One Bite of the Apple

This post is by Lucian Bebchuk of Harvard Law School

The Wall Street Journal published today my op-ed piece on backdating and corporate governance. The piece, which builds on the Lucky CEOs and Lucky Directors studies discussed earlier in this blog, discusses backdating in Apple Computer and beyond. Here is what it says:

Apple Computer annoucned a week ago the conclusions of a special board committee that examined the “improper dating” of over 6,000 option grants during 1997-2002. The committee found no basis for having less than “complete confidence in [CEO] Steve Jobs and the senior management team,” placing full responsibility for past problems on the company’s former CFO and general counsel. But the company’s report fails to dispel concerns about Apple’s governance.

In reviewing past grant awards, the report discusses separately grants awarded to directors and to Mr. Jobs, but in lumps grants to senior managers other than Jobs together with all other grants. The company is surprisingly silent on whether any of these senior managers received “improperly dated” grants.

The report indicates that Mr. Jobs “was aware of recommended the selection of some favorable grant dates,” but states that “he did not receive or financially benefit from these grants.” But even though Mr. Jobs did not personally benefit from these grants, it turns out that he did benefit from other improperly timed grants.

In particular, Mr. Jobs received in 2002 an award of at-the-money options to buy 7.5 million Apple shares, roughly 2% of the total shares then outstanding. The grant was backdated by two months, which significantly increased the award’s value. Surprisingly, Apple did not disclose the backdating of this large CEO grant in October when it announced the committee’s “key findings.”

When reporting about this grant in 2003, Apple noted that the grant comprised 32% of the total options awarded to Apple employees during 2002, and explicitly stated that the grant’s exercise price was equal to the stock price on the grant date. Apple’s report does not provide any insight into why the special committee found as fully acceptable the failure by Mr. Jobs and all other directors to notice the erroneous recording and reporting of this significant grant.

The special committee concluded that Mr. Jobs did not appreciate the “accounting implications” that the improper dating of grants had for Apple’s financial statements. But improper dating may be viewed as wrong for reasons other than the accounting consequences. Thus, it is unfortunate that the report says little about what Mr. Jobs and other current senior managers knew and believed about the improper dating beyond noting Mr. Jobs’s failure to appreciate the accounting implications.

Finally, the account suggested by Apple’s report leaves readers wondering what incentive the former CFO and general counsel had to engage in improper dating. CFOs and generals counsel commonly do not have primary responsibility for attracting and compensating employees. Why would these two former executives engage in massive backdating of thousands of grants without at least tacit support from other members of senior management? Why would they act to increase the compensation of a CEO who was unaware of their having done so? These mysteries add to the questions posed by the company’s report.

Steve Jobs’s great accomplishments have well earned him a place in the pantheon of high-tech leaders and visionaries. And Apple’s senior management has undoubtedly done very well for shareholders during the past several years. All of this, however, clearly does not compel the conclusion that Apple’s governance has performed adequately with respect to option grants. And the company’s report falls far short of providing a basis for accepting such a conclusion.

Beyond Apple Computer, there are many other apples in the barrel of companies whose past option grant practices raise serious questions. In a recent study, Lucky CEOs, Yaniv Grinstein, Urs Peyer and I estimate that 12% of public firms were invovled in lucky grants awarded at monthly lows that cannot be explained by sheer luck. In a subsequent study, Lucky Directors, we further show that outside directors received lucky grants not produced by sheer luck in an estimated 7% of public firms.

We also find evidence linking lucky grants with governance problems. CEO lucky grants were more common when the board lacked a majority of independent directors. In contrast to claims that gains from backdated grants served as an efficient substitute for other forms of compensation, CEOs getting lucky grants received more, not less, total reported compensation. Lucky grants to outside directors were more common in firms with entrenching arrangements that protect incumbents from removal. And outside directors’ luck was correlated with CEO luck.

For corporate America to improve its governance going forward, boards should face up to–and fully share with shareholders–past governance problems in their companies.


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One Comment

  1. J. Richard Finlay
    Posted Sunday, January 7, 2007 at 2:15 am | Permalink

    I, too, am of the view that the company’s independent directors took an overly narrow approach to their mandate. They should have probed further into what was done, why it was done and the implications for the company’s reputation and culture. It is not enough to say that CEO Steve Jobs did not make unlawful or improper gains from options manipulation. Improprieties occurred on his watch. He permitted or encouraged backdating in his capacity as the most senior executive of the organization. He is the one who sets the moral tone for the rest of the company.

    I am unaware in either the pre or post Enron era where it was acceptable that there could be the slightest doubt in the word or integrity of the company’s CEO. Concerns must, therefore, also focus on specifically how Jobs assisted in the backdating, what his precise role was and whether he misled investors as to the disclosures that were made at the time and have subsequently been proven false to the tune of $84 million.

    The report also asserts that Mr. Jobs was unaware of the “accounting” implications involved. He has been CEO of the company for a considerable period and is widely reputed to be a “hands-on” manager. A Ken Lay type excuse that Mr. Jobs was not aware of what was happening around him or did not understand even the ethical implications of what he was doing, and was not bright enough even to seek counsel about any uncertainty, not only is not plausible, but even if it were would still raise serious questions about the standards of competency in the company’s top management.

    Inasmuch as CEOs have been recently fired for making false statements on their resumes and have had their bonuses reduced because of plagiarism, it appears that Apple’s board has not adequately considered the full implications, including far-reaching ethical implications, of what has occurred. What failures in governance oversight, along with the size and functioning of the board, that may have contributed to the fiasco, and what needs to be done to address these shortcomings, also appear to have escaped the board’s gaze.

    It’s clear from the actions of all the players involved that there should be more fallout from Apple’s revelations. The failure of the board to probe deeper and give Jobs a pass for this kind of conduct is bad enough. I have already talked with a number of CEOs and directors who are astonished at the board’s obvious and ill-advised attempts to sweep Jobs’ role under the carpet. But the failure of the SEC and the media to prevent that from occurring carries profound implications for the governance and leadership of corporate America and the confidence of the investors who rely upon it.

    You are doing a very important job of raising awareness of these issues, and of the consequences of the current dysfunctional state of CEO compensation and the disengaged boards that contribute to it.