By: Cydney Posner

New SEC Chairman Christopher Cox announced today the issuance of informal staff progress reports, intended to stimulate discussion, on the Staff's ongoing evaluation of proposals to value employee stock options for financial reporting purposes. The analysis addresses the possible use of a market-based approach to value employee stock options. A market-based approach essentially involves an instrument that will be traded among willing buyers and sellers, and the use of the instrument's market price as a reasonable estimate of the grant-date fair value of employee stock options. (Chairman Cox is known to have opposed option expensing when he was in Congress.)

Cox maintains that the SEC's approach "has been, and remains, the encouragement of robust efforts in the private sector to design market instruments that have the potential to accurately measure the cost of employee stock option grants to the issuer...As the [Office of Economic Analysis] memorandum makes clear, the use of an appropriate market instrument for estimating the fair value of employee stock options has some distinct advantages over a model-based approach. Most importantly, the instrument's price could establish the issuer's true cost of the option grant, by having it priced by the market....We remain committed to the promotion of competition between different approaches. Ideally, that competition will also lead to further innovation in models used to value employee stock options."

Donald Nicolaisen, SEC Chief Accountant who resigned this week, issued a circumspect and, shall we say, less enthusiastic, statement.  Advocating public dialogue and recognizing that FAS 123R states that the best evidence of fair value for employee stock options is observable market prices of identical or similar instruments in active markets, Nicolaisen suggested that one of the two basic types of market-based approaches may turn out to be productive: "Broadly speaking, my staff and I, with help from OEA, have become comfortable that it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee stock options using either of the methodologies that seek to track returns to holders of options or the obligations of the issuer of those options. Further, while I recognize alternative views and new facts are possible, at this point, we have significant doubts based on OEA's views, as to whether it would be possible to design an instrument that would achieve the measurement objective of Statement 123R by relying on similar contractual terms and conditions. That is primarily because of the difficulties inherent in replicating the employer-employee relationship in an issuer-investor arrangement.

"While various strategies have been considered and I encourage further efforts in the future, we are not aware of any instruments that have actually been sold in the market in an effort to obtain an observable market price for use in valuing employee stock options. Without actual market information, I do not believe at this point that it is possible to definitively conclude that the strategies that have been considered, or others that could be developed, would produce an estimate of fair value that complies with Statement 123R. For example, if an instrument were designed that my staff and I believed could produce an appropriate value in a market-based transaction, but the actual transaction price proved to be significantly different from the price that would be expected based on broadly accepted modeling techniques, questions would arise about whether the instrument itself and the marketing of the instrument were sufficient to achieve a true fair value exchange price. These questions may dissipate over time should market-based transactions become common, but early users would have to address and resolve such questions to their satisfaction and to that of their auditor before the transaction price could be used as the only basis to measure the fair value of the applicable employee stock options. In addition, appropriate disclosures would be required to be included in filings regarding the approach used to estimate the fair value of employee stock options

The OEA analysis explains that, "to meet the objectives of Statement 123R, each element of the market-based approach must be consistent with the measurement of fair value:

  • A market instrument that confers net payments on its holder that are equal in value to the fair value of all or part of the employee stock option grant.
  • A credible information plan that enables prospective buyers and sellers to price the instrument. For example, the plan should provide information about the exercise behavior of the employees in the grant. It should be easily accessible to all market participants to reduce the potential for adverse selection.
  • A market pricing mechanism through which the instrument can be traded to generate a price. It should encourage participation in the market in order to promote competition among willing buyers and sellers."
The analysis looked primarily at two categories of market-based approaches: the "tracking" approach and the "terms and conditions" approach. The analysis concludes that, of the two approaches, only the tracking approach appears likely to produce a reasonable estimate of the fair value of employee stock options.

Under tracking approaches, willing buyers and sellers trade rights to future payouts that are identical to the future flows of net receipts by employees or, equivalently, net obligations of the company under the grant. The Staff concludes that the following two designs are consistent with measurement of fair value:

  • An instrument that promises payments to its holder that are similar to the future intrinsic values realized by employees under the grant. This can be accomplished through the competitive sale by the company of an instrument with payments that track the intrinsic value realized by employees upon exercise of some or all of the applicable stock options.
  • An instrument that assigns obligations to a third-party holder that are similar to the actual net obligations of the company to employees under the option grant. This can be accomplished by paying a qualified third-party to meet some or all of the company's obligations to employees under the option grant.
Under the terms-and-conditions approach, a market instrument would be designed to impose on its holder replicated substantive terms and conditions that employees face under an option contract, with intended result that the market price of the instrument could be used as a reasonable estimate of fair value. For example, the holder of the market instrument would face the same prohibitions against trading and hedging of the instrument as employees face under the terms of the granted options. In theory, this would lead the holder to make the same exercise decisions as employees. The analysis concludes, however, that there are inherent difficulties with this type of instrument that would likely prevent its market price from being a reasonable estimate of fair value, the greatest difficulty being that the cost of the option grant to the company would depend upon considerations that were not captured by the terms and conditions that employees faced under the option contract. In addition, the analysis contends that simply replicating the terms and conditions that the employee faces under the option contract would not be sufficient to lead an investor in the instrument to exhibit exercise behavior similar to the exercise behaviors of employees under the grant. As a result, the analysis concludes that the terms-and-conditions approach would not result in a transaction price that would be a reasonable measure of the cost of the option grant to the issuer and, thus, would not meet the fair value measurement objective of the standard.

In addition, the Staff concluded that the tracking approach to the design of market instruments appeared easier to implement than the terms-and-conditions approach.

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