ShareThisBy KATHLEEN PENDER
Few chief executives are more synonymous with their companies than Apple Computer Inc.'s Steve Jobs. He helped rejuvenate the company he co-founded, first with candy-colored iMacs, then the iPod and now Intel-based computers, all the while skippering another hugely successful company, animation studio Pixar. He is seen as Apple's savior, visionary and public face.
If Jobs were to be personally implicated in the options irregularities the company is investigating, Apple and its stock price would surely suffer, at least in the short run. A Jobs departure would overshadow any financial restatements the company makes. Despite his reputation as a hands-on manager, investors and most analysts seem to think there is little chance Jobs was involved in any options problems at Apple. Since Apple first disclosed it was investigating options irregularities, its stock price is up significantly more than the overall market.
At this point, there is no evidence that Jobs was involved in any wrongdoing, although he did receive one huge Apple option grant in question.
But analyst Richard Farmer of Merrill Lynch says he can't rule out the possibility that Jobs was involved in options backdating at Pixar. If Jobs was involved, it could jeopardize his role at Apple, Farmer says in a research report.
"We believe there are not yet enough facts to form a conclusion on whether key executives might have been involved in creating options irregularities at Apple or Pixar, and our default assumption is that Jobs is not likely to have been involved; however, our review of Pixar disclosures does not allow us to rule out the possibility, given Jobs was a member of the board that made options decisions, and our analysis suggests these may contain irregularities," Farmer wrote.
He says the key question for investors "is whether he knowingly participated in creating option irregularities (at either Apple or Pixar) in a way that constitutes serious direct personal misconduct, which could lead the SEC to take legal action against him, including potentially barring his ability to serve as a director, officer, or financial reporting executive of any public company, including Apple."
Apple is one of 43 companies that have begun internal investigations into their options practices. An additional 78 companies have announced government investigations, according to a recent tally by proxy advisory firm Glass, Lewis & Co.
Of these 121 companies, Apple is the third largest by market value, after UnitedHealth Group and Home Depot.
The central question in these investigations is whether grant dates were manipulated to enhance the value of stock options awarded to executives and, in some cases, lower-level employees.
How options work
An option gives the holder the right to buy stock at a fixed price, known as the strike or exercise price, over a number of years, usually 10. If the market price rises above the strike price, the holder can exercise the option, that is buy the stock at the strike price. The holder can then sell the stock at the market price and pocket the difference.
Option grants typically vest, or become available to exercise, over a number of years.
If the strike price is above the market price, the option is said to be out of the money and can't be exercised. If the strike price is below the market price, the option is in the money and can be cashed in as soon as it vests.
Under old accounting rules, companies didn't have to deduct options as a compensation expense as long as the strike price was not lower than the market price on the grant date. The grant date is usually the day the board or its compensation committee or other designated authority approved the options.
Most companies set their strike prices equal to their market prices on grant dates, or said they did.
However, to make their options potentially more valuable from the get-go, some companies might have set the strike price equal to the market price on a previous date, when the market price was lower, creating a discounted or in-the-money option.
To avoid having to show a compensation expense for this option, some companies might have fudged grant dates to make it look as though the option were actually awarded on the earlier date.
This practice, known as backdating, could violate accounting, disclosure and tax regulations. Depending on the circumstances, it could result in civil and potentially criminal charges, financial restatements and tax penalties.
Several former top executives of Brocade Communications Systems Inc. and Comverse Technology Inc. are facing civil and criminal fraud charges in connection with alleged backdating schemes.
Many of the 121 companies being investigated granted options on dates that seemed too propitious to be the result of chance.
Apple options
Apple announced on June 29 that an internal investigation had discovered irregularities related to the issuance of certain stock options from 1997 to 2001.
According to the Indiana University Internal Audit Web site, an irregularity "refers to the intentional misstatement or omission of significant information in accounting records, financial statements, other reports, documents or records."
On Aug. 3, Apple said it had discovered additional irregularities likely to result in financial restatements. It said its financial reports from September 2002 onward should not be relied upon.
On Aug. 11, Apple announced it had missed the deadline for filing its latest quarterly statement. As a result, Nasdaq initiated a process that ultimately could lead to delisting Apple's stock, if no corrective action were taken.
Apple declined to comment further on its investigation or Jobs.
Between from 1997 to 2001, Apple issued options to various executives on 13 dates, according to Farmer's report.
