Next Chapter Re: Apple’s Backdating Woes

On Friday, December 29, 2006 Apple Computer filed its delinquent 10-K and 10-Q reports, restating certain results and taking a non-cash charge of $84 million related to its improper stock option transactions.  The reports reiterate the conclusion  of a Special Committee headed by Al Gore which found no misconduct by current management but serious questions about the conduct of two prior officers.  The reports also acknowledge that the company’s founder and CEO, Steven Jobs, “was aware or recommended the selection of some favorable grant dates [but] he did not receive or financially benefit from these grants or appreciate the accounting implications.”  The reports detail a number of errors in the option granting process. 

No doubt Apple hopes that completing its stock option probe and filing its SEC reports is the end of the matter.  New reports, however, suggest otherwise.  According to BusinessWeek.com, The Recorder, a trade journal in San Francisco, claims that federal investigators are looking into the question of whether Apple may have falsified documents in connection with improper stock option grants.  A report by the Financial Times also raises questions about the extent to which Mr. Jobs’ reputation may be harmed by the matter.  According to the Financial Times, a few day before Apple introduced the iPod music player on October 23, 2001, Mr. Jobs was given 7.5 million options without the required authorization of the company’s board and at a near low point for the stock.  Later when these options were underwater following a stock split, Mr. Jobs surrendered them and received restricted stock.. http://www.ft.com/cms/s/801e1b82-9605-11db-9976-0000779e2340.html 

The issuance of these options appear to coincide with those detailed in Apple’s SEC filings, which were recorded improperly as having been approved at a board meeting that did not take place.  According to Apple’s SEC filings on Friday, one set of improperly issued options had a grant date of October 19, 2001.  This grant was approved originally at a Board meeting on August 29, 2001 with an exercise price of $17.83.  The terms of the grant were not finalized until December 18, 2001.  The grant ,however, was dated October 19, 2001 with an exercise price of $18.30.  According to Apple, the “approval for the grant was improperly recorded as occurring at a special Board meeting on October 19, 2001.  Such a special Board meeting did not occur.  There was no evidence, however, that any current member of management was aware of this irregularity.” 

Although Apple claims it is continuing to cooperate with the DOJ criminal and the SEC civil investigators, it is unclear if cooperation will be sufficient to forestall charges.  Questions have been raised since the beginning concerning Apple’s handling of the matter.  When Apple initially learned it might have stock option problems and received requests for information from the government, the company chose not to disclose the matter for months.  Later when it did disclose the matter the company stated that it had no obligation to make any earlier disclosure.  As we noted in an earlier entry in blog, that is an accurate statement of the law.  Whether it is the best shareholder relations or evidences cooperation has yet to be seen.  See Blog entry 9/5/06 “A Difficult Choice: “To Disclose Or Not To Disclose” an SEC Investigation.”

Unique Theory on Sale of Unregistered Securities – Investment Banker’s Short Sales Prior to a PIPE Offering

Wednesday the SEC filed a settled civil injunctive action alleging insider trading, selling of unregistered securities, and failure to supervise in connection with CompuDyne Corporation’s sale of a Private Investment in Public Equity (“PIPE”) against Northern Virginia investment banker Friedman, Billings, Ramsey & Co.; its founder and Co-Chairman and Co-Chief Executive Officer, Emanuel Friedman; Director of Compliance, Nicholas Nichols; and Head Trader, Scott Dreyer. In the settlement, FBR consented to pay $3,755,839. Messrs. Friedman and Nichols consented to pay $754,046 and $60,000, respectively. The three defendants also consented to the entry of SEC orders censuring FBR and Dreyer, requiring Dreyer to pay $19,870, and ordering the firm to comply with certain undertakings. Mr. Friedman consented to an order barring him from association in a supervisory capacity with a broker or dealer with a right to reapply for association after two years. Friedman Billings has served as a key investment banker to the Northern Virginal high tech community.

See SEC v. Friedman, Billings, Ramsey & Co., Inc. et. al., Civil Action No. 06-cv-02160 http://www.sec.gov/litigation/litreleases/2006/lr19950.htm, http://www.sec.gov/litigation/complaints/2006/comp19950.pdf; see also In the Matter of Scott E. Dreyer, Administrative Proceeding File No. 3-12510 http://www.sec.gov/litigation/admin/2006/33-8761.pdf. In a PIPE offering a placement agent or underwriter, such as FBR, places restricted shares of a public company (CompuDyne) with accredited investors who have executed a purchase agreement with the public company. As part of the arrangement the public company agrees to file a resale registration statement within a specific time so the investors can sell the shares to the public. The investors do not pay for the shares until just before or after the resale registration is effective.

According to the SEC’s complaint, CompuDyne’s shares were traded thinly at the time of the PIPE offering. In advance of the resale, information flowed from the investment banking and sales side of FBR to the trading side without restriction. The trading department, based on information from the offering, sold CompuDyne shares short with the intent to cover from shares purchased in the resale from firm clients. According to the complaint, the PIPE offering information was material non-public information and, thus, trading on that information is insider trading in violation of the antifraud provisions of the federal securities laws. At the same time, permitting the information about the offering to flow out of the investment banking and sales arm of FBR constituted a failure to supervise and have appropriate procedures in place. The sale of unregistered securities occurred because FBR sold CompuDyne’s shares short prior to the actual resale, although the shares of the company were publicly traded. The SEC tied this claim to factual allegations that the short sales were made with the intent of, and in fact were, covered with shares from the resale – i.e. shares that had not yet been part of a public offering and were restricted at the time of the short sale. The approach of this complaint is interesting and worth considering. The insider trading claim is based on the theory that CompuDyne shares were part of a trading market. Thus, an insider – or temporary insider such as FBR – who has material non-public information and trades based on that information violates the antifraud rules. This is textbook insider trading. Similarly, standard industry practice dictates that an investment bank should prohibit information flow from its investment banking and sales operations to its sales arm. Yet, what is interesting is the theory of the Section 5 sale of unregistered securities claim. The Section 5 claim is based on the theory that the short sales were made prior to the effective date of the resale registration statement for the then restricted PIPE shares. At the time of those short sales, however, there was a trading market for CompuDyne shares. Since the short sales could have been covered from that market one could argue that there was no Section 5 violation. The SEC appears to have avoided this difficulty by integrating the short sales into the resale. This is done with two key factual allegations: (1) a claim that CompuDyne’s shares were traded very thinly suggesting that the shorts could not be covered (at least easily) from the market; and (2) a specific allegation that the shorts were made from FBR’s market maker account and would be, and in fact were, covered by purchases in the resale aftermarket from firm clients. Thus, the SEC claimed in its complaint that “FBR and Friedman, in effect, sold their customers’ PIPE shares prior to their registration.” These allegations suggest that FBR violated Section 5 and took unfair advantage of its clients. The SEC’s Section 5 claim, which might at first appear very questionable, ties together based on the factual allegations. In contrast, if the short sales were made and covered on an exchange the theory would clearly be problematic at best.