SEC launches formal probe of KB Home

The Securities and Exchange Commission has launched a formal investigation into stock option practices at KB Home, a move that could distract the home builder as it struggles to rebound from a deep housing slump, analysts said.

The probe, which KB disclosed Friday, comes at a crucial time for the Los Angeles-based company. KB Home, along with the rest of the home-building industry, is struggling to bounce back from a steep slide in sales and rapidly eroding profit margins.

A formal SEC probe, which must be approved in a vote by the agency’s commissioners, ratchets up regulators’ ability to use tough enforcement tools, such as subpoenas, to obtain additional records and compel testimony. Responding to the inquiry is likely to require considerable attention from KB’s senior executives.

“In any business when you have top management focused on things other than executing the business strategy, it will be a distraction,” said analyst John Tomlinson of Majestic Research in New York.

The probe also could further hinder the company in convincing Wall Street that it has a workable turnaround plan, analysts said. Whereas its competitors have sought to keep Wall Street abreast of changing business conditions, KB Home has been largely mum about its sales or specific business conditions since last summer, when it disclosed that federal authorities had opened an informal probe of its stock option grant practices.

“They haven’t been able to keep investors updated on the state of the business,” said Gregory Gieber, a home-building analyst with A.G. Edwards & Sons. “This has to take time away from the CEO, who has to deal with this nasty housing environment.”

KB Home disclosed in a regulatory filing this month that the value of its housing stock had dropped $255 million and that it would record $88 million in penalties as the result of canceling land purchases.

On Friday, the company declined to comment other than to say that it was continuing to fully cooperate with regulators.

KB shares tumbled $1.24, or 2%, to close at $50.98 on Friday as part of a broad sell-off among home-builder issues.

The SEC has launched informal and formal probes of more than 130 companies that allegedly manipulated stock option grants to enhance their value through a process called backdating. On Friday, an SEC spokesman declined to comment on the KB Home case.

KB Home drew regulators’ scrutiny in part because of its generous payouts to longtime Chief Executive Bruce Karatz, who was one of the nation’s highest-paid executives. In the last three years, he collected more than $232 million in compensation, much of which came from cashing in stock option grants.

An internal review by KB Home’s board last year uncovered instances of inflated stock option awards that prompted Karatz’s ouster in November and led to the need to restate three years of earnings. The company also delayed filing its fiscal third- and fourth-quarter financial results because of the option mess.

KB Home’s board acknowledged in November that the company had used “incorrect measurement dates” for financial reporting purposes of annual stock option grants. The board dismissed its head of human resources and chief legal officer after concluding that the pair had selected the grant dates under the company’s stock option plans. And it said CEO Karatz, who also served as board chairman, would retire immediately and repay the company $13 million in gains made from inflated option awards.

KB Home has said it will release its restated and delayed financial statements and a revised executive compensation policy sometime next month.

Many experts believe that the internal report prepared by KB Home’s board as well as other significant corporate documents are probably already in the hands of authorities, providing a road map for the government’s probe.

Still, the SEC’s decision to open a formal investigation suggests that there are additional matters of concern the government wants to examine.

“To both the investment community and to the board, it sends a message that there is some activity here that appears to be potentially significant,” said Frank Reddick, a corporate and securities attorney in the Los Angeles office of law firm Akin Gump.

By ousting Karatz, the board made the executive a high-profile target for federal authorities, legal experts said. The launch of a formal probe could help regulators pursue the former CEO more vigorously.

“A formal investigation doesn’t mean that the company is in any further trouble, but it is a way for the SEC to subpoena former officers and employees, as well as other third parties such as brokerage firms,” said Jan Handzlik, a former federal prosecutor of white-collar crimes and now an L.A.-based securities lawyer at Howrey, a Washington-based law firm.

Handzlik also pointed out that the onset of a formal investigation didn’t mean the government had a slam-dunk case against KB or Karatz.

“It shouldn’t be construed as an indication of guilt or liability but rather an ordinary step in the enforcement process,” he said.

Calls to Karatz’s representatives weren’t returned.

A formal SEC investigation can lead to fines against a company or individuals or to orders barring individuals from serving as officers in public companies. The results of an SEC inquiry also could grab the interest of the local U.S. attorney’s office, which could pursue criminal charges.

KB Chief Executive Jeffrey T. Mezger will attempt to conduct business as usual Monday at an appearance in Riverside County with Martha Stewart at a KB Home development co-branded with her.

The company said sales of homes at the community in Perris had been above average since they began two weeks ago.

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