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Wednesday, December 05, 2007

oPtion$ Book Club: A (Fictional) Version of the Backdating Scandal

I wanted to respond to the question posed by Dan Lyons: could Jobs still be indicted for the backdating at Apple?  And perhaps, the question lurking behind this one: why hasn't he been indicted already?

Many of the "oPtion$" reviews have noted its  somewhat fanciful plot.  What surprised me about the book, however, was how close the plot points actually followed reality. 

  • In the book, Apple GC Sonya Bourne resigns almost immediately after the backdating scandal breaks.  In reality, Apple GC Nancy Heinen resigned in May 2006 without a reported reason.  She has since been civilly charged by the SEC for backdating.
  • In the  book, Apple blames former CFO and board member Zack Johnson for the backdating.  After Apple blames him for the scandal, Johnson then agrees to a plea and to testify against Jobs.  In reality, former Apple CFO and board member Fred Anderson settled SEC backdating charges for a payment of a civil penalty and a $3.49 million disgorgement.  He also issued a statement claiming that Jobs knew about and in some cases directed the backdating.
  • In the book, the final straw for the Apple board is when they find out that Jobs falsely claimed that certain options were approved at a board meeting that never happened.  In reality, Anderson claims that Jobs provided assurances that the board had approved certain grants and that Anderson "relied" on these assurances.

One of the reasons why I was eager to read "oPtion$" was to see its take on the role Jobs played in the backdating.  What was fake Steve's motive?

Motive plays a critical role in the backdating scandal.  Why did firms backdate their options grants?  Was it simply to manage the process so that the company could (knowingly) reward its employees more handsomely, given accounting constraints?  Or was backdating an attempt by some in the company (generally the officers) to increase their compensation without the approval of the board or shareholders?

The fake Steve of "oPtion$" doesn't really show his cards to the readers on this point.  Fake Steve is so rich that he seems unconcerned and disconnected from his yearly compensation.  But at other points, he seems well aware of what happened.  For example, he justifies backdating at Pixar as a way to "sweeten things a little bit more" for John Lasseter, who was being courted by Disney at the time (p. 112-13).  (Thus, in fake Steve's view, Disney is to blame for the backdating.)  At another point, former CFO Johnson claims that Jobs knew all about the backdating and, in fact, directed Jonhson to do it (pp. 87-89).  During the conversation, Jobs claims ignorance.   Although it seems like we're not supposed to believe Jobs here, he never comes out and confesses to the reader.  He just doesn't seem to care.

The closest the book comes to laying out the case against backdating is this soliloquy from Apple's chairman Tom Bowditch (p. 89):

I know what you did.  You double-dipped.  Wasn't enough for you to get ten million shares.  You had to backdate them, too, and try to squeeze a little extra out of it. . . . Maybe you figure nobody in Washington actually reads those forms you send in every quarter.  Maybe you figured nobody would care, or that they'd give you a pass because you're the Great Steve Jobs.  Well, you're wrong.

But it's hard to know if this is an accurate indictment, because (1) Jobs never owns up to this, and (2) Bowditch turns out to have a huge short position in Apple stock and thus wants Jobs to resign.

As I've said before, it's clear to me that backdating was a method of increasing the value of the options and thus increasing the value of the pay.  I don't think many CFOs said, "We can give 10 million backdated options or 10.2 million correctly date options -- which is better?"  Instead, I'd guess that the number of options was settled on, and then the backdating was applied as a "bonus."

But who knew about the bonus?  That seems critical.  If the board was on board with the backdating, it seems less like stealing.  Since the board is charged with negotiating and approving executive pay, the board's knowledge would seem to lend the corporation's approval.  Dennis Kozlowski sits in jail because he failed to get board approval for expenses and loan forgiveness.  The same could be said of backdating.

Even with Board approval, however, there are problems.  "Backdating" is, by definition, lying about the date of the option.  So a scheme of backdating is designed to mislead somebody -- the board, shareholders, and/or the SEC -- about the date of the grant.  A scheme to avoid the accounting rule in this manner is akin to other forms of accounting gamesmanship.  The scheme in Brocade was apparently along these lines.  Moreover, as Vic Fleischer has discussed, companies that were backdating options were also violating the tax law.

My sense is that when it comes to Steve Jobs, criminal charges would only come if he knew about the backdating and purposefully circumvented the board and/or accounting rules in conducting the scheme.  There is certainly evidence from Fred Anderson to this effect.  But the independent Apple report seems to place all the blame on Anderson and Heinen.  Perhaps the SEC is being overly credulous, as Lyons indicates, in believing that Jobs was not intimately involved in the scheme.  But perhaps the government may have decided to avoid a risky trial based on Jobs's intent.  In the Brocade case, there appears to have been sufficient evidence that Reyes knowingly and repeatedly backdated to avoid the accounting hit.  Although the judge in the Brocade case indicated some concern with the mens rea issue, there was evidence from a former human resources employee that Mr. Reyes told her that the practice was “not illegal if you don’t get caught.”  There may not be such clear evidence of knowing illegality with respect to Jobs.

I don't know all of the facts, certainly, so I don't want to endorse or justify this decision.  Without all of the facts, we can only speculate about motives -- which is part of what makes "oPtion$" so fun.  In the book, an iPhone-crazed mob chases U.S. attorney Doyle to his death.  I'm not sure whether this is poetic justice or an exaggerated metaphor for reality.

