Tough Questions for Apple

Even if the options mess doesn't play out as a worst-case scenario, the iPod maker has some important questions to answer about policy and procedure

by Arik Hesseldahl

It's been a decade almost to the day since Apple Computer (AAPL) announced it would acquire NeXT Computer. The deal brought Steve Jobs back within Apple's Cupertino (Calif.) walls, setting in motion an epic turnaround that's sure to rank among the greatest second acts of American corporate history. Righting the foundering ship wasn't easy at first, though the effort has picked up speed in recent years as the iPod music player has gone from curiosity to cultural icon, helping boost sales of other Apple products and luring investors to Apple stock.

But there's little time for celebration this anniversary. Apple executives instead are coming to grips with a scandal concerning the granting of stock options, and they're preparing to release long-delayed regulatory filings that investors and analysts hope will shed light on what happened, who's responsible for misdating of certain grants, and the likely impact on Apple's bottom line.

On Dec. 29, after the close of the market, Apple is expected to file its quarterly and annual reports with the Securities & Exchange Commission. Apple has already acknowledged some 15 instances where options appear to have grant dates that predate approval. That suggests the possibility of backdating, or changing a grant date to artificially boost the value of the option, a practice that can understate compensation costs and overstate profit.

The extent of the damage the practice may have caused Apple took center stage in recent days amid news reports that Jobs received 7.5 million options without the board's approval and that minutes of board meetings were falsified to suggest directors had indeed approved the grant (see BusinessWeek.com, 12/28/06, "Apple's Options Woes Deepen"). Apple's shares dipped and recovered amid conflicting views on how profound an effect the options issue will have on Jobs and the company he runs.

But as Apple executives prepare to deliver the documents, there's a long and growing list of unanswered questions. Here are a few:

1. What did Steve Jobs know about the backdating of options, and when did he become aware of the practice?

Apple in October said that in some cases, "Jobs was aware that favorable grant dates had been selected." It also said "he did not receive or otherwise benefit from these grants and was unaware of the accounting implications." Jobs has retained a lawyer in relation to the options issue. Getting the full story on what he knew, and what he did once he became aware of the practice, will be crucial.

In 1997, near the time when Jobs assumed full CEO responsibilities, an internal Apple memo leaked to CNet, the technology news service, suggested stock options, rather than cash, would be the basis of bonuses at Apple in the future. Knowing this, Apple should disclose exactly which people were in the chain of command, both in the executive suite and on the board of directors, for approving options grants to employees at all times from this point forward.

2. If Jobs or any other senior managers knew executives were not following procedures, policies, and laws during the period in question, what action was taken to correct the actions and discipline or dismiss those responsible?

Apple, again in October, said it uncovered "serious concerns regarding the actions of two former officers in connection with the accounting, recording, and reporting of stock-option grants." It didn't identify the individuals and said it hadn't found any misconduct by its current management team.

Longtime Apple general counsel Nancy Heinen, who is according to some reports a potential target of a criminal investigation, left suddenly on May 1, 2006. Her attorneys haven't returned calls seeking comment. The board resignation of former Chief Financial Officer Fred Anderson was announced on Oct. 4, the same day Apple announced the findings of its options investigation. His counsel also hasn't returned calls seeking comment.

3. Which employees were granted options in the 15 instances where backdating is said to have occurred? What, if any, financial benefit did they incur? What was the final disposition of those options?

It stands to reason that if no one benefited financially from the backdating, intentional or not, of these options, then the probability of criminal prosecution against the company drops. "If there was no financial benefit, it's a much less appealing case to prosecutors," says William Sullivan, a securities lawyer with Paul, Hastings, Janofsky & Walker in San Diego. According to the Recorder, a legal journal based in San Francisco, federal investigators are considering whether to pursue a criminal investigation into the matter.

4. What are the periods for which financial results will have to be restated, and by what amounts? Additionally, what are the tax implications?

Generally, given the number of options involved, the restatements and tax implications aren't likely to be meaningful for a company with nearly $20 billion in revenue last year, and a cash reserve of $10 billion. Repayment of any back taxes, plus any fines on top of that, will likely amount to pocket change, but the amounts should be spelled out regardless of size, if only to erase any shadows of doubt among shareholders.

5. What new procedures, policies, and review requirements are now in place to ensure something like this doesn't happen again?

In the wake of the options mess, Apple appears to be showing a preference for granting blocks of restricted stock that vest over time to senior employees. Documenting the controls, policies, and procedures around these grants will be important as well.

6. Should the fallout of the options matter result in the departure of Jobs—however unlikely that scenario may be—what plans are in place for the board to name a successor? Who might that person be?

The uncomfortable set of questions couldn't help but be raised in 2005 when Apple disclosed that Jobs had undergone surgery for pancreatic cancer. Jobs recovered, but now as Apple grapples with the options issue, and even if the odds are long that he's in serious trouble, the questions can't help but resurface.