Report: SEC Blesses Auction System for Options Valuation

January 30, 2007 ( - Federal securities regulators have reportedly approved a market-based employee stock option valuation system for the first time.

Securities and Exchange Commission (SEC) Chief Accountant Conrad Hewitt said in a recent letter that the auction system put together by Zions Bancorp of Salt Lake City was permissible to use so the company could determine market values for its employee stock options, the Wall Street Journal reported.

Hewitt’s position represents a turnaround for the regulatory agency that had already rebuffed efforts by computer networking company Cisco Systems in 2005 to replace the academically derived valuation models with a market-driven alternative (See  Cisco Options Plan Nixed by SEC ).

class=”times”> According to the news report, the SEC and accounting rulemakers have previously blessed market-based approaches as best for valuing options (See  The Bottom Line: Stock Answer ).   Hewitt told the Journal that the problem is that current valuation models produce “hypothetical numbers” while market-based approaches produce what “may be a real number.”

class=”times”> Hewitt cautioned that each auction based on the Zions approach would have to be individually analyzed to determine whether it actually generated a market value.

class=”times”> Artificially High Values

class=”times”> The impetus for the drive to find a market approach acceptable to regulators grew in 2006 with the rule that companies would have to book an expense for issuing stock options (See   FASB Hands Down Option Expensing Proposal ).

class=”times”> The differences between employee stock options and stock options traded on financial exchanges have left many companies complaining bitterly that existing valuation systems such as the widely used Black-Scholes model generate artificially high option values. That results in a too-high charge against profit, some believe.

class=”times”> While the two types of options give holders the right to buy stock at a preset price at a future date, stock options traded on financial exchanges typically come due in at most two years and there isn’t any vesting requirement. Employee options, on the other hand, typically vest over a number of years and they can be exercised in some cases over a 10-year period.

class=”times”> According to the Journal report, Zions last year created securities that mimic the stock options granted to its employees and sold the securities to sophisticated investors in a public auction last June. The company developed a market value for the options from the bidding, which was roughly half the value of its options as calculated by academic models.

class=”times”> The bank then submitted its results to a months-long review by the SEC.