Apple's Options Woes Deepen

News reports of falsified documents sent investors scurrying. The stock price has recovered, but Apple's legal troubles are far from over

by Arik Hesseldahl

For Apple (AAPL), it was beginning to look a lot like, well, Christmas. Analysts pointed to brisk sales of iPods and iTunes during the holidays, the most recent earnings report indicated robust demand for Macs, and the blogosphere was abuzz with rumors of hot new gadgets to be unveiled by Apple Chief Executive Steve Jobs in January.

But then came reminders that the company remains mired in an options mess. Early in the normally quiet week before the New Year, a California legal trade publication reported that Apple may have falsified documents relating to stock-option grants made to executives between 1996 and 2002, and that CEO Steve Jobs has retained his own lawyer in relation to the probe.

Jobs Retains Counsel

The Recorder, a legal journal based in San Francisco, said federal investigators are focusing on a set of documents concerning Apple's handling of stock-option grants. An Apple spokesman declined to comment on the report, but a source familiar with the matter confirmed to BusinessWeek.com that Jobs has retained an outside attorney. The person didn't identify the counsel.

The report—and a later article in the Financial Times—served as reminders that Apple has yet to move beyond concerns over its handling of stock-option grants to executives. It also raises questions about the extent to which Steve Jobs' reputation may be harmed by the matter.

Apple has already owned up to "irregularities" and said an internal investigation found several instances where Apple options grants appeared to have grant dates that predated approval. It also has said Jobs was aware of the practice but that he didn't benefit personally from it—and that the company hadn't found misconduct by its current management team (see BusinessWeek.com, 6/29/06, "Apple's 'Irregular' Options," and 10/5/06, "Apple Comes Clean on Options").

Apple is among dozens of companies, many of them in the tech industry, now being called on the carpet for how they doled out options. More disclosures are likely to emerge by Dec. 29, when Apple is due to file its quarterly and fiscal yearend reports with the Securities & Exchange Commission.

Investigation Targets

Meanwhile, according to the Recorder, federal officials are weighing the revelation of falsified documents as they consider pursuing a criminal investigation against the company or current and former executives. The report said that investigators appear to be focusing primarily on the actions of two executives, former General Counsel Nancy Heinen, and former Chief Financial Officer and Director Fred Anderson. A Financial Times report, published early on Dec. 28, cited unidentified sources as saying Jobs was handed 7.5 million options in 2001 without the required authorization of the company's board.

The approval date of this block of options coincides with a crucial point in Apple's corporate history: The grant came only a day after the company had reported quarterly earnings, at a time when the stock was trading near its lowest point during the calendar year, and only a few days before Oct. 23, the day that Apple introduced the iPod music player. Even so, by 2003 these options were worthless and Jobs voluntarily canceled 27.5 million options because they were underwater. In exchange he received restricted stock.

Anderson had been CFO since March, 1996, and retired on June 1, 2004. A week later he was named a director of the company but resigned his board seat on Oct. 4 in the aftermath of Apple's investigation. Since leaving Apple's board, Anderson also has retained a lawyer, Jerome Roth, of Munger, Tolles & Olson in San Francisco. Roth didn't return a call seeking comment.

Heinen had joined Apple following its 1996 acquisition of Next, the deal that also brought Jobs back to Apple after an absence of more than a decade. Heinen left the company suddenly on May 1, 2006, and within three months had retained two criminal defense lawyers, Cristina Arguedas and Miles Ehrlich. Neither lawyer returned calls seeking comment.

Jobs Defended

Many tech companies relied heavily on stock options in the late 1990s and early part of this decade as a means to compensate and retain employees. In Apple's case, options grants were made at times when the stock price was at a historical low and in close relation to major announcements. In one instance, Anderson was among the executives who received stock-option grants with approval dates of July 11, the day that Apple's stock hit a 10-year low. Within a month, the announcement of a $500 million strategic investment from Microsoft (MSFT) sent the stock soaring and created a huge paper profit for the executives who received the grants.

Analyst reports from Piper Jaffray's (PJC) Gene Munster and UBS' (UBS) Ben Reitzes urged calm. "If individuals at Apple did falsify certain options documents, that is clearly a negative for the company," Munster wrote. "We believe there is less than a five percent chance that Steve Jobs would have been personally involved."

That sentiment was echoed by Reitzes. "Investors seem to be reacting to the mention of Steve Jobs," he wrote. "We believe it could make sense to obtain counsel given his immense personal fortune and influence. We believe Apple seems to be on track toward putting options issues behind it and expect delayed filings within two days. We should also receive more information regarding the probe and the potential impact on management."

Concern about the implications of the reports weighed on Apple shares on Dec. 28. In afternoon trading, the stock declined $1.2, or 1.5%, to $80.32.

A New Legal Eagle

The potential financial impact of any restatements related to the options matter on Apple is expected to be minimal. The number of options involved is not sufficient to materially impact Apple, which said in a preliminary report in October that it had clocked $19.3 billion in revenue, with $1.9 billion in profit, and reported a cash position of more than $10 billion in its fiscal fourth quarter (see BusinessWeek.com, 10/19/06, "Apple's Big Mac").

Apple has also called in a new legal ringer. On Nov. 13, Apple announced that it had hired Donald Rosenberg as senior vice-president, general counsel, and secretary, replacing Heinen. Rosenberg joined Apple after a stint as general counsel at IBM (IBM). Highly regarded after some 30 years on IBM's legal team, Rosenberg has a reputation as a tough negotiator. His primary job at IBM before becoming general counsel was interacting with regulatory agencies like the Justice Dept. and the SEC. As part of his compensation package, he received a grant of 200,000 shares of restricted stock, according to SEC filings. The restricted stock will vest in blocks of 50,000 shares each until 2010.

But the cloud of worry about a criminal probe into the matter can't be discounted, says Jill Fisch, a professor of corporate and securities law at the Fordham University Law School in New York, and a former Justice Dept. trial attorney. "Once you start seeing falsified documents, that shows knowledge of wrongdoing as opposed to an accounting screw-up or a coincidence," Fisch says.

"The Tone at the Top"

The documents in question, Fisch said, are likely to be internal Apple documents relating to compensation records. But if Apple employees were found to have falsified them, the offense could be just as serious as filing false reports with the SEC. And in deciding whether to proceed with a criminal case, the particular facts surrounding any supposedly falsified documents will weigh heavily. "The government will consider the extent to which people knew they were doing something wrong, the size of the economic gains," she says. "The government will be much more concerned about the tone at the top and whether or not it thinks there was a climate of corruption as opposed to scattered instances of accounting mistakes."

Apple has tried to portray the options matter as one in which it has taken all the correct steps by voluntarily taking the matter to the SEC, cooperating fully with regulators, and disclosing its findings in a timely manner. But cooperation may not be enough to stave off a criminal prosecution, Fisch says. "The fact that Apple cooperated fully wouldn't save any one executive from prosecution."