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Apple Releases Stock Option Backdating Report

Steve Jobs did not benefit from the discontinued practice of stock-option backdating at Apple, a company board committee led by board member and former Vice President Al Gore reported at the end of December. While Jobs approved back-dated options for others, the committee said he did not “appreciate the accounting implications.”

Apple restated its earnings as part of a filing with the Securities and Exchange Commission (SEC), dropping their previously stated figures over a period that stretches back as far as 1998 by $105 million before tax, or $84 million after tax.

We discussed Apple’s involvement with stock-option backdating a few months ago (see “Apple Reports on Options Backdating Problems,” 2006-10-09), noting that while the practice of choosing the optimum date on which to set a stock option price is legal, backdated options must be reported and correctly accounted for.

The backdating options probe did not look into allegations raised in a lawsuit filed against Apple late in 2006 that allege spring-loaded options. In that case, advance knowledge of a positive event are used as a catalyst to issue options before the event occurs. According to the Los Angeles Times, the lawsuit claims that one million spring-loaded options were awarded just prior to the 1997 investment of $150 million by Microsoft shortly after Steve Jobs return to Apple. The options gained $7.7 million in value within one day of being issued due to news of the Microsoft investment.

The practice of backdating options does not materially affect companies, because the expense associated with option grants isn’t an outlay of cash. Thus, the accounting issues have more to do with the overall viability and perceived ethics of a company, and the perception of its future potential earnings and profit – really two different kinds of net income. Backdating sucks money out of the stock market, not a company’s own coffers, by gaming the system, essentially using retrospective knowledge of the stock price over time as a kind of time machine. It’s not fair to stockholders or stock traders.

Apple has offered a small degree of transparency about the problem, disclosing a few early details before this filing. Jobs even apologized for engaging in the behavior. Apple, like many companies, revised its practices in 2003 when a new law went into effect governing the reporting of option grants. Grants must now be reported within two days, minimizing even legal backdating, but some financial academics have said they have found backdating problems in some firms – not Apple – dating from 2003 and later.

A summary of the findings of the board’s special committee are found in Apple’s 10K filing, their report to the SEC for the fiscal year ending 30-Sep-06 that was delayed until this internal investigation was completed. Over 42,000 option grants were made in the period in question – between October 1996 and January 2003 – and about 6,500 had incorrect dates.

A small number of grants had a large effect, however, with 660 special grants representing $48 million of the restatement, and one set of options given to Jobs – and later canceled – causing $20 million of the restatement.

Jobs’s grants were originally issued in 2000 and 2001, covering 10 million and 7.5 million option shares, respectively. The second grant was backdated from 18-Dec-01 (stock at $21.01, adjusted for later splits) to 19-Oct-01 ($18.30) or a difference of about $20 million. The board later canceled the options and gave Jobs 5 million restricted shares in March 2003 (now split to 10 million shares). He thus never saw any financial advantage from the option grants. (Jobs had Apple sell nearly half the stock in March 2006 to pay a $300 million tax bill when the stock vested that month; he retained about 5.5 million shares now worth a bit under $500 million.)

On page 85 of the 10K filing, Apple states bluntly that “the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording, and reporting of stock option grants.” This might be read as referring to former financial head Fred Anderson, who resigned from the board in October 2006, and general counsel Nancy Heinen, who left in May 2006 without a reported reason.

Anderson’s attorney told the Wall Street Journal that Anderson wasn’t involved in “any day-to-day role in the granting, reporting, and accounting of stock options.” An attorney for Heinen told the New York Times, “Nancy Heinen has a well-earned reputation over 20 years for honesty and integrity, and any rumors to the contrary are without foundation.”

There’s still the potential for the SEC to find other fault via its own investigation, although the bona fides of having Al Gore lead a committee that reports it spent nearly 27,000 person-hours poring through a million documents and interviewing 40 employees should forestall any surprises for the current management. The SEC may require penalties from Apple, and could decide to pursue legal action against Jobs or other current or former management.

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