Could the SEC spoil Apple’s upcoming party?

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Could the SEC spoil Apple's upcoming party?

Cupertino (CA) – When a company’s doing well and rolling out new products, as is the case with Apple over the past four years, it has the luxury of timing the release of good news on a drop-by-drop basis, on its own terms. But a Securities and Exchange Commission investigation has apparently turned up some disturbing news, the result of which is the company’s announcement this morning of a delay to its upcoming quarterly earnings report.

That report has typically been the prelude to all the other good news that falls thereafter, such as new product rollouts, some of which may come as soon as Monday. But the quarterly earnings report delay, along with the delay in the filing of Apple’s Form 10-Q report with the SEC, could throw off the company’s entire timing. The problem is how both investors and customers react to the news that Apple may have failed to report the backdating of stock option grants to its key executives, perhaps CEO Steve Jobs among them.

Backdating is not illegal – though some may consider it questionable, the practice is actually quite prevalent throughout large US businesses. Corporate executives are often granted stock options as part of their regular compensation, and many businesses contend that granting options in lieu of cash is a cost-saving measure that benefits shareholders. But to inflate the value of those options – which is precisely how you have to view this measure – backdating enables a company to date the issuance of options retroactive to the present date, at a time when a company’s stock sold for significantly less.

Essentially, an option is a right to buy stock at a given price; and backdating sets that price in the past. So if your company issues you options for 10,000 shares at a time your stock price is $80, and the “exercise date” is set back in the past when the value was $40, then immediately, the value of those options becomes ($80 – $40) X 10000, or $400,000. Had the options been issued today instead of in the past, their value would have been $0.

Again, this practice is perfectly legal, even though it appears to be generating money from out of nowhere. What is illegal is the practice of generating money out of nowhere (see: “Enron”), which essentially means, not having accounted for that money in earnings statements. Suppose a company planned to backdate options for its executives on a certain date, believing that its stock value would rise after that date. It could then report the valuation of those options, as stock values do rise, as an expense, which would reduce earnings. This would be both legal and acceptable. Not reporting those expenses would be illegal.

This is the problem Apple faces, which is why this portion of this morning’s statement from the company is so ominous: “The Company has not determined the amount of such charges, the resulting tax and accounting impact, or which periods may require restatement. Accordingly, the Company today filed a Form 8-K stating that the financial statements and all earnings and press releases and similar communications issued by the Company relating to periods commencing on September 29, 2002 should therefore not be relied upon.”

In other words, Apple doesn’t know how much its executives earned on account of backdated option grants, the amount of which should have been reflected in its quarterly statements for the past four years, but which today’s announcement indicates was not.

In September 2002, Apple stock traded for around $7.25 per share, according to Morningstar data. At around noon today, it was trading at $66.40. So we’re not talking about a 50% gain, and now you see how monumental the problem could be. But that $66.40 is down over $3 in trading just today, reflecting stockholders’ fears that they may now be holding over-valued stock. Analysts including Morningstar have announced they’re re-evaluating Apple stock, after having praised the company as recently as last week.

The likely penalty from the SEC, should one come, would be a stiff fine, which Apple could probably sustain. The real penalty could come from investor backlash, upon realizing the length and extent to which Apple’s earnings may have been inflated. That backlash could subside if the SEC’s investigation turns up dozens more well-known institutions suspected of not reporting their backdated option grants, in which case, Apple would be just one among the multitude. In any event, the mood may be less than ceremonious in days to come, as Apple finds itself in a more 1999-like position of attempting to explain away its problems.