Apple Computers is the latest in a long series of headlines relating to the SEC's crackdown on backdated option grants - an issue potentially affecting a number of public companies, primarily in the tech sector. Apple recently launched its own internal investigation which uncovered several violations which may significantly impact the valuation of their stock. In an 8k filing with the SEC dated August 4th, Apple stated:

“Apple’s financial statements for the fiscal years ended 2003, 2004 and 2005, the interim periods contained therein, the fiscal quarters ended December 31, 2005 and April 1, 2006, and all earnings and press releases and similar communications issued by Apple relating to periods commencing on September 29, 2002 should no longer be relied upon.”

The company also notified investors that it would likely delay its 10Q filing with the SEC until further notice. Many other tech companies are also feeling the heat as the SEC cracks down. Among the potentially affected companies are Broadcom, Rambus, Sycamore Networks, and McAfee. Currently, Brocade is the only company facing criminal charges by the SEC. If found guilty, company officers involved in the crime can face up to 20 years in prison and $5 million in fines.

What Are Backdated Option Grants?

Option backdating occurs when a company grants a call option (a right but not obligation to buy at a certain price) with an exercise price below the price of the stock on the day of the grant. This means that the owner is entitled to an immediate gain on paper if he/she decided to immediately exercise their option. Now, as surprising as it sounds, this is not illegal. In fact, it is perfectly legal for a company to backdate options; however, the option grants must be classified as being backdated.

The SEC recently got involved when it discovered that several companies were classifying these backdated option grants as a type in which the exercise price is the same as the stock price on the day of the offer. This enabled companies to hide millions of dollars of expenses from the public, which in turn artificially boosted net income by reducing operating expenses. As a result many companies may be forced to restate many years worth of earnings due to the manipulation of net income. This will force investors to revalue (to the downside) the companies based on the new lower net income levels. Needless to say, these investigations will have a material effect on the offending companies.

In October 2001, Computer Associates, one of the world's largest software companies, reported pro-forma income of $359M for its fiscal 2nd quarter, nearly a 60% increase over the previous year. The impressive numbers were the result of a new business model, which stretched software revenues over the entire year. At the same time, the company reported to the SEC a loss of $291M for the quarter using GAAP. This story underscores the importance of always relying on GAAP-based SEC filings and also illustrates one of the most common genres of creative accounting - revenue recognition.

Revenue recognition is simply when a company books its sales. Most companies book their sales when delivery has occurred or services have been rendered, while others do it when the company receives payment. Some companies, however, book sales more creatively or outright fraudulently. Although Computer Associates technically did nothing illegal, but their new results were misleading to some investors. Some more fraudulent companies might go the extra mile and actually book future sales as current revenue. This happened at Xerox in the late 1990s and into 2000 when they accelerated the revenue recognition of leasing equipment over four years. This time, even the GAAP financial statements showed a higher net income. So, how can investors see through this smoke screen?

The key is looking at the one thing that most accounting tricks cannot change - cash. The simple check is this: Compare net income from the balance sheet to cash from operations on the statement of cash flows. If these two numbers do not correlate, then something is amiss. When Xerox showed a net income of over $100M and operating cash flow was -$8M, clearly something was wrong! By using this simple five-minute check, investors can avoid many of the most common types of accounting fraud.

Where do you find this information? A company's financial statements can be found quarterly in form 10Q and yearly in form 10k, usually under Section 1. A company's net income can be found towards the bottom of the Income Statement, and indicates how much the company "made" - that is, all revenues minus all operating expenses. The company's cash from operations can be found in the statement of cash flows, in the first section "cash flow from operating activities". The number we are looking for is "net cash provided by operating activities" or simply "net operating cash". This number takes all cash receives and subtracts all cash expenditures. Even if a company claims a future sale on net income, they could not have possibly received cash for it - and that's how we can tell! For an example of a 10Q statement, check out Microsoft's latest filing.

You can find all of the SEC filings filed by a company, including their annual report and financial statements at SECFilings.com.

