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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, 2007, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

SEC's Chief Economist On Stock Options
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Posted by: Jack Ciesielski 9/7/2005 6:56 AM
At the the Swedish Institute for Financial Research Conference on Corporate Governance, Chester Spatt, Chief Economist of the SEC, delivered a meandering speech entitled "Governance, the Board and Compensation." Mr. Spatt covered a lot of territory, and I'd recommend his speech to anybody who's interested in those three topics. But it's his remarks about stock option compensation that are of most interest, even if they do echo an earlier speech of his. A couple of them:

"One striking feature of these programs is the discreteness of vesting dates and option exercise dates. The option grants tend to occur infrequently, e.g., annually or quarterly. This seems to be rather puzzling. Why is that an efficient form of compensation, for example, as compared to a more continuous set of vesting dates, option exercise dates and option exercise prices? Given that relevant economic decisions are being made more frequently (continuously?), it is hard to rationalize compensation that is so discontinuous. Discontinuous compensation is vulnerable to manipulation, without obvious advantages over a smooth compensation profile."

That's an interesting proposition, one that analysts don't usually stop to consider. (Usually, the only question analysts have about options is "how much will they cut earnings when they're expensed?" Before that question evolved, the usual question was "Will the options standard actually pass?") But it's a really good question: why should options be dispensed in one or two big lumps in a year, instead of continuously like other compensation? Is it to make the manager-recipients stick around to see if their goody bag will be big enough to warrant staying another couple of years until vesting? Is it because the vetting by attorneys and comp consultants would add too much visible cost? I can't think of any really good reasons.

But I agree with him: giving one really big grant a year will be "more vulnerable to manipulation." When one transaction like that will have an effect for years to come, as it will when stock options are finally expensed under Statement 123R, there'll be plenty of incentive to skinny down that option grant valuation as much as possible.

Spatt goes on to draw an interesting analogy from sales quotas to repriced options. When a salesperson faces impossible quotas, they lose their incentive to sell. Revise their quota downward to an attainable level, and their incentives are renewed. When an exec is faced with deep out-of-the-money options, issuing new options or repricing the old ones accomplishes the same thing.



"...some firms that use options extensively suggest that it is difficult to assess the cost of these options at the time of the grant. This is an interesting argument, though it does raise the question of how a firm can be comfortable that it is meeting its fiduciary responsibility to its shareholders when a substantial portion of its compensation is paid through a tool whose anticipated cost it does not understand and cannot quantify. If managers are acting in the best interests of investors, we would expect firms to use compensation tools whose costs they clearly understand and can internalize and that instruments whose anticipated cost cannot be identified at the time of the grant would not be attractive. Indeed, some firms who are large users of options are among the strongest critics of the adequacy of existing modeling tools for employee stock option valuation."

Another good point, though it's one that's not necessarily new: if firms complain that option expensing is wrong because options "can't be valued", then how are they acting on behalf of their shareholders if they constantly issue equity instruments for which they can't determine a value?

The only disappointment in Spatt's comments were his remarks, or perhaps, non-remarks on the current Cisco proposal for creating a derivative instrument to mimic values of employee stock options:

"... A few alternatives have been suggested that attempt to develop instruments that would replicate the valuation of these options from the perspective of a market instrument. Issuers may indeed utilize efforts to construct marketed instruments that replicate the cash flows and valuations of employee stock options. Of course, it would be important for the instrument and the associated market distribution and information disclosure to be properly designed in order to provide an estimate of the fair value cost incurred by the firm in issuing employee stock options. Ultimately, the development of such markets and the potential availability of the underlying exercise data and the market prices of these instruments would lead to further refinement of the underlying valuation models and provide benefits even beyond the specific issuer structuring such transactions."

There's very little meat in those comments about whether or not the SEC will permit firms to use fabricated options to represent the values of the employee options. It's a performance worthy of Alan Greenspan for now - but eventually the Commission is going to have to decide on these proposals. We're all ears.


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