Another look: Did Steve Jobs 'financially benefit' from backdated options?
You'll recall that in late December, when a special committee of independent Apple (AAPL) directors exonerated CEO Steve Jobs of any wrongdoing in connection with the options backdating that it admitted had occurred at that company, it stressed, among other things, that Jobs had not "financially benefited" from any of the backdating.
Others have already questioned the special committee's interpretation of financial benefit (see, e.g., this Washington Post article, focusing on the fact that the options were later exchanged for 5 million shares of restricted stock), and I have previously argued (here) that whether someone ultimately succeeded in realizing a financial benefit is irrelevant to the question of whether he attempted or conspired to violate various securities, tax, or accounting laws or rules.
But there's a simpler reason, still, that, I think, Jobs did "financially benefit" from some of the backdating at Apple. It stems from a very unusual fact about Jobs's two enormous options grants, which I only stumbled on recently when re-reading some of his SEC filings: large portions of each grant vested immediately.
Usually, of course, options don't start vesting for at least a year. (Under a typical vesting schedule, about a quarter of the optinons vest after a year, and the remainder vest on a pro rata monthly or annual basis over the next three or four years.) The delayed vesting is what makes them so hard to value: no one knows whether they'll be worth squat to the recipient by the time they start vesting. That's why people come up with complicated statistical estimation formulas for valuing options grants, like the Black-Scholes test.
Now I'm not criticizing Apple for making an exception from the usual vesting customs for Jobs, because Jobs had famously been receiving only $1 per year in compensation at Apple since returning to the company in 1997, so he was clearly entitled to some immediate compensation for past performance.
But the immediate vesting does seem to me to change the analysis of whether he "financially benefitted" from options backdating. (So far as I know, the committee was not using "financial benefit" as any term of art, with a specialized definition; they seem to have been using it the way it's understood at a gut-level in ordinary English.) The special committee acknowledged, remember, that the 7,500,000 options that Jobs was ostensibly granted on October 19, 2001, when Apple's price was $18.30 a share, had not really been "finalized" until December 18, 2001, when the price was $20.01 per share. (In addition, the committee found, the Apple board had not really met at all on October 19, 2001, as board minutes falsely indicated.) Accordingly, the committee determined that the accounting for these options had been improper, and it included a correction for this mistake in Apple's restatement. (The commmittee also found, in fairness, that the Apple board had first approved this grant to Jobs in August 2001, at a time when Apple's price was even lower than it was on October 19, 2001.)
Well, one-quarter of these admittedly backdated options -- representing 1,875,000 underlying shares -- vested immediately, according to a Form 4 Jobs filed with the SEC on March 20, 2003. (Similarly, fully one half of the 10 million shares ostensibly granted to him on January 12, 2000 vested immediately. But I'm ignoring those, because the the special committee concluded that that earlier grant -- notwithstanding some eyebrow-raising circumstances -- was properly accounted for.)
The value of Jobs's 1,875,000 vested options as of the day on which we now know that they were really granted are easy to calculate. On December 18, 2001, when the grant was finalized, the value of those vested options was the fair market value of the underlying shares ($39,393,750) minus the cost of exercising them at the strike price ($34,312,500). That's $5,081,250. All of that money was available to Jobs for the asking, then and there, and therefore I don't see why all of it wouldn't be considered "financial benefit."
How much of that financial benefit came from backdating? All of it. Had those options' strike price been set as of December 18, 2001, as the special committee says they should have been -- instead of as of October 19, 2001, when the phantom board meeting took place -- their intrinsic value to Jobs on that date would have been zero.
At this point in my argument, I'm sure, members of the Apple special committee would protest: there was no financial benefit, because Jobs never exercised those options. (He cancelled all his options in March 2003, when they were underwater, and received restricted stock in their place.) And I would reply: No, he did financially benefit, but he then took a calculated gamble with his gains -- the way we are all constantly taking calculated gambles with all of our assets -- which did not pay off in the short term. He chose not to exercise the options immediately, hoping for even bigger gains down the road. His gamble didn't happen to pay off, or at least hadn't as of March 2003, when he took another calculated gamble, and traded in the options for restricted stock. (My colleague Geoff Colvin analyzes here why agreeing to the trade-in was actually Jobs's biggest mistake of all.)
Say someone gives me a gift of $5,081,250. Say I sink it all into an uninsured beach house which later gets leveled by a flood surge stemming from a hurricane. Or say I put it all into the next Enron, and it soon plummets to worthlessness. Would anyone say that I had experienced no "financial benefit" from the $5,081,250 gift? I don't think so.
Apple spokesman Steve Dowling says: "The most important point is that both options grants, which were underwater, were cancelled. No options were ever exercised. . . . Following exhaustive independent investigation, the special committee found that Steve [Jobs] was not aware of any irregularities associated with [these grants]."
