Apple and the Options Backdating Scandal of the Past Decade
In 2001, Apple’s board of directors and some of its executives backdated options without properly reporting to the SEC. This was one of many options backdating scandals to occur within the last decade. Although most of Apple’s executives and directors knew that backdating was illegal and unethical, they succumbed to various pressures, including group conformity and conformity to authority. To prevent similar fraudulent activity in the future, Apple should take measures to increase consequences for bad behavior or incentivize whistle-blowers.
Options backdating consists of granting an option that is dated prior to the date the option is actually granted. It allows the grantee to receive options that are already in the money, which allows him or her to glean a much higher profit. Options backdating is not illegal per se, it becomes illegal when it is improperly expensed in the company’s financial records or it is not properly disclosed to the SEC and investors.
One study estimated that as many as 43% of publicly traded companies backdated options between 1996 and 2002 (1). Apple admitted to granting backdated options on 15 dates between 1997 and 2002 (2). In 2006, Apple had to take an $84 million charge to correct erroneous financial statements resulting from options backdating (3). In 2007, the SEC charged Apple’s former general counsel, Nancy Heinen, with fraudulently selecting earlier dates for two grants, one in February 2001 and another in December 2001, which involved Apple’s former CFO, Fred Anderson, Apple’s CEO, Steve Jobs, and other executives (4). In 2007 and 2008, Heinen, Jobs, and Anderson all settled with the SEC (5). Shareholders also won a $14 million claim against Apple filed after Apple corrected its financial statements in 2006.
It is rare for someone to commit unethical behavior without the expectation of gaining some sort of benefit. In Apple’s case, there were two groups that benefited from fraudulent options backdating: the executives (the grantees) and the board of directors.
The benefit to the executives was obvious – they were able to obtain a large profit from options that may have otherwise been of little or no value. In a deposition for the case SEC v. Heinen, Jobs also claimed that recognition by his peers was what drove him to ask for the options. He stated, “It wasn’t so much about the money, but everybody likes to be recognized by their peers” (6). Jobs and the other executives felt that they deserved a reward for their contributions to the company. They may have been justified in their expectation of large compensation: these top Apple executives could have easily joined a competing company and received large sign-on bonuses and salaries. Anderson and Jobs were credited with saving Apple from bankruptcy in the late 1990’s. However, being compensated through backdated options enabled them to hide some of their compensation and keep it off of Apple’s income statement.
The board of directors benefited from the backdated options by being able to reward Jobs and other top executives who were valuable to the company. The board did not want to lose any of the executives and therefore wanted to give them an incentive to stay with Apple. The backdated option grants in question occurred towards the end of the tech bubble when many executives were switching companies. Many of the options that Jobs and other executives had been granted were worthless due to the collapse of the tech bubble. The board wanted to ensure that the Apple executives received significant compensation for their efforts. To some degree, the board as well as the executives also benefited when expenses left off of financial statements made the company appear to be more profitable than it actually was.
However, the board of directors’ loyalty should have been to the investors who they were supposed to be representing. Investors were the major losers in the scandal. They were deceived when Apple appeared to be more profitable than they actually were. After news of the scandal broke, Apple’s stock and reputation suffered from the ongoing investigation and frequent bad press. The scandal also forced the resignation of Anderson and Heinen and hurt Jobs’ reputation.
Part of the reason that the board may have failed to live up to their responsibilities to the investors was the close ties they had with Jobs. In August of 1997, Jobs had asked three members of Apple’s board to resign and to appoint him and three of his acquaintances (who were respected businessmen) to replace them (7). These three men had an interest in keeping favor with Jobs since he helped them to get on the board and since they had friendly personal relationships. The four of them together had majority control over Apple’s board. While these members of the board appeared to be independent (since they came from different companies), their close ties with Jobs resulted in a conflict of interest. They were likely more loyal to Jobs and his executive team than they were to the investors they were supposed to be representing.
Apple’s fraudulent options backdating was not limited to one person, there were many people involved. The board approved the December options backdated to October as well as 14 other backdated options grants between 1997 and 2002. A subordinate to Heinen then allegedly fabricated bogus board minutes for the October date at which the December options were dated. Jobs, Heinen, and Anderson all accepted backdated options as some point during 2001, although it appears Jobs, Anderson, and the board did not know about the fabricated minutes.
Not only were Apple’s backdated options known to many people, but the practice extended throughout the business community. Since directors often serve on more than one board, they form a tight-knit community of interlocking boards. Researchers found that interlocking boards were the “biggest conduit for transferring information about options backdating” (1).
The amount of people who knew about backdating and did nothing to stop it is evidence of group conformity. The idea to backdate options at Apple was likely first brought up by a board member or high executive who had participated in options backdating at another firm. Since he or she had already successfully backdated options, it gave that person and the idea more credibility. There may have been other directors and executives who were interlocked with boards that had also previously participated in backdated options. As more directors and executives appeared to favor the idea at Apple, it became more difficult for any one person to oppose options backdating.
