game Vincent Martinez  

The SEC’s Chief Economist Ponders Options


As mentioned in an earlier post, the SEC has its own chief economist, Chester Spatt, who oversees the Office of Economic Analysis.

Last Thursday, Mr. Spat spoke at a private investment trust conference at Carnegie-Mellon University. His speech did not address the current tussle over the derived option markets being developed jointly by the SEC and the technology sector; he only mentioned that “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 process to be properly designed in order to provide an estimate of the fair value cost incurred by the firm in issuing employee stock options.”

“Proper design” is what the argument is all about, so far. The concern is that what issuers call “proper design” might be called a “structured transaction” by investors.

Anyway, there were some other interesting questions raised by Mr. Spatt in his speech, having to do with executive compensation and stock options. A couple excerpts that might make your wheels turn a little faster; in all cases the emphasis is my own, not Mr. Spatt’s.

“One striking feature of these (option)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.”

“If the option moves too far out of the money, the firm will sometimes reset the exercise price by granting new replacement options (”reload” options). While this is often criticized and suggests that the original grant understated the intended compensation, it may be necessary to provide the desired marginal incentives. In understanding the incentive structure I think it is useful for firms to focus upon incentives that are “renegotiation proof” and would be consistent over time and not require updating.”

“Interestingly, 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 tools whose anticipated cost cannot be identified at the time of the grant would not be attractive.”

Good points, all of them. And the interesting thing is that the points he raised all relate to issues that should be resolved by companies before they ever issue options, let alone scuffle over their valuation. We’re way past that now, but Mr. Spatt’s comments are still thought-provoking and worth your time to read.

Dissent Across The Sea

Plenty of dissent here in the States about stock option expensing, for sure. This article from the Financial Times shows that there’s plenty of dissent over standard-setting overseas as well: “European companies cry foul over accounting.”

The article mentions the “European Roundtable of Industrialists” representing some of Europe’s largest companies, as being opposed to “the (IASB) working group set up to examine transatlantic convergence in accounting standards of pressing ahead despite widespread concerns among companies and investors.” They claim that process over the choosing of the working group’s members “lacks transparency and we suspect has been biased towards achieving a pre-determined outcome.”

Deja vu all over again. If you don’t like the outcome of standard-setting, attack the process. Perfected by Silicon Valley, circa 1994. Wonder where the European Roundtable got their idea?