September 14, 2007

SEC’s Enforcement Division Establishes Four “Working Groups”

According to this MSNBC article, the SEC’s Enforcement Division has established four working groups to focus on the discrete issues associated with each one. The working groups are: subprime lending; hedge funds and insider trading; option backdating; and muni-bond offerings.

From a historical perspective, the formation of working groups is somewhat unusual, but not unprecedented. To me, they seem like common sense. Nearly everyone in the Enforcement Division is a generalist that takes on any – and all – types of cases. Now it looks like the Division is formally setting up these groups to specialize in certain types of cases. Precedents include the group that focused on muni securities cases in the mid- to late-’90s, the formation of the Internet enforcement group in the mid-’90s and the formation of the Accounting Fraud Task Force around 2000.

The Proper Valuation of ESOARS

Armed with an independent study, the Council of Institutional Investors continues to lobby the SEC to rescind its endorsement of ESOARS. Recall that I’ve blogged several times about ESOARS – it’s a derivative instrument invented by Zions Bancorp to establish market values for stock option grants. We have more information on this instrument in our “ESOARS” Practice Area.

In this podcast, Greta Hotopp of Compensation Valuation provides some insight into ESOARS (the Compensation Valuation study is the one cited by CII), including:

– Why did you conduct a study of Zions Bancorp’s ESOARS?
– Did your evaluation indicate that these ESOARS would allow for true price discovery?
– What other findings were made during your evaluation?

Accounting Issues for ESOARS?

A while back, there was a flurry of articles about accounting uncertainty that may derail the expansion of the market for ESOARS. Here is an excerpt from one of those articles:

“While critics have focused on whether auctions are a valid way to value stock options, a sleeper issue is how to account for such financial instruments, a seemingly technical question that could make or break the market for such products. ‘We are in talks with FASB to try to get our Esoars instruments treated as equity,’ said Zions vice president Evan Hill.

Deeming such products to be equities would be the best possible result for Zions, although it may delay trading until 2008. However, if standard-setters decide such products are a liability, they likely would be categorized as derivatives, dealing a one-two punch that could boost costs and volatility and raise valuation questions anew, making the tracking instrument far less appealing to companies looking for new ways to value employee stock options.

The reason: derivatives must be marked to market, generally each quarter. While the accounting for employee stock option grants wouldn’t change under such an approach, companies would have to reassess any tracking instrument used in valuing those options. That might require frequent auctions, or reverting to options-pricing models, defeating the purpose of using Esoars-type products. Another downside is that as a liability, any increase in the value of the tracking securities would be treated as an expense, reducing earnings.

‘I don’t see it as deal killer, I see it as a deal complicator,” said Hill. He predicted that some companies wouldn’t object to using Esoars, even if they must be accounted for as a liability, but acknowledged others might decide that “it’s just more headache than it’s worth.'”

Before he left the SEC, Chief Economist Chester Spatt puzzled aloud as to how accounting policy can reward innovative approaches in a speech. Here is an excerpt:

“An interesting challenge with respect to fair value accounting is how can accounting policy reward innovative approaches? To the extent that the goal of accounting policy is to replicate a particular measurement objective, how can innovative ways to define or reach that objective be encouraged? Indeed, from the perspective of a registrant it is plausible that the goal is to minimize the expense being measured rather than measuring the expenses more accurately. This suggests potential tension between designs that are of interest to registrants and those that measure the expense more accurately, especially if the out-of-pocket cost of implementing that market-based approach exceeds that of implementing the model alternative.”

Don’t Forget to Register for the “Chicago” Concert

I will be seeing many of you at the “15th Annual NASPP Conference” in a few weeks. For those of you who need a break, don’t forget to take advantage of the free “Chicago” concert on Tuesday, October 9th. You must register in advance to attend this event – and space is limited. Even if you don’t really like the band, there is something unique about attending an event with a group of fellow conference attendees that changes the nature of the conference.

I remember the mad panic last year when folks were trying to register at the last minute for Huey Lewis. It was too late and they were bummed. Don’t be that person.

Remember that the concert is offered to NASPP Conference session attendees only (also the NASPP cannot accommodate guests for the concert). Thanks to Fidelity Investments for co-sponsoring this event with the NASPP!

– Broc Romanek