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Form 10-K reflects the restatement of our consolidated financial statements as of December 31, 2005 and for
the years ended December 31, 2004 and 2003.
On February 6, 2007, we announced the substantial completion of an internal investigation into our
historical stock option granting practices. Since that date, we have completed one additional witness interview,
which did not alter the results of the investigation. The investigation uncovered irregularities related to the
issuance of certain stock option grants made between 1998 and 2005. A Special Committee of the Board
oversaw the investigation. The Special Committee authorized the General Counsel and Chief Financial Officer
(who joined Digital River in January 2006 and February 2005, respectively) to conduct the investigation, with
the assistance of outside counsel and forensic experts.
In particular, as a result of the internal investigation, the Special Committee concluded, and the Audit
Committee and Board of Directors agree, that we used incorrect measurement dates for financial accounting
purposes for certain stock option grants in prior periods. Therefore, we have recorded additional non-cash
stock-based compensation expense and related tax effect with regard to certain past stock option grants, and
we are restating previously filed financial statements in this Form 10-K. These adjustments, after-tax,
amounted to $9.4 million, spread over the nine year period from 1998 through 2006. The full year adjustment
to 2006 was recorded in the fourth quarter of 2006 due to its insignificance.
The Special Committee investigation examined each stock option grant from August 1998 through
December 2006 (the “relevant period”), a total of 69 distinct grant dates. These grants include all of the
options granted since our initial public offering in August 1998. In all cases, the investigation considered the
particular facts and circumstances surrounding each grant date, including all available documentation, relevant
email archives, and interviews with present and former directors, officers, employees, and advisors.
Based on the totality of the evidence and the applicable law, the Special Committee found that no officer
or director engaged in any wrongdoing for personal enrichment. The Special Committee also concluded that
no director or member of the committee charged with awarding stock options to employees (the Stock Option
Committee) knowingly failed to comply with the relevant accounting principles.
The Special Committee’s analysis determined that eighteen grant dates, representing three million shares,
were not the proper measurement dates for the related options. Specifically, the Special Committee’s
investigation identified certain non-officer employee grants for which the Stock Option Committee, with the
involvement of our finance staff, selected grant dates in order to obtain favorable exercise prices. This did not
occur with respect to any grants to directors or members of the Stock Option Committee, and thus did not
result in any financial benefit to those individuals. Additionally, the Special Committee determined that on
certain occasions, the Stock Option Committee unknowingly exceeded its authority in granting stock options
to Section 16 officers, which options should have been granted by the Board. In each of these instances, the
Board ratified the grants at a subsequent meeting. The Special Committee also discovered a small number of
instances where option grant dates preceded employee hire dates; such instances are attributable to either
administrative error or a practice of pricing options for certain employees as of the employment offer date.
Finally, the Special Committee identified six occasions when we did not properly expense option grants to
consultants.
More generally, the internal investigation revealed weaknesses in our internal controls and record-keeping
related to stock options during the relevant period. In particular, we lacked appropriate systems to ensure
adequate communication between our accounting and human resources departments pertaining to the option
grant process. Thus, the accounting personnel did not consistently receive accurate information necessary to
determine appropriate measurement dates. Moreover, we failed to prepare adequate minutes of meetings of the
Compensation Committee and Stock Option Committee.
Beginning in January 2003, we strengthened our internal controls and made significant improvements to
our stock option granting practices. The Special Committee did not identify any measurement date issues
78
DIGITAL RIVER, INC.
Notes to Consolidated Financial Statements — (Continued)