Posted by Matt Bodie on December 5, 2007 at 12:10 PM in Books, Corporate, oPtion$ Book Club | Permalink


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In my opinion, Dennis Kozlowski, Joseph Nacchio and now Reyes, Jensen and anybody else wrapped up in this options mess are all victims of way overzealous white collar prosecutions. Nacchio was actually convicted of insider trading using forward looking statements! Incredible! I realize we have a hysterical public ready to hang every CEO as a witch but we need to use some discretion here and look for real crime and I haven't seen any of that- on any of these cases- in years. What I find amazing about the backdating cases is the juries say they need to go by the law.... did the offenders such as this VP HR really know the law? That she was engaging in a practice that could get her locked up for 20 years, with no benefit to her? That just flies in the face of common sense. Anyway I stumbled on this Option$ blog and know a little about these scandals. Jobs/Apple are actually the worst offenders- with the most evidence of the CEO knowing and the largest grants involved. So if Jobs (and Lassiter) escapes a criminal prosecution and all the others go down, its hard to see how justice is served.

Posted by: BRT1 | Dec 6, 2007 1:51:42 PM

Dennis Kozlowski did have approval from the Board. It was written in his contract and the Board approves his contract. Isn't that approval from the Board? He was paid according to his contract - he did not need approval for each time he was paid, however, the DA had a field day with the way he asked questions with the witnesses and it came out as if there was no approval when indeed there was! Dennis Kozlowski did no wrong - it was the judicial system that did wrong by convicting a man whom deserves everything he earned!!

Posted by: MAK | Dec 5, 2007 8:05:42 PM

Sorry my links didn't post well but the first link that explains apple backdating is from Roger Parloff's excellent Fortune legalpad blog, from April 25, 2007 "SEC sees Apple backdating as one woman fraud spree".

And the Brocade article is from Businessweek, August2007, "New Stock Option Fears in the Valley".

You can read these two pieces and compare the cases yourselves. The bottom line is- both CEOs Jobs and Reyes signed backdated paperwork that somebody else prepared, that is their crime. But Jobs benefitted materially as he was included in the plan, and Reyes did not (Reyes was a participant in an incentivized executive plan which has completely different rules and the backdating scandal applies to employee plans only). Possibly as a consequence of his participation in the employee plan, Jobs' emails have been recovered that clearly show a knowledge of backdating, and a former executive of Apple Fred Anderson is willing to testify that Jobs knew. None of that is true with Brocade, there is nothing to indicate he knew backdating needed to be expensed. There was a terse email from 2004 where Reyes corrected a communique to Verisign saying "It is illegal to backdate option grants" (corrected from what he said earlier)- which ironically is wrong, but the date of that email was 2004 and the period in question for Brocade backdating was 2000,2001. By 2004 he must have known something was up, but that was way after the fact.

Posted by: BRT1 | Dec 5, 2007 12:38:43 PM

I have heard similar arguments about how Jobs can be innocent and Reyes can be guilty before. My advice is- don't kid yourself. Those that are claiming there was more evidence against Reyes than Jobs, and therefore justice is done- are mostly in a state of denial and don't want to see Jobs in a red jumpsuit, but have no problems with OTHER CEOs that suffer that fate.

Reyes' "its not illegal if you don't get caught" was an untethered remark where the witness couldn't remember the subject of the discussion. Hardly solid evidence and called out as such by Judge Breyer.

Here is all you need to know to compare Brocade/Reyes and Apple/Jobs on the backdating issue:

The Executive Team grant, which was nominally dated January 17, 2001, worked like this, according to the SEC complaint. On January 30 Heinen emailed CEO Jobs and CFO Anderson spreadsheets laying out Apple’s stock prices for every day in the month of January, and recommending possible dates on which to retroactively date the grant. In her email to Jobs she wrote, “To avoid any perception that the Board was acting in appropriately [sic] for insiders prior to Macworld announcements, I suggest we use Jan. 10, the day after your Macworld keynote, at $16.563. That was one of the lowest closes of the month, after the $14.875 price on Jan 2. I don’t think the [Executive Team] would object to the $1.688 difference to avoid claims of inappropriate conduct.”

The conversation Anderson says he had with Jobs — in which he explained the accounting ramifications of choosing any date prior to when the board had actually given its approval — would have had to occur early in the process of awarding the grant, at a time when Jobs was planning to use the Jan. 2 date for the grant (the date Heinen thought would look too much like springloading). Anderson’s attorney says that Anderson “was told by Mr. Jobs that the Board had given its prior approval and the Board would verify it.” When asked about this account by the Wall Street Journal yesterday, Jobs referred the question to an Apple spokesperson, who declined comment.

For starters, REYES—unlike executives such as Apple (AAPL) CEO Steve Jobs and former United Healthcare (UNH) CEO Bill McGuire—did not receive backdated options himself. "This will set a tone that an executive can have mens rea—"a guilty mind"—even if he didn't personally line his own pockets," says George Stamboulidis, head of Baker Hostetler's white-collar defense practice. That's important, as an element of the securities fraud, false statement and records falsification charges on which REYES was convicted requires that the defendant understand that his or her actions were illegal.

What's more, the case against REYES included no blockbuster smoking guns to prove that he knowingly broke the law. For example, the government had no overheard conversations or e-mails in which REYES admitted his involvement in the alleged scheme with former Brocade human resources chief Stephanie Jensen. The pair, prosecutors say, routinely falsified paperwork so that Brocade's finance department would process it without incurring accounting charges required for options grants given at below the market price.

Posted by: BRT1 | Dec 5, 2007 12:27:35 PM

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