Wednesday, August 19, 2009

Apple Needs Outside Director

08/19/09 - 10:12 AM EDT


Eric Jackson

NEW YORK (TheStreet) -- Speculation has begun on who should fill Apple's(AAPL Quote) open board seat, which opened up after Google's(GOOG Quote) CEO Eric Schmidt decided to step down.

Apple's Chief Operating Officer Tim Cook, who took over running the company while CEO Steve Jobs took time off earlier this year for health issues, has been mentioned as a potential director. That would be the wrong choice.

Despite Apple's enormous financial success over the past five years, its board has flubbed on several issues. It needs to appoint one or two new outside directors who demonstrate to its investors that it takes shareholder concerns more seriously.

Apple's stock growth has been phenomenal since the start of 2004. It's up 1,457% vs. -2% for the Nasdaq. Although Google's gone up three times since its 2004 IPO, Apple is up 9.5 times over that same period. Clearly, Steve Jobs deserves kudos for the groundwork he laid for this success since his triumphant return to the top spot at the company in 1997.

Consider this remarkable fact: Apple spends only $1.3 billion a year on R&D (or about 3% of its overall revenues), compared to Microsoft's(MSFT Quote) almost $10 billion, or about 14% of its overall revenue. Is there another large public company that comes to mind that is more innovative than Apple with such a great return on investment for innovation?

I salute Jobs and the entire company for their results. Yet, I'd remind Apple investors that performance like this brings power. Jobs evaded blame in 2001 in a stock-option back-dating scandal that might have claimed other CEOs. He also announced a six-month leave of absence from Apple earlier this year, without disclosing what he was being treated for. Just because you're a titan of business doesn't mean you shouldn't have to answer to someone.

Since his return in 1997, Jobs has constructed a board around him that is very CEO-friendly. The majority of his directors are active CEOs. This board has taken a hands-off approach and let Jobs run his business. The results speak for themselves. Yet, this lax governance has led to problems. Jobs should use Schmidt's board opening to appoint an outsider non-CEO, not the insider Cook or yet another active CEO.

Apple's board today is made up of eight directors: Steve Jobs; Al Gore; Mickey Drexler, former head of Gap(GPS Quote) and now head of J. Crew(JCG Quote); Andrea Jung who leads Avon Products(AVP Quote); Jerry York, onetime CFO of IBM(IBM Quote) and colleague of Kirk Kerkorian who resigned from GM's board in 2006; Art Levinson, who heads Genentech(DNA Quote), William Campbell, chairman of Intuit(INTU Quote), and Schmidt of Google.

I have no issue with the qualifications of Gore, York, or Campbell to serve on Apple's board (although both Campbell and York have served on this board for 12 years now, which, in my estimation, greatly hinders their independence and ability to question Jobs and Apple with a true arm's length perspective). My concern, if I were a shareholder, would be the abundance of the number of active CEOs on this board.

Drexler, Jung, Levinson and Schmidt are all current CEOs, making them naturally sympathetic to Jobs' position at Apple. I'm sure they are all professionals who take their Apple role seriously, but they likely operate by a "golden rule" of sorts: "Ask Steve questions, as you would like to be asked." In other words, don't make him uncomfortable or challenge.

CEO sympathy would also impact questions of executive compensation and granting stock options. Having more current CEOs on your board has been found to predict greater CEO control and executive pay.

Go back to the stock-option back-dating issue of 2001, which involved Jobs. At that time, he was granted 7.5 million Apple shares with an exercise price of $18.30. Later, it was alleged that the exercise price should have been $21.10, which would have led to additional taxable income for Jobs of $20 million.

Apple again allegedly overstated its earnings by this amount. The company claimed a special board meeting had approved this matter, but evidence came to light later this didn't occur. In late 2006, an independent internal Apple investigation declared that Jobs knew nothing and had returned the options.

In 2007, Fred Anderson, Apple's former CFO at the time, said Jobs knew everything and recommended certain favorable dates for issuing the grants. Later, the SEC and the Department of Justice announced it would file no charges against Jobs, allowing Jobs and the former board to sidestep the issue entirely.

So who was on Apple's Compensation Committee at the time these shenanigans happened in 2001? It turns out that Apple didn't have one then. They had a two-person compensation committee in 2000 -- Gareth Chang, who was an active CEO of a small tech company at the time, and Edgar Woolard who was chairman of what then called Conoco and now called ConocoPhillips(COP Quote). Woolard left the board in 2000 and Apple decided it didn't need a comp committee. Instead, it said in its proxy statement that the entire board would fill that role.

In 2001, the members of the Apple board who had responsibility for the stock-option back-dating were Jobs, Levinson, Chang, York, Campbell, Drexler and Oracle's(ORCL Quote) CEO Larry Ellison. This means that 71% of the board then were active CEOs -- an even higher percentage than that of the current board (63%).

This stock-option back-dating problem is a perfect example of why governance matters -- even when it involves the seemingly small fact of who sits on what board committee. Earlier this week, academics uncovered evidence that stock option back-dating was much more prevalent in recent years than anyone first thought.

In this case, when several red flags were raised that should have alerted Apple's board to action, they did nothing - presumably because company performance was good so why rock the boat. In this case, it appears, Jobs was fortunate that possible federal action was not taken -- for whatever reason. Proper board governance should never have allowed that potential risk to face the company.

If Cook has done an outstanding job and warrants being on the board, that's fine, but not on this board at this time. Apple should either redo the composition of the entire board with more outsider perspectives and also include Cook, or appoint an outsider now for this vacant seat.

An outsider doesn't have to be a source of conflict, but he or she should be a source of independent thinking on Apple's board which is currently dominated by Steve's chums.

-- Written by Eric Jackson in Naples, Fla.

At the time of publication, Jackson's fund was long Microsoft.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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