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Susan M. Stein
Affirmative Insurance Holdings (NDQ: AFFM)

Can ESOARS Cure Option-Expensing Pains?


By: Tammy Whitehouse | February 20, 2007
As Zions Bancorp prepares to introduce a new financial instrument to let the open market establish an expense value for employee stock options, the market itself is watching with guarded optimism.

Observers wonder whether auctioning employee stock option appreciation rights (ESOARS, a moniker Zions is already trying to trademark) will determine a value that ultimately withstands regulatory scrutiny. Will the security adequately capture the terms and conditions of the underlying stock option? Will there be enough buyers? Will it be an efficient alternative to the valuation models already accepted by auditors and regulators?

“My initial take is that this is a positive development in the marketplace,” says Michael Littenberg, a partner with the law firm Schulte Roth & Zabel, who focuses on stock option valuations. “It’s a complicated product so it will take some time for the market to digest it and understand it.”

Zions’ new security is developed with the specific goal of establishing a market-based value for employee stock options in compliance with Financial Accounting Standard No. 123R, Share-based Payment. FAS 123R requires companies to charge the value of employee stock options against earnings, but gives companies latitude to select from several accepted valuation models the method they will use to determine the expense amount. The rule acknowledges that a market-based reference would provide better evidence of a value for expensing purposes, but that no such market exists.

Zions conducted a test auction of the security last summer based on its own grant of employee stock options, and shared its results and conclusions in a 23-page submission to the Securities and Exchange Commission last fall. Chief Accountant Conrad Hewitt endorsed the concept earlier this year, provided that Zions made a few modifications to assure that the security complies with the requirements of FAS 123R.

Zions is now lining up prospective customers to hold an online auction as early as March to sell the security based on a company’s grant of employee stock options. Observers are curious to see who the early adopters will be.

“Most companies are going to be hesitant to be the first ones out of the gate,” Littenberg says. “They like others to be the guinea pig. That will be the real challenge here.”

The ESOARS derivative is a tracking security, meant to follow the value of an underlying pool of employee stock options by paying holders of the security based on the exercise of options in the underlying pool. Zions says it would issue units of the appreciation rights’ security in a ratio of 1 to 10 to the underlying pool of options—meaning that a company granting 1 million stock options would sell 100,000 units of the tracking security.

The security would be sold via an online modified Dutch auction process. Bidders would offer a price for a specific number of units they wish to buy, but the ultimate selling price is the one at which all of the units will sell. The auction has a set closing time, but closing is extended by two minutes each time there is a bid within two minutes of the closing.

Zions Vice President Evan Hill says the two-minute extension gives buyers time to react to a final bid, to assure that the price settles into the highest price bidders are willing to pay, not the last price bidders had a chance to offer as the auction drew to a close. “In theory the optimal price for both sides (seller and buyer of the security) is zero,” he explains. “So we wanted to make sure we’ve got a market clearing price. We didn’t want to risk SEC scrutiny that the issuer and the buyer would both want the lowest price.”

The ultimate buyers of the security are paid, on a quarterly basis, a prorated share of the gain employees realize as they exercise their options. The units are not tied to any specific employee’s exercise, but to the exercise of all employees in aggregate in the underlying pool of options, Hill says.

If options are forfeited by employees, holders of the security get a prorated reimbursement with interest. That’s a twist from Zions’ original plan to allow buyers to take forfeiture risk into consideration when setting their price. (Hewitt pointed out that FAS 123R does not allow the expensed option value to take forfeiture into consideration.)

Mike O’Rourke, a partner with the accounting firm Berenfeld, Spritzer, Shechter and Sheer, says one question is whether the Zions instrument adequately tracks the terms and conditions of an employee stock option, so that it can serve as a marker for the option’s value. He’s curious about whether auditors or regulators will become concerned that buyers of the new security will have some liquidity choices while employees holding the underlying options have none.

If buyers of the security have some ability to trade the security, but employees have no liquidity, “in that circumstance you might have to consider some discount as proxy for the illiquidity,” O’Rourke says. “Honestly, it raises an issue, but we haven’t had any experience with it yet to determine what to do about it.”

Hill contends that ESOARS should capture the terms and conditions of the underlying stock option in a different way. “Investors receive cash or stock as employees exercise their [employee stock options], which have the limiting terms and conditions,” he says. To further limit ESOARS holders by limiting their liquidity “would hit them twice and reduce the value too much,” Hill says.

O’Rourke also wonders if auditors and regulators will look for some kind of reconciliation between the value established by the security sale, compared with the value established by an accepted model. Hewitt told Zions that the SEC won’t necessarily object if the two processes reach different value conclusions, but he also cautioned that management should compare the two and make note of any difference.

The question has arisen in part because Zions’ initial auction of the ESOARS established a price for the options well below the value found using the widely accepted Black-Scholes model to price options. Zions points to the revised provision for forfeiture and the two-minute auction extension process as changes that may create a greater alignment of value.

Zions also says the initial pricing may have been affected by a technological problem—servers repeatedly crashed and rebooted during the final minutes of the auction, possibly interfering with the bidding process—which the bank promises has been addressed and will not affect future auctions.

Mike Piazza, a partner with the law firm of Dorsey & Whitney, says questions also may arise over whether enough investment-savvy buyers willing to try ESOARS will emerge, since the existence of an adequate demand is critical to satisfy valuation criteria. “I can’t really tell who the market is,” he says. “Maybe a few senior hedge fund managers who want to dabble in this?”

O’Rourke says there are no hard-and-fast thresholds about how many bidders are necessary to assure enough activity to establish a credible price, but it’s a factor sure to be of interest to regulators. Littenberg says he senses that there is enough interest and a large enough pool of prospective bidders that the market will “gain traction.”

Espen Robak, president of Pluris Valuation Advisors LLC, says companies will have to weigh the prospective benefits of selling a tracking security if they will still be expected to use a valuation model as well. Says he: “It may be that all the Zions method accomplishes is to add one more layer of analysis to the process for measuring ESO grant expenses, resulting in additional expenditure of hours by the accounting department, auditor and outside valuation consultant.”