Troubles at Mercury Interactive are a lesson about doing the right thing

When you examine a dark and seldom-visited cellar for cracks in the foundation, your flashlight beam might illuminate other problems — termites, perhaps, or water damage — that you didn't expect.

We've now reached such an "uh-oh" moment in the growing stock-option controversy swirling around Silicon Valley.

Mercury Interactive, a Mountain View, Calif., software company, was one of the first to be approached about options by investigators at the Securities and Exchange Commission (SEC), back in November 2004.

So Mercury is further along in self-investigation than the nearly two dozen other valley companies now under federal investigation for possible improper backdating of options.

Mercury's president and chief financial officer recently held a 90-minute conference call with stock market analysts to discuss the results of a long and costly internal investigation that culminated in a dense 160-page report submitted to the SEC.

The report and the call paint a troubling picture of a company with failings that extended well beyond backdating.

If every company accused of backdating has similar goblins lurking in the shadows, the valley could be headed for a very scary ride.

Here's some of what Mercury, which makes software for managing technology infrastructure at big corporations, acknowledges:

• The chief executive, chief financial officer and general counsel were effectively fired by the board of directors in November 2005.

• The company is erasing $567 million in previously reported pre-tax profits from 1992 through 2004 to account for backdating and other misbehavior related to stock options.

• That misbehavior didn't end when the Sarbanes-Oxley reform law took effect in 2002, with top executives acting "to deliberately override certain controls" on stock options through March 2005.

• Three directors serving on Mercury's compensation committee from 1998 to 2002 should have raised questions — but didn't — about lax policies involving options, according to Mercury's filing. The SEC is now threatening to bring civil charges against those directors and at least one former Mercury executive. The three directors have stepped down from the compensation committee and other committees, although they remain members of the board.

• From 1998 to March 2005, Mercury didn't follow all the rules for granting loans to pay for stock purchases by executives. The company handed out cash without requiring sufficient collateral and forgave loans without good reasons. Departing executives also got to keep their options, with the company falsely claiming the former employees were serving as consultants.

• Top executives, from 1997 to 2002, "appear to have deliberately overridden controls in order to manage or influence the timing of quarter-end shipments, without public disclosure." In other words, they polished the numbers, seeking to achieve a "desired consistency" quarter to quarter.

• Mercury's stock was delisted from the Nasdaq in January after the company failed to keep current on its financial filings. The chief financial officer recently said it would be several months at least before Mercury is current on its filings and can reapply to Nasdaq.

Mercury has spent $70 million on lawyers and accountants to untangle the mess, a process that included auditors wading through a staggering 2 million internal documents.

The company's new management is still working on settlements with the SEC and the Internal Revenue Service, and faces at least two big shareholder lawsuits.

You'd think all this bad news would be crushing to Mercury, a midsize company with about 3,000 employees.

But Mercury is profitable and, according to the current CEO on Wednesday, is growing faster than its competitors. Sales jumped to $843 million in 2005, from $686 million in 2004 and $506 million in 2003.

This means Mercury isn't another Enron or WorldCom, where panicked executives were trying to hide massive business failure. But the options violations at Mercury and other valley companies could trigger more regulation, in the same way the collapse of Enron and WorldCom led directly to Sarbanes-Oxley.

What's more, Mercury has blown $70 million and untold hours of work time that could otherwise have gone to productive activity.

Attorney Thomas LaWer said the valley's entrepreneurial culture moves so fast that companies "don't always wait to get everything right."

Now those companies may be forced to slow down. Silicon Valley creates technology that really does change the world, but we still have to play by the rules.