The commission’s Bureau of Economic Analysis rejected the idea of selling employee stock option reference securities (ESORS) – restricted options – to institutional investors as Cisco had proposed, and using their value to estimate the value of the options issued by the company (see Cisco Proposes New Options Instrument ).
Christopher Cox, the new chairman of the commission, announced the conclusions of the staff on Friday and made a point of encouraging continued private-sector efforts to value options in a press release . The effort has taken on new urgency since an accounting rule on the issue went into effect this year requiring companies to report the value of options granted to employees as an expense. Cisco’s proposal is also important because the company will be one of the first to come under the dictates of the Financial Accounting Standards Board (FASB)’s options expensing rule. That rule goes into effect June 15 for fiscal years beginning after that date; Cisco’s fiscal year begins July 31 (See SEC Makes it Official: FASB 123 Implementation Date Moved Back Again ).
The SEC said that many of the restrictions, like barring an employee from transferring the option or hedging its value through trades in other securities, could affect their value to the employee but not the cost to the company issuing the options – and it is the latter that is supposed to be measured under the new regulations.
The commission’s economists suggested two ways of using markets to value the options, but Donald Nicolaisen, the commission’s chief accountant, acknowledged the “difficulties inherent in replicating the employer-employee relationship in an issuer-investor arrangement” , and he also expressed doubts that the two methods outlined would be embraced quickly by any companies. One such plan would involve finding buyers who would, in effect, agree to accept the same returns that options holders as a group receive. Of course, those buyers would not have the ability to time when the options were exercised (as employees would), and they would suffer by having some number of options forfeited (as some of the employees with options quit before they could exercise the options).
The other plan backed by the economists would essentially involve a company paying a third party to take on its risk of having to issue shares to employees who exercise options, an alternative that would likely be extremely expensive.
Cisco’s alternative had already drawn fire from the Council of Institutional Investors and Ohio and Florida state pension funds (see Cisco’s New Options Instrument Faces Opposition ). In letters to the SEC, the investors argued that the derivative investments may cut the cost of expensing options by as much as 90% compared with valuation models, and they want the regulators to hold public hearings on the proposal, according to Bloomberg. Cisco argued that they can’t know if the derivatives will lower option costs until they sell them.
In a statement, Mr. Cox called the staff’s conclusions “tentative and subject to ongoing assessment” and said the commission encouraged efforts to find the best ways to value options.
“Over time,” he added, “as issuers and accountants gain more experience in valuing employee stock options for financial reporting purposes, particular approaches may begin to emerge as best practices, and the range of potential methodologies will likely narrow. For now, however, it is not our intention to narrow the field and to limit experimentation, but rather to welcome it.”