The pressure to conform to a group is very real, as Solomon Asch showed in his experiments. Jobs, Anderson, and Heinen were all respected executives. Apple’s board of directors included well respected businesspeople, such as Intuit Chairman William Campbell and Oracle Chairman Larry Ellison. These men had significant power within the business community and within the technology industry. Calling into question the ethics of any of the executives or board members would have taken significant courage. So many firms were involved with backdating that it was very easy for Apple to conform to the common business practice, despite the fact that it was unethical and fraudulent.
Adding to the pressure to conform was an uncertainty about the consequences of options backdating. There were no high profile cases of options backdating until 2005 to 2006. This made the long term consequences in 2001 very vague while the short term benefits – such as the large income for Jobs and the other executives – were readily apparent. Nevertheless, the executives and directors should have realized the considerable consequences should the fraudulent backdating ever be discovered. Even though it seemed at the time that the chances of being caught were remote (no major firms had been caught up to that point), if Apple were to get caught the consequences were likely to be severe for the executives, directors, and for the company they represented. The severity of the long term consequence should have compensated for the seemingly small probability of being caught.
While the widespread usage of options backdating created some ambiguity regarding the ethics of the act, Heinen’s subordinate that fabricated the October 2001 board meeting minutes (allegedly Heinen told her to do so, although it has never been proven) knew that doing so was unethical. In addition to the pressures already mentioned, the subordinate was also subject to conformity to authority. The pressure to obey authority was demonstrated in Stanley Milgram’s experiments. This subordinate was ultimately responsible to Heinen, who reported to Jobs and Anderson. While Heinen and her subordinate knew the law very well (Heinen was Apple’s general counsel), they decided to commit fraud at least partially as a result of pressure from superiors. One New York Times article stated, “You get the strong impression that nobody dared to say no to Mr. Jobs, a notoriously difficult and abrasive chief executive. One imagines the trepidation of the compensation committee members – or Ms. Heinen – in telling him that he couldn't get a low option price because the stock had risen during the negotiations” (8).
Jobs and Heinen never admitted to any wrongdoing. Part of Jobs’ defense, and part of the reason that many investors did not criticize him as much, was that he did not profit from the backdated December option grant. The stock subsequently fell and the options were underwater, even though they had been backdated. The fact that Jobs did not profit is not a valid defense. He fully expected to profit – and many of the backdated options were to compensate other executives who did profit. Jobs’ lack of a profit was irrelevant to whether he acted unethically in the first place. Jobs also claimed that he did not understand all the accounting implications of backdated options, but Anderson claims that he made Jobs aware of the implications and that Jobs knew what was going on. In addition to the board, Jobs also had a responsibility to shareholders to understand the implications of what he was signing. Certainly, as CFO, Anderson felt responsible and that is likely part of the reason that he was the first to resign in the scandal.
The SEC, the government, and investors have taken many steps to prevent options backdating from continuing to occur. Sarbanes Oxley has made options backdating more difficult by shortening the time frame firms have to report options grants. Investors have developed methods to detect options backdating more quickly. The media attention that options backdating has received has also played a roll in discouraging future backdating. However, such measures will not prevent further commissions of other types of corporate fraud, except to the extent to which they increase the perceived or actual consequences to fraud.
Increasing the consequences of corporate fraud is one way in which a company can discourage fraud. If Apple had developed a more strict punishment to anyone involved in financial misstatements, such as immediate dismissal from the company or the board, the participants in options backdating may have acted more carefully. In particular, the fact that Jobs did not receive any significant punishment from Apple shows that Apple and Apple’s board of directors did not take the deceptive activity seriously enough, and that there were not sufficient disincentives to unethical behavior. Apple’s management did not admit to the fraud until they saw the serious consequences facing other firms where options backdating had been discovered.
Some firms have attempted to teach ethical behavior and instill an ethical corporate culture within their firms. This would have likely have been ineffective in preventing options backdating at Apple. The unethical acts were at the very top of the corporate ladder and even among the board of directors. These people were most likely insulated at some level from any initiatives they did not create themselves and from typical ethics training courses. A certain amount of hubris often accompanies top executives that would have made them less prone to consider ethics being taught mostly to subordinates.
A better way in which Apple could have caught the fraud in its infancy would have been to reward whistle-blowing. Whistle-blowing is easier said than done: a whistle-blower would have had to confront Apple’s board of directors and its top executives. However, the amount of people that knew about the scandal and kept quiet shows that there was not a significant enough reward for ethical action. If Apple would have had a substantial financial reward to give to whistle-blowers, such as an amount equal to 5% of the financial misstatement, it may have enticed a subordinate or one of the executives or directors themselves to bring the fraudulent activity to light. This reward could be accompanied or replaced by clemency if the whistle-blower was involved in the scandal. The mere presence of such a policy may have discouraged some of the participants from acting contrary to Apple shareholders’ interests.
The possibility of corporate fraud, such as options backdating, is a very real threat even after the many scandals that have been uncovered. Group conformity, conformity to authority, and poor judgment of consequences all pressure individuals, such as Jobs, Heinen, and Anderson, to act unethically. Apple and companies like it can prevent future unethical behavior by increasing consequences and rewarding the ethical behavior of whistle-blowers.
by Blake Taylor, 18 May 2009
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