SEC Approves Curious ESOP Securities

The US SEC issued a letter last week allowing Zions Bancorporation to value its employee stock options by auctioning a security which serves no economic purpose other than to price (or rather underprice) these options. Most ESOP valuations use a valuation model like Black Scholes or a binomial model. However, the accounting standards also allow a market based approach. What Zions proposed to do is to issue a security that offers to outside investors the actual cash flows obtained by its employees by exercising their options.

Logically, a company that seeks to hedge its ESOP costs should be on the other side of this transaction – it should be buying a security that reimburses the ESOP costs instead of selling the security which effectively magnifies the ESOP costs. When Zions sells this security, it is behaving like an importer who sells foreign currency forward and exacerbates the currency risk instead of buying foreign currency to hedge the risk.

If a company follows a stupid risk management policy, that should normally be a matter of concern to its investors and not to its regulator. But in this case, the design of the instrument has a completely perverse implication. As Floyd Norris put it very succintly in his column (“S.E.C. Approves New Method for Companies to Value Stock Options”, New York Times, February 2, 2007)

A major problem with such auctions, and the reason that the S.E.C. may have to watch over them, is that they are fundamentally unlike other security sales in that both the seller and the buyer would be happy to see a low price – the buyer to get something cheap and the seller to be able to minimize the reported expense of issuing options to employees.

The SEC’s letter does state that the size of the offering and the number of bidders (as well was their independence) would be factors that should be considered in determining whether an auction was an appropriate market pricing mechanism. It would have been helpful to state rather that the number of bidders, their independence and the size of the offering must be such as to overcome the presumption that the entire exercise is an Enronic accounting gimick. In my view, such a presumption would be justified because the security serves no other economic purpose for the issuer.

Posted at 1:39 pm IST on Fri, 2 Feb 2007         permanent link

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