock by insiders in any month in company history, according to Thomson Financial.
But the letter that Cummins wrote to the FDA was inaccurate on several accounts, he acknowledged during an interview in August.
In that interview, Cummins conceded he did not discover his late mother's body. Rather, Cummins said, the Mercer County, Pa., coroner's office informed him of her death.
He also said he does not know whether his mother was diagnosed with depression, or if her death certificate says she committed suicide. In fact, the death certificate and coroner's report state she died of natural causes.
As for where the term "treatment-resistant depression" he cited comes from, Cummins said, "We invented it."
Cummins burst into tears when discussing his mother. When he regained his composure, he said, "If you look at what Cyberonics has accomplished, it's not for the faint of heart.
"The leader of Cyberonics has to be willing to stand up and say, 'We're going to make it.'
"As the leader of Cyberonics, even if you're scared beyond words, you have to be able to convince people they can do the impossible."
Posted 11/20/2006 10:22 PM ET |
