Apple Computer stock dropped recently after the San Francisco Recorder, a legal newspaper, said Federal prosecutors are examining Apple’s stock option documents to decide whether to file criminal charges. That was an escalation from the previous level of expectations. Some of the stock’s cheerleaders are saying it won’t hurt Apple or Steve Jobs, and there is not a chance he will be leaving Apple.

I think that’s wrong, or at least expresses a lot more certainty than any outsider could know. The other, quieter announcement was that Steve Jobs has “decided” that he needs to hire his own attorney to deal with the SEC and the Justice Department from now on. Up to now, he has been represented by the company’s outside law firm.

One of the big advantages of being in and around Silicon Valley for 25 years is the déjà vu effect. I have seen this before. CEOs usually don’t hire their own counsel until the company counsel tells them that the company’s interests and the CEO’s interests have diverged. In other words, if Apple’s counsel has seen enough to believe the company was hurt and the CEO was involved in it, they have the potential of representing the company in a lawsuit against the CEO, and therefore have to advise him that they can no longer represent him..

Now that the company has admitted Jobs knew about the backdating, I think the next announcement we will see is that Steve Jobs has been notified he is the target of a criminal investigation, and then the Board will have a very difficult time doing anything other than suspending him until the investigation is over.

I think these things because I have been through the numbers, including what I believe is the largest stock option grant ever, to Steve Jobs in January 2000.

Overall, since the current proxy disclosure rules started in 1994, Apple made 15 rounds of options grants through their September, 2002 fiscal year. If you look at the price of those grants compared to the annual range of the stock for the six months prior to the grant and the six months following the grant, all 15 should average somewhere around the 50th percentile of the annual range. Some grants made right before the stock declined would be in higher percentiles, while others made right before the stock shot up would be in lower percentiles. But averaging all 15 rounds together, it seems reasonable to expect the 50th percentile if no funny business was going on.

Apple’s grants average in the 15th or 16th percentile. That is powerful evidence that a company backdated, or at least granted options right before they had reason to believe the stock was going to jump. Of course, Apple has now admitted that they backdated options, and Jobs knew about it

There are three transactions the SEC and Justice Department probably are looking at for backdating. One was on July 11, 1997, when Apple repriced options and executives turned in old options with a $7.44 strike price for an equal number of new options with a $3.31 strike price. There were only two other days in the 1997 fiscal year when the stock closed at a lower price. On August 6, only 26 days after the repricing date, the stock jumped 33% and then added another 11% on August 7. The question is whether someone decided on August 8 that July 11 would have been a great day to make the repricing effective.

A second case was January 17, 2001, when four top officers (not including Jobs) got options totaling two million shares at $8.41 a share. A few months before, on the last business day of the 2000 fiscal year, September 29, AAPL was cut in half when they preannounced an earnings shortfall. It kept dropping to the $8.41 option price, and then staged a nearly 60% rally in four months.

The third and most serous case is the giant 40 million share (split-adjusted) grant at $21.80 a share to Jobs on January 12, 2000. This one is a bit tricky, as the company has said Jobs “didn’t benefit” because the stock eventually went below the option price. But here’s what really happened.

In the previous 26 trading days, AAPL fell 26%. Jobs then got his grant on the exact day the stock hit its low, and the stock rose 65% in the following 10 weeks. The issue, again, is whether someone decided in February or March that January 12 was a great day to price the boss’s options, it being the lowest price for many months. AAPL stock eventually went below the option price, and the options were cancelled. The company says due to “irregularities in the grants, the options were canceled and resulted in no financial gain to the CEO.”

Oh, really? This bunch of options would have expired in January 2010. Apple’s stock kept declining in the tech bear market, so the Board gave him 10-year options on another 15 million shares in October 2001. But the second batch went underwater, too, and on March 19, 2003, Jobs “voluntarily cancelled” all 55 million options. That’s why the company claims there was no financial benefit to him from the perfectly-timed 40 million share grant.

But the Board of Directors Compensation Committee report for that year disclosed that “in exchange for his cancelled options” Jobs was given 10 million split-adjusted shares worth around $75 million at the time. They were restricted from sale for three years, and when they became free to trade on March 19, 2006, they were worth $640 million. Not bad!

Here’s the rub, and I am indebted to compensation consultant Graef Crystal for doing the calculations. How did Apple’s Board decide on the number 10 million shares? Almost certainly, they used an options pricing model to calculate the current value of the options, which still had seven and eight years to expiration. Even though they were underwater on that day, the long time to expiration gave them value. Crystal used the Black-Scholes option pricing model to calculate the current value of the 55 million options: $77 million. That’s close enough to $75 million to believe this was their methodology.

But remember that the value of the options also depends on their strike price, and the very favorable strike price on the first 40 million grant raised their value quite a bit. If the strike prices of the two contracts had been set at the 50th percentile of the daily closing prices in their respective fiscal years, the calculated value on March 19, 2003 would have been $10 million less, around $67 million. So the Board might have given him, say, $65 million in shares instead of $75 million, or 8.7 million shares instead of 10 million. Those 8.7 million shares would have been worth $557 million when the sale restrictions expired on March 19, 2006, instead of $640 million. That’s an $83 million difference.

Yet in an October 4, 2006 filing with the SEC, Apple said: “In a few instances, Apple CEO Steve Jobs was aware that favorable grant dates had been selected, but he did not receive or otherwise benefit from these grants and was unaware of the accounting implications.” He didn’t receive the grants? He didn’t benefit from the grants? What about the $83 million? Get real.

It now appears that the paper trail around the October 2001 grant (7.5 million shares at the time; 15 million split-adjusted) was falsified. Recently, Apple has been saying that, yes, there was something wrong with the first and maybe both of these grants, but Jobs was not aware of the “irregularities.” But Jobs also was CEO of Pixar at the same time, which also appears to have backdated stock options. So he is the only CEO of two companies caught in this scandal, and it looks to me like someone on the East Coast has decided to teach the freewheeling entrepreneurs on the West Coast a little lesson by nailing a very big target. I still think there is a substantial risk that Jobs will be forced to leave Apple, and therefore it is too risky to step into the stock yet.

Source by Michael Murphy