Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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,

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.


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