James River Coal Company (JRCC) is a coal company that mines, processes and sells regular coal (the kind used for energy). Back in February of this year, the company was issued an ultimatum by Pirate Capital (an activist hedge fund), who threatened to start a proxy war if the Board of Directors didn't comply with their demands to put the company up for sale or reform. In their 13D filing with the SEC on February 10th, Pirate Capital argued that the company's management were inexperienced and illequiped to run the company. Perhaps more importantly, Pirate insisted that the company was grossly undervalued:

"Pirate Capital has had significant discussions with investment
bankers and is highly confident that there are a number of strategic buyers
that would be interested in purchasing the Company at a substantial premium
to the current stock price.  We have been advised that such a strategic
transaction could provide existing James River investors an opportunity to
participate in the upside of a more diversified operator with a stronger
balance sheet and just as importantly, a deeper and stronger management team
better positioned to derive value from James River's assets."

And keep in mind this was written in February when JRCC sat in the $40s! At the end of their letter to the Board, they stated:

"Should the Board fail to meet Pirate Capital's demands, it is our
intention to provide the requisite advance notice to the Company of our
intention to solicit proxies to elect a slate of directors to gain control
of the Board at the Company's next annual meeting."

Well, it turns out that the board did fail to meet the demands, and Pirate released an intention to solicit proxies on July 5th through another 13D filing which provided a "Shareholder Notice of Intent to Nominate Persons for Election as Directors and to Move Certain Business" along with a "Demand for Right to Inspect Books" which would give Pirate Capital shareholder information that the need to solicit a proxy vote to institute four of their own directors. This potential hostile takeover is set to take place at the company's next annual meeting, which will be set after the company has completed analyzing Pirate Capital's proposals and intentions.

This is a great stock to keep an eye on - If a hostile takeover does successfully take place, Pirate Capital will have four of their own board appointees and will likely try and sell the company. This should result in a substancial premium over the current price, especially given Pirate Capital's average acquisition prices. Here are the filings for Pirate Capital and James River Coal Company (JRCC).

Have you ever wished you could look over the shoulders of Wall Street's best and brightest? Thanks to the SEC's ownership disclosure rule, it is possible for anyone to watch the most successful traders and investors in the market. This SEC rule requires anyone who acquires more than 10% of a company to disclose the number of shares they hold, the price they purchased at, and even their investment objectives. This rule applies to everyone from the successful activist hedge fund Pirate Capital to Warren Buffet himself! Let's take a look at how you can track some of today's top money managers...

The first step is finding an investor worth watching. Now, the downside of this rule is that these investors do not reveal ownership until their holdings reach 10%, so it is important to seek out those that care about the long-term, not those interested in making a quick buck (because they have already averaged in at much better prices while not disclosing ownership). One of the most popular groups to watch are activist hedge funds, like Pirate Capital or Steel Partners. These groups vigorously take over companies and work to unlock shareholder value by turning around the company, forcing share buybacks, forcing dividend payments, or selling off the company in pieces. This has resulted in 20% - 30% annual returns for Pirate Capital, and similar returns for Steel Partners. Often times savvy individual investors can catch a free ride on these forced liquidation events and dividends. Obviously the second most popular group to watch are market savvy individuals like Warren Buffet, and their companies.

There are several types of filings to keep an eye on:

• 13D-G will let you view when the investor acquires more than 10% of a company and also the investor's investment objectives.
  
• Form 4 will let you know each time the investor trades in the companies they own (more than 10%).
• 13F will show you a holdings report for the investor along with the amount, value, and voting power of the shares they hold.

In addition to this required content, these filings can also include things such as letters to management, letters to the board of directors, shareholder demands, calls for a proxy vote, and other material that can be of enormous interest to opportunistic investors. Therefore, it is always important to read any attached exhibits.

To keep up to date with all of these filings, SECFilings.com allows you to subscribe to instant e-mail alerts. Simply add the companies, funds, and investors of interest and instantly receive notice when they file paperwork with the SEC!

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