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Operational Risk: Why Apple CEO Steve Jobs Should Resign
January 8, 2007

Operational Risk: Why Apple CEO Steve Jobs Should Resign

Operational Risk: The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition includes legal risk, which is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. It also includes the exposure to litigation from all aspects of an institution�s activities. The definition does not include strategic or reputational risks.

We have been big fans of Apple Computer (NASDAQ:AAPL) and its CEO, Steve Jobs, for quite some time -- even before Dennis Santiago and Chris Whalen founded Institutional Risk Analytics in August 2003. Last February, for example, Barron's lionized us for our bullish stance and caused a bit of a ruckus in bubble land by repeating our long-held view that a tie-up between AAPL and Walt Disney (NYSE:DIS) would be all so sweet, in large part because of the value creating catalyst of Steve Jobs.

Needless to say, when reports of stock options backdating at AAPL first hit the news last year, we felt like chucking our cookies. Some comfort remained, however, because those dutiful public affairs minions at AAPL kept telling the media and the company's investors (we don't have a position in AAPL or DIS, for the record) that the Jobster "was not aware" of the stock options backdating and other bad acts.

Between the first half of 2006 and December 29, 2006, however, when the company filed its delayed 10-K with the SEC, a Special Committee of the AAPL board of directors gradually revealed that Mr. Jobs was not only aware of the back dating of the stocks options, but that he actually was involved in recommending some of the exercise dates. Yuk!

On Page 3 of the AAPL 10-K NT it states: "Although the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications. The Special Committee also found that the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording and reporting of stock option grants."

Based on the report by the Special Committee, a number of commentators concluded that the errors and omissions committed by Mr. Jobs and other AAPL directors, errors and omissions that are now the subject of at least nine shareholder lawsuits and an investigation by federal prosecutors, are not a big deal. Our friend Tom Donlan, for instance, editorializing in this week's issue of Barron's, likens AAPL shareholders demanding the removal of Jobs and his fellow directors to misguided Jacobins whose extreme reaction to a minor infraction will ultimately damage their own interests.

We respectfully disagree with that conclusion and believe that Mr. Jobs and his fellow AAPL directors should step down as soon as possible. Here are just some of our reasons:

First, by failing to disclose the options grants accurately and in a timely fashion, Jobs and the AAPL directors involved apparently violated federal securities laws. Moreover, the actions and/or omissions by Jobs and other directors and officers of the corporation which are alleged in various civil lawsuits seemly violated the company's stock options plans, plans which were approved by shareholder vote, including the provision that the exercise price of the grants would be "no less than 100% of the fair market value" of the price of the stock on the day of the grant.

Second, several of the civil lawsuits allege that starting in 1997, Jobs and the AAPL board engaged in a series of options grants for various officers of the corporation at below market price. This included a grant to Jobs himself in January 2000, apparently contradicting the company's statement that Jobs himself did not benefit. Many of these grants, the lawsuits allege, were "spring loaded" to coincide with a public announcement by AAPL that had the effect of greatly increasing the value of the options. And all of these options grants were designed to benefit insiders with personal and professional ties to Jobs and members of the board of directors of AAPL.

Third and perhaps most seriously, the failure by Jobs and other officers and directors of AAPL to perform their fiduciary duty to the corporation, and to properly conduct and disclose the grant of options to company insiders, has exposed AAPL to considerable legal and financial risks, and has created financial expenses and liabilities for the corporation which did not previously exist. That's why at the top of this comment we include the definition of Operational Risk taken from the Office of the Comptroller of the Currency, a definition that is derived from the COSO framework for enterprise risk management. No officer of a US corporation, public or private, can credibly claim to be ignorant of the fiduciary requirements set forth in the COSO framework.

Fourth, because Jobs and several current and former officers and directors of AAPL are now defendants in almost a dozen civil lawsuits and are reported to be targets in a federal criminal investigation, the ability of these individuals to serve as independent fiduciaries of the corporation is compromised. Steve Jobs, former Vice President Al Gore, former CFO Fred Anderson and a number of other current and former officers and directors, many with long-standing personal ties to AAPL and Jobs, are facing prolonged litigation and possible criminal sanctions. Indeed, the direct involvement of Al Gore in this legal morass may effectively end the former Vice President's hopes to again seek the US presidency in 2008.

Given the legal conflicts already mentioned, the investigation of Jobs conducted by the AAPL board deserves little if any weight, in our view. Lynn Turner, managing director of research at Glass Lewis and former chief accountant at the SEC, told the San Jose Mercury News that "Apple's board deserves an 'F' for how it has handled its backdating investigation... The question is not merely one of whether Jobs benefited or not, but also one of whether Jobs was involved in the backdating of documents, or providing investors with misleading or incomplete disclosures."

As much as we continue to admire AAPL and its management team as an innovative technology company, we cannot help but notice how little attention is given to investor information on the AAPL web site. If you take the time to visit www.apple.com, you will notice that there is no obvious link directing investors and others to the company's SEC filings and press releases. Everything on the AAPL web site seems focused on product and news announcements regarding same. Buried beneath the product hype, at the bottom of the AAPL home page, under a small, barely noticeable tab labeled "media info," you'll find another link that takes you to AAPL's news release library and SEC filings.

What is really sad about the AAPL options scandal is that it did not need to happen. Jobs and the rest of the AAPL board are wealthy, well-educated people with access to the best legal advice and possessing the time and resources to get this right. When we see members of the US business elite behaving in such an ill-considered fashion, it confirms in our mind why we do, in fact, need prescriptive laws like Sarbanes-Oxley. Even in the wake of scandals like Enron and World Com, still there seems to be something lacking in the DNA of corporate America when it comes to basic issues like public disclosure and corporate governance.

The sloppiness and lack of attention to legal requirements seemingly in evidence at AAPL is present at many other technology companies, where the entrepreneurial culture puts business and profits first on the scale of priorities, including options grants, and everything else a distant second. In some parts of Silicon Valley, there is still a barely hidden contempt for legal norms of disclosure and documentation that, in the case of AAPL and a growing number of companies, is creating serious legal problems and new financial liabilities, a cost that ultimately will come out of the pocket of shareholders.

In coming months, other high tech companies may be forced to restate their accounting disclosure and in the process will lose the services of valuable officers and directors, and all because of poor internal controls and procedures with respect to awarding stock options. We can scarcely imagine a situation more ridiculous, more destructive to shareholder value at the organizations concerned and more hurtful to investor confidence generally, thus our view that the parties responsible must be held fully accountable before the law -- no matter who they are.

Questions? Comments? [email protected]

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