Of course, from previous posts on this subject, I understand by now that any reader of this blog who owns Apple shares does not care one whit whether Jobs backdated options or benefited from the practice; they just want him to stay as CEO and make them some more money. But what do people think about my reasoning? Did he experience "financial benefit" from backdating, or didn't he?
Posted by Roger Parloff 7:32 AM 16 Comments | Add a Comment
I agree 100%. If they were vested, there was an immediate benefit whether he chose to exercise or not.
I'm still curious to see what, if anything, regulators do about it. Apple's statements that he even recommended certain dates, but did not understand the implications is just nuts. No other executive in the US could get away with saying anything that outrageous.
He's accountable to shareholders, so the shareholders have to decide what to do.
Of course he financially benefitted. You are right on.
Also, Apple admits that the backdated options were "replaced" with restricted stock...Do you think they discounted that "replacement" by the amount of benefit he realized from teh backdating? If he didn't benefit from the options, then why were they "replaced" with something valuable.
The Apple BOD did not approve a CEO grant on Dec 18 and then look for a prior date with a lower price to benefit Jobs. As you point out, the BOD first approved the grant on Aug 29.
The intent of the board to make the grant was in the published minutes of the Aug 29 meeting. The grant was finalized Dec 18. At some point between Aug 29 and Dec 18 Jobs and Apple must have agreed to final terms of the grant and set the date for Oct 19. Setting that date established the value of Jobs' compensation which was approved by the next BOD meeting. It would be dfficult for either Jobs or Apple to agree to a grant if neither knew its value. As to the forged minutes of the meeting that never took place, were those minutes ever published? And, if the public record of the Dec 18 board meeting showed the grant was approved then, why would Jobs be dumb enough to fake a meeting approving the grant at an earlier meeting?
Ed Moisio raises some good questions, but they are questions that the Apple BOD chose not to address and clear up when it published its terse and opaque exoneration of Jobs in late December. It did not explain, for instance, whether and/or how the forged minutes of a board meeting that did not take place in October ever got approved by the board at a subsequent meeting. But the BOD does not claim that all the backdating at Apple occurred innocently. On the contrary, it strongly implies that serious wrongdoing did occur. It just indicates that the wrongdoing was entirely the fault of two unnamed executives who are no longer with the company, and that Jobs knew nothing about it, even though he did sometimes "recommend" grant dates. Given that some of the backdating seems to have been intended to benefit Jobs, that the options constituted Jobs sole compensation, and that Jobs is a notorious micromanager, the board's conclusions are just difficult to credit.
"But what do people think about my reasoning? Did he experience "financial benefit" from backdating, or didn't he?"
While I cannot answer for all "people", I can answer for me.
First, I think that we have to understand that financially benefit here means -- specifically because of the back dating.
NO one would accept option grants if there was no chance of benefiting. :-)
The only way to benefit is to sell the shares at more than their noted "value". Options that have stock that sinks in value are not a benefit. :-)
Normally, the criminal side is to knowingly set the "value" and sales dates to absolutely provide a "profit". Options that are not exercised or drop thru the floor, are not benefits. Period.
You say that they still are benefits because later Mr Jobs changed the options for restricted stock. I say no. If he had received a million jars of peanut butter and then exchanged that for a million jars of jelly, its just an exchange. The first effort did not work out right and we agree to exchange it for the second.
Now, the exchange of options for stock can be questioned for its "gift" value, tax issues, etc, but if it was handled correctly, then there is no issue.
In summary, for the options issue to ba valid, they have to have been exercised so that Jobs received a "contrived" profit. Everything else is a political effort not a legal effort.
Your article does make the point that that there was 'value' in the options he received, but I think the bigger point here is whether the backdating of options was done to injure or 'steal' money from shareholders. The SEC is an organization set up to protect shareholders. No question that Apple was doing (as well as many tech companies at the time) was wrong.... however, most of it was done in an effort to keep companies most their valuable assets (i.e. good employees). Jobs is not 'innocent' of these charges - but then again I don't believe he was being malicious either (as some CEOs were in using company worth as a private bank disregarding the shareholders).
Oh, nonsense. The problem with your argument is obvious. When you and I trade equities it is not the BUY transaction but the SELL transaction that creates value, and thus a taxable event. Last time I checked, the IRS is only interested in my SELL transactions and does not base the value of my portfolio on what the value of my account was on any particular day.
It is indeed unfortunate that Jobs did not exercise his options when they became immediately vested. However, why should this be treated any differently than when you or I trade? Once again, you are blaming Jobs for what he could have done but didn't do.
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First, I think you're really stretching to say that he benefited. In an opportunity cost way, possibly, but in actuality, no.
