ESOARS: A Flawed Product


Steven Balsam’s article (“ A Bid for Fair Value ,” Sept. 07, page 42) fails to discuss an evaluation of the suitability of Zions ESOARS performed, at the request of the Council of Institutional Investors, by noted valuation expert Stephen A. Ross and his colleagues at Compensation Valuation Inc. (“CVI Report”). The CVI Report (which can be downloaded from the Council of Institutional Investors’ Web site ) concludes that: “The ESOARS product is too flawed to serve as a reliable valuation tool for FAS 123R purposes. While the tracking security itself is imperfect but not unreasonable, in combination with the auction mechanism and surrounding conditions and incentives, the design serves primarily to produce a predictably downward biased result. “…In sum, ESOARS require major modifications [(none of which Zions has yet made)] before they can correctly reflect the true cost to the company of its [employee stock options (“ESOs”)]…Without remedies or alternatives…the ESOARS price should not be accepted by auditors nor certified by senior executives as correctly measuring the cost of a company’s ESOs.”

I discussed, or had e-mail exchanges about, the CVI Report with a number of leading valuation, accounting and auditing experts, including current and former accounting and auditing standard setters and regulators (and including Mr. Balsam). The general consensus of those experts was that they agreed with Mr. Ross’ conclusions. Many of those experts also indicated that Zions ESOARS, as currently structured, violates the spirit of the principles-based fair value measurement guidance set forth in FASB Statement no. 123(R), Share-Based Payment .

As a leading voice for credible financial reporting of stock option compensation costs, the Council of Institutional Investors believes that the CVI Report should be required reading for every chief financial officer, audit committee member, external auditor and regulator of a company that is currently using, or is contemplating the use of, Zions ESOARS to value their employee stock option costs. To ignore such information raises issues of professional responsibility, particularly for auditors and other CPAs.

Jeff Mahoney, CPA
Mahoney is general counsel
for the Council of Institutional Investors.

Author’s reply: I have reviewed the CVI report. Dr. Ross, the primary author, is a renowned academic, known in particular for his role in developing the binomial model many now use for valuing stock options. Consequently, his views are not to be taken lightly.

As pointed out in my article, the SEC, while finding ESOARS acceptable (with the emphasis on “acceptable”), set conditions that should be met for each auction to qualify as an appropriate market-pricing mechanism. Those conditions (for example, the size of the offering, number of bidders, etc.) are similar to those pointed out by Dr. Ross, and need to be considered by auditors before they accept the results of the auction for valuation purposes.

I should note that my article merely attempted to give a balanced account of the ESOARS, and the issues surrounding it. While I find ESOARS to be an innovative attempt to attach a market value to employee stock options, corporations need to consider the benefits and costs of ESOARS in deciding whether the security is right for them. As a postscript, please note the SEC, after considering the concerns of the Council of Institutional Investors, recently gave Zions Bancorp the final clearance to use ESOARS.

Steven Balsam, CPA, Ph.D.


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