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Chief Accountant Encourages Market-Based Approach to Valuing Employee Stock Options

SEC Chief Accountant Conrad Hewitt has responded to the Council of Institutional Investors' request that the SEC delay its approval of Zions Bancorporation's auction-based system for valuing employee share-based payment awards under FASB Statement No. 123R. In a letter dated February 23, Hewitt noted that the SEC has encouraged the private sector to design market instruments that reflect the value of employee option grants as an alternative to the current models for estimating fair values. Hewitt said that bringing market forces to bear on the valuation of employee stock options has the potential to improve the quality of financial reporting.

Zions Bancorporation submitted materials to the SEC in September 2006 which summarized its issuance of employee stock option appreciation rights securities ("ESOARS"). Zions asked the Office of the Chief Accountant whether ESOARS was sufficiently designed to be used as a market-based approach to valuing employee share-based awards. The staff advised that, with certain modifications, it concurred that ESOARS was sufficiently designed as a basis for valuing employee stock options under FASB Statement 123R.

Zions plans to use ESOARS for its own FASB Statement 123R stock option valuation, but also plans to advise other public companies and assist in their use of ESOARS. Zions Direct, a non-banking broker-dealer subsidiary of Zions First National Bank, will act as the auction agent. Zions has a patent pending on its design and market pricing mechanism.

In his January 25 letter to Zions, Hewitt noted that investors in ESOARS purchase the right to payments that are affected by the forfeiture rate of the underlying awards. He said that investors would have to consider the effect of employee forfeitures when determining the price they are willing to pay to acquire ESOARS. FASB Statement 123R precludes the consideration of forfeitures when estimating the grant date fair value of employee share-based payment awards.

Zions outlined two possible modifications to its design to eliminate the effect of forfeitures on investors in ESOARS. Hewitt said that either modification would allow investors to eliminate the consideration of forfeiture rates when determining the price they were willing to pay. Once the modifications are adopted, Hewitt said the instrument would be sufficiently designed to be used as a market-based approach to FASB Statement 123R.

Hewitt said that two factors in Zions' first auction --the two-minute rule mechanism and technological delays --may have contributed to a market clearing price for ESOARS that may not have been representative of the fair value of the underlying awards. Accordingly, market pricing mechanisms for the June 2006 auction may not have been sufficiently designed for FASB Statement 123R purposes.

The staff recommended that each ESOARS auction be analyzed to determine whether the auctions resulted in an appropriate market pricing mechanism and outlined the factors that Zions should consider in its analysis. The auction prices for ESOARS do not have to replicate those produced by models in order to be deemed suitable, according to the staff. However, the staff advised that management may find it useful to compare the auction results to the estimated fair value of the instrument derived through broadly accepted modeling techniques.

The staff concluded that Zions had made sufficient progress in identifying a suitable market-based approach and urged the financial services company to continue to share its analysis of future auctions of ESOARS. The Washington Post reported that the Council of Institutional Investors complained in a February 5 letter that the staff had approved the auction-based system without investor input. CII asked for a delay of the staff's approval until it has had time to study the potential effects. 

Hewitt replied to CII that the Commission is committed to ensuring that high quality information about compensation is reported to investors. He invited CII and other representatives of the investor community to share their views with him and his staff.

Jacquelyn Lumb