Second, it's not illegal to backdate options, and especially, going back to that time, backdating was not a practice that was vilified as it is now. So yes, Jobs helped to choose dates (and thus set the amount of the award) but it was not his responsibility to account for it on financial statements. He delegated that task to (and trusted) his legal and financial executives.
Third, when Jobs "traded" the options in, the amount the Board awarded him need not have had any relationship with the traded-in amount. The Board could've awarded him 10 billion dollars instead; that would've been the Board's perogative. In the same way, the Board, when choosing to backdate, is just awarding the recipient more. As long as the Board agrees, and it is properly accounted for so that the shareholders know (and implicitly agree when the Board comes up for re-election), it is all above board.
Hmm. The analogy of using 5 mil to buy an uninsured beach house and then losing it doesn't quite pertinent?
Jobs, by not exercising the option, didn't buy the beach house.
There is no analogy there, is there?
I confess, being innocent, that I don't follow your reasoning, quite.
Receiving the options, even if they were immediately realizable as cash, is a benefit. It would be like receiving a check for your birthday, which you could cash immediately. But if don't cash it, you haven't benefitted financially; yes, you have been given a benefit, a gift, a donum, but it's only value exists in its potential, and if you don't realize that potential--or actualize it by ercising it--then your benefit isn't financial. It remains, as it were, a sign of approval or esteem.
That it could be "replaced" acknowledges that the company intended to benefit him, to replace what was not realized with something that could be realized in a financial sense by selling it (the stock).
Yes, I'm a shareholder and am keen to see Jobs remain in place. And no, I don't think that he was "innocent" of a knowledge of what he was doing.
But your argument doesn't seem logical to me.
Perhaps I misunderstand.
Thanks for the thoughts.
First of all, if the Board approved the options in August then it is a done deal as of that date...no options are issued to employees until Board approval and they are considered granted as of that date. If the material terms of the option purchase agreement change, however, then there might be reason to seek another subsequent Board approval for the grant because it is essentially a new grant. Secondly, the fact that 1/4 of them vested immediately, well, that's no biggie either. It is not uncommon for companies to issue employees options where 1/4 of them vest immediately - especially employees who aren't receiving salaries. Thirdly, while a grant of 7 or 8 million shares seems like a lot to you or me for a personal account, this is really not that extravagant considering the size and prosperity of Apple and Jobs' role in the company. Apple has how many presently outstanding shares? I agree with the previous poster, the SEC was created to protect the shareholders, if the shareholders weren't harmed then who cares.
In the strictest sense of the wording financial benefit was obtained because potential value or the right but not the obligation to potential value was traded for actual value. But the question for the SEC is was there intent to defraud by this act and explicitly how? It is this sense of financial benefit I believe the board was addressing. I feel the SEC is building it's case on sand if it's trying to indict Jobs. The facts play out like a movie. You can't can't imply fraudulent intent from the way things played out. This is not as clear cut as trading on insider information. Jobs lost huge potential value for immediate value but if you're going to hang him on receiving immediate value for surrendering his options I say where is the fraud. He can't even write off his potential losses on future or past tax returns so the government already got it's cut.
Well, of course he received a benefit. He traded them in for something else of substantial value. That's it.
Steve will have to go, and soon. His fingerprints are all over other deals that will put the lie to any claims that he did not know what was going on.
I hope the board of directors at Apple has a succession plan in place...it is one of their responsibilities.
I can�t say about financially benefited� but did he profit? Really, isn�t that the question?
Is the SEC looking for financial benefits or profits? Given the author�s reasoning, I guess you could say that a �benefit�, realized or not, may or may not have occurred.
However, a profit�certainly as it concerns the U.S. Government� would be taxable. Were any taxes owed for this benefit? No. So, what you can say for sure is that Jobs did not profit.
With regard to the lesser charge of �benefit�: If you have a gym membership that is fully vested but goes unused, did you receive any benefit? Are you sure? Perhaps you�re more fit and have a lower cholesterol level, but just don�t realize it. Because the fact is, Sir or Madam, that you have, in fact, benefited.
You really have to go back to the first board meeting where they said, "Jobs value=X." X was then actualized in an option grant, approved late. Then the options went underwater and no longer = X. Then the board gives him unresticted stock that = X, Jobs' value. Now, Jobs didn't benefit from the options when he traded them for stock. He benefited from the board valuation Jobs=X. The problem with all these silly arguements is that they attribute no cause to the grant of options or the grant of stock. So, the grant of stock is not "exchanged," even if that is the word they used for the options. By Roger P's reasoning this "exchange" would be $0 for X. But it's not, the initial value of Jobs is X.
Pretty tough to argue that he benefitted when he didn't.
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