On six of these dates, Apple's stock price was at or near a monthly low and substantially below its monthly high. In other words, these options were granted just after a drop in the stock price or just before a rise.
In one well-timed grant, on Aug. 5, 1997, Apple gave a total of 820,250 options to four executives (excluding Jobs).
The next day, Jobs, who had recently returned as a special adviser to the struggling company, announced he had brokered a deal in which Microsoft would invest $150 million in Apple and share patented technologies. The news sent Apple's stock price soaring almost 50 percent in two days.
The timing of this grant could have been pure coincidence. Or it could have been the result of backdating or spring-loading, which refers to granting options just before a company announces good news likely to drive up its stock price. The SEC has not ruled on the legality of spring-loading, although one commissioner, Paul Atkins, has said he thinks it's fine.
On Jan. 12, 2000, Apple gave Jobs options on 10 million shares (before subsequent splits) at a price that turned out to be a low for the quarter. During the next five trading days, Apple stock climbed 30 percent.
Apple's proxy that year said, "all options were granted at an exercise price equal to the fair market value ... on the date of grant."
Later in 2000, Apple's stock cratered and Jobs' options fell deeply out of the money. In March 2003, he canceled all his outstanding options (except those he had received as a director) in exchange for restricted stock.
Jobs' role
Many analysts have said that if there was any backdating at Apple, Jobs could not have been involved.
"Even in the worst-case scenario where (Apple) is found guilty of improper options granting, we do not believe Steve Jobs is liable, the reason being the compensation committee at (Apple) is run by an independent board that is not comprised of employees of (Apple)," American Technology Research analyst Shaw Wu wrote.
In a report, JPMorgan analyst Bill Shope says it "is extremely unlikely" that Jobs was involved because "all options grants are determined and approved by a compensation committee ... and Steve Jobs has never had any official role in the process."
It's worth noting that Kobi Alexander, the former Comverse CEO who is facing backdating charges, was not on his board's compensation committee.
Pixar options
Between 1997 and 2004, five out of seven Pixar grants were recorded at the lowest possible price within the months they were granted, Farmer notes. He estimates the probability of this happening by chance at about 1 in 168,000.
Moreover, four of the seven grants were recorded at the lowest price within the fiscal years they were granted. Farmer calculates the odds of this happening randomly at 1 in 112 million.
On Feb. 21, 1997, Pixar granted options to its creative genius John Lasseter one trading day before the company announced a five-picture deal with Walt Disney. The news gave Pixar stock a two-day gain of 55 percent.
Farmer notes that spring-loading, as opposed to backdating, might explain some grants. But, he adds, "we believe that irregularities and/or backdating at Pixar was likely. ..."
Pixar was acquired by Disney in May. Neither company has disclosed an internal or external investigation into Pixar's options. Pixar did not return phone calls.
According to its proxy statements, Pixar had a two-person compensation committee, but the committee did not meet from 1997 through 2004, although it took certain actions by written consent in 2003 and 2004.
Instead, Pixar's board of directors "performed similar functions" to the compensation committee during these years, the proxies say.
According to Farmer, Pixar's board included only four directors who were common during the years when option grants were at monthly lows: Jobs, who was Pixar's chairman and CEO; entertainment lawyer Skip Brittenham; Joseph Graziano, a former Apple chief financial officer and director; and Larry Sonsini, an attorney with Wilson Sonsini Goodrich & Rosati.
Sonsini has also done legal work for Apple and was a director at Brocade. Former Brocade CEO Gregory Reyes, who is facing criminal charges, told BusinessWeek that Sonsini urged the Brocade board to make Reyes a "committee of one" to grant options as he wished in 1999. Sonsini's firm did not return calls.
The bottom line
Most analysts say that if Apple revises its financial statements to correct the options problems, it is not likely to have much impact on the stock.
Rod Bare, a stock analyst with Morningstar, says that for most companies that have corrected options mistakes, "the cumulative effect of the restatement is pretty modest." He expects the same will hold true with Apple.
Companies are valued on their expected future earnings, so restating financials does not always hurt their stock.
The impact of an executive departure would be more dramatic, at least in the short run.
If we woke up one day and Jobs had been indicted or fired, "I think we'd see 10 bucks or so knocked off" the stock price, Bare says.
Farmer agrees: "Although we would be among the first to acknowledge the many significant contributions Steve Jobs has made to Apple ... we believe Apple's brand, technology, and network effect assets are largely independent of the company's leadership."
(E-mail Kathleen Pender at kpender(at)sfchronicle.com.)
