On October 17, the Securities and Exchange Commission approved a market-based method for valuing employee stock options under Financial Accounting Standards (FASB) Statement No. 123R. The Office of the Chief Accountant of the SEC issued a letter to Zions Bancorporation permitting Zions to use an auction process to value employee stock options under FASB Statement No. 123R. The SEC gave preliminary clearance to Zions in January of 2007 for the use of the auction process, but attached some conditions to its approval.

FASB Statement No. 123R governs the accounting for employee stock options. It requires that all equity based awards to employees be recognized in the income statement based upon their fair value. The two most common pricing methodologies used for establishing the fair value are the Black Scholes model and the Lattice or Binomial model. The SEC’s October 17 letter provides a potential alternative to these methodologies.

The Zions system creates “tracking securities” called Employee Stock Option Appreciation Rights Securities (ESOARS) that emulate options awarded to employees. The ESOARS are sold to institutions and sophisticated individuals in an auction process. ESOARS track the value of an employee stock option grant by making payments to holders of the securities at the same time as employees exercise their options. In this way ESOARS attempt to replicate the value of the employee options.

Zions first held an ESOARS auction in May of 2006, providing a market value based on bids received. The value was about half that derived under the Black Scholes model. The Company intends to use the valuation for FASB 123R purposes.

The SEC’s October 17 letter states that the ESOARS instrument was sufficiently designed to be used as a market-based method for valuing employee stock options under FASB Statement No. 123R. Further, the SEC did not object to Zions’ position that the market clearing price of ESOARS in the May 2007 auction was a reasonable estimate of the grant-date fair value of employee stock options granted by Zions in May 2007

The SEC articulated the following minimum key factors to use in evaluating any future auction process used to determine grant-date fair value: 

  • Are there a sufficient number of sophisticated bidders to constitute an active market? 
  • Do the bidders have sufficient information to value the investment and make an investment decision? 
  • Does the pattern of bidding reflect what one would normally observe in an active market? 
  • Do the bidders’ perceptions of material costs of holding, hedging or trading the instrument substantially affect their valuation of the instrument?

The SEC also noted with approval the use of a model-based price to cross-check the values derived from using a market-based approach.

The SEC stated its support for the development of a variety of competing market-based objective measurements of the fair value of employee stock options. As such, the SEC’s October 17 letter may open the door for other companies to use the same approach or alternative approaches to establish stock option grant-date fair value under FASB Statement No. 123R.