In a January 25 letter, the Securities and Exchange Commission’s Chief Accountant, Conrad Hewitt, gave financial services firm Zions Bancorporation permission to implement its market-based system to determine the value of options granted to employees, subject to certain modifications to eliminate the effect of forfeiture rates on pricing. This is the first time the SEC has allowed the use of a market-based model instead of academic models to determine the cost of stock-based compensation. Many commentators contend that academic models overvalue options and expect that market-based models will lead to lower compensation expense when options are granted.
In order to determine the market price of its options, Zions created Employee Stock Option Appreciation Rights Securities (ESOARS), which are derivative securities that mimic options granted to executives and other employees. ESOARS are securities that entitle holders to receive specified payments from Zions upon the exercise, if any, from time to time of stock options comprising a reference pool of stock options that Zions has granted to its employees. Such “tracking securities,” when sold at auction, are intended to establish the market value for a company’s stock options. Zions tested the ESOARS in June 2006, selling the securities in a small public auction. The market price determined by the auction came to about 68% of the Black-Scholes price.
The SEC also noted that, because of two factors, the June 2006 auction price may not have been representative of the fair value of the underlying employee share-based payment awards, and the June 2006 auction may not have been a sufficient basis for valuing the options. Accordingly, the SEC recommended that each ESOARS auction be analyzed to determine whether it results in an appropriate market pricing mechanism. Factors to be considered include:
- The size of the ESOARS offering relative to market demand
- The number of bidders and their independence
- Any technological flaws in the auction process
- Bidder perception concerning costs of holding, helping or trading the securities
- Comparing the auction price to the price determined by an academic model
The SEC “encouraged” Zions to share with them the results and analysis of future auctions.
In his letter, Chief Accountant Hewitt noted that an auction-based estimate of fair value may have advantages over a model-based approach and expressed hope that the interplay of academic models and alternatives such as auction-based models could lead to improvements in option pricing.