Steve Jobs apologized last week while announcing the results of an internal investigation regarding Apple’s backdating of stock options, in which options were granted on a preferentially low stock price date instead of the date upon which the grant was decided. Jobs said that no current management was involved in backdating options, which occurred on 15 dates between 1997 and 2002.
Separately, Apple’s former chief financial officer, Fred Anderson, resigned from the Apple board, on which he had served after leaving his executive position in 2004. While Apple stated that two unnamed former officers of the company were involved in backdating stock, it made no connection between Anderson resigning and that statement. As CFO, Anderson would theoretically have been involved in accounting for options, but in other Silicon Valley firms that are being looked at for the same charges, officers other than the CFO and some lower-level executives handled or manipulated the mechanics to avoid general oversight.
Apple said that Jobs was not the beneficiary of any of these grants, but he was aware of some of them. However, the firm said that he was “unaware of the accounting implications,” which is not an unreasonable statement. Jobs wouldn’t be involved in the day-to-day work of issuing options and reconciling them on the books.
If the material Apple provides to the Securities and Exchange Commission (SEC) meets with its approval, Apple may be out of the woods with no real repercussions. The company will need to restate earnings, but because stock options are involved, that won’t involve any change in its cash positions. It’s possible Apple might be required to pay minor fines to the SEC, as well.
The two former executives could face separate actions, even if Apple faces none, and could be prosecuted on criminal offenses, barred from serving as officers in public companies, be fined, or experience none of the above. Without knowing their particular actions, there’s no way to predict that outcome.
The backdating scandal involves stock options, which are the right but not the requirement to purchase stock at a given price, typically on or after a certain date, or during a date range. Companies issue options to employees and others to reward them if the company’s stock increases above the strike price of the option, or the price at which it was granted.
Exercising an option means paying the option price, which can be zero, a few pennies a share, or much higher. With the stock options exercised, you own actual stock, but may face restrictions on selling that stock. (Some companies, like Microsoft, have bypassed options grants largely or entirely, and simply give employees stock, which may also have limitations on when it can be sold.)
When stock options are backdated, companies choose the date on which the stock price was at its lowest in a given quarter or a longer period, and then backdate the option grant to that date. One recent report revealed that a firm had issued options to an employee after his death, backdated to when he was still alive, in order to benefit his estate.
This practice is not illegal if fully disclosed. In the companies being looked at, the accounting didn’t include the correct liability for these options, tax liabilities were overlooked, and other reporting was omitted. While little or no cash changes hands between a company and an option grantee, issuing options and subsequently having them exercised changes the amount of stock a company possesses, and thus – among other factors – changes its capability to raise cash or issue options in the future and dilutes the stock in the general marketplace.
Dozens of firms were caught up in the revelation of this practice, which typically occurred in the late 1990s up to 2002, during the dot-com era when stock options went from a typically long-term proposition for gain to quick, meteoric run-ups. The Sarbanes-Oxley Act of 2002 changed the landscape because it requires stock options to be reported within two days of being issued. Previously, companies reported months or even more than a year after issuing options, allowing time to rejigger the dates. Reports show that many reports are still being filed late, however.
Stock option backdating is a big deal. Entire management teams at some firms have been forced to resign. Indictments have been flying. Restatements of income on the order of billions have already happened. Back taxes will often be owed, as well. So far, the SEC is investigating on the order of 80 companies. Some have made a clean breast of their practices and issued reports; others have resisted and may face full-scale SEC lawsuits as a result.
Is this a black eye for Apple? Absolutely. Apple’s accounting folks have up to this point had clean hands and generally received good marks for how they report financial results. Unless further investigation should reveal more than this first report, however, Apple has limited the risk of further problems, and Steve Jobs will remain in his exalted role.