If you've been following the sad saga of options backdating at Mercury Interactive ( MERQ), you already know that something went seriously wrong at the business software maker.

But if you haven't read Mercury's recent regulatory filings, you have no idea how bad things got. Simply put, the former management team made up the rules as it went along -- and not just about options -- and the board of directors did exactly nothing to stop them.

Sure, those are harsh words. But consider these points made in the company's recent filings:

  • The special committee of the board that investigated the matter found 54 instances of backdated option grants.
  • Grants were made to people before they became employees, and in some cases after their employment status was unclear
  • .
  • Exercise dates for options exercised by some executives were apparently reported incorrectly -- and "In each case, the price of our common stock was substantially lower on the reported exercise date than on the date the option was actually exercised."
  • That last point has a hidden catch for shareholders, according to the filings. The misdating had the effect of lowering taxable income for the executives, and that, in turn, results in a potential penalty to the company for failing to pay the right amount of withholding tax.

    Then there's the little matter of a $1 million loan made to ex-CEO Amnon Landon that may not have been approved by the board. In any case, supporting documentation was lacking, although the loan has since been repaid.

    There's also a tantalizing reference to "certain inappropriate expense reimbursements that were made to our former CEO." That phrase appears a number of times in the document, but nowhere is it explained. I called Mercury to find out, and a spokesman refused to comment. Isn't that something shareholders have a right to know? I guess not.

    But wait, there more. Landan, former CFO Sharlene Abrams, who left in 2001, and possibly others (the filing is not clear on this point), overrode internal controls "to manage or influence the timing of quarter-end shipments and influence the timing and level at which certain expense items and accruals were recorded to achieve a desired consistency of reported financial results."

    This week, Abrams, who is now CFO of Opsware ( OPSW), and current Mercury board members Igal Kohavi, Yair Shamir and Giora Yaron, received Wells notices from the Securities and Exchange Commission. Opsware is not a target of the SEC investigation and Abrams remains in her position, although a finding by the SEC could mean that she could no longer serve as an officer or director of a public company.

    Executive misconduct is bad enough, but you have to wonder what the board, which is legally required to act as a watchdog, was doing for all those years. Gary Lutin, an investment banker who runs an online forum for shareholders of another trouble company -- CA ( NYSE) -- puts it this way.

    "Whether they were simply out to lunch or somehow benefiting isn't known, but they were clearly not doing their job as the overseer of investors' interests," Lutin says

    But there's a larger point here as well, says Lutin. "This and the CA case raise the issue of whether there really is a practical process by which the well-intentioned good citizen can actually do what is expected of them."

    By "good citizen," Lutin means Mercury's major institutional shareholders -- in this case, Wellington Management, S.A.C. Capital Advisors, and J& W Seligman, all companies with good records on governance issues. But so far as I can tell, none have filed a 13D with the SEC that would provide notice that they intend to be more than a passive holder.

    Lutin points out, however, that the SEC doesn't seem so interested in allowing shareholders to replace errant directors. In fact, the Amalgamated Bank's LongView Collective Investment fund submitted a proposal to replace CA directors Alfonse D'Amato, the former Republican senator from New York, and Lewis S. Ranieri, former vice chairman of Salomon Brothers.

    Longview spokesman and counsel Cornish Hitchcock says both men were on board when misconduct took place and should be removed. CA's position is that they weren't. But what's important here is the process, not the particulars of their performance on the board.

    The SEC has ruled that CA can exclude the proposal from its proxy. And that means shareholders won't be able to vote them out. The best they can do is withhold their votes. LongView has appealed the ruling. If LongView loses, it appears that a very nasty precedent will have been set.

    Mercury's current management says it has "scrubbed" the company from top to bottom, spending $70 million in the process. Fair enough. And there's no indication that the current officers had anything to do with the misconduct of their predecessors.

    But Mercury has been seriously damaged, so damaged, in fact, that some analysts believe the only way to go is a sale. Katherine Egbert, the well-regarded analyst at Jefferies, says, "We think it highly likely that Mercury will be acquired before it is re-listed. And given the current timeline, it doesn't look like relisting will happen before 2007, she says in a note published Thursday. Jefferies does not have an investment banking relationship with Mercury.

    She certainly could be right, and the obvious suspects would be Hewlett-Packard ( HPQ) and CA. But that's another matter.

    Nobody on Wall Street would argue that a rank-and-file worker who refused to do his or her job shouldn't be fired. Shouldn't the same standard apply to well-compensated directors who do little more than warm a chair? The SEC needs to be reminded that shareholders, not management, not the board, own the company. Their rights must be respected.

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