Backdating Executive Stock Options: The Role of Volatility, Part I

Executive stock options continue to grab headlines. In late 2004, after a parade of protests, the Financial Accounting Standards Board issued the "Summary of Statement No. 123 (revised 2004): Share-Based Payment". Intending to promote transparency, FASB's rule requires public companies "to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award" and to recognize the cost "over the period during which an employee is required to provide service in exchange for the award-the requisite service period (usually the vesting period)."

Following suit, on July 26, 2006, the U.S. Securities and Exchange Commission announced news about additional (and arguably more comprehensive) disclosure rules for all sorts of executive compensation vehicles, including stock options. The SEC plans to provide "additional guidance regarding disclosure of company programs, plans and practices relating to the granting of options, including in particular the timing of option grants in coordination with the release of material nonpublic information and the selection of exercise prices that differ from the underlying stock's price on the grant date."

(Click here and here for recent posts on this topic.)

Now, backdating takes a bow. The Corporate Library describes this practice as "awarding stock options on one date, and then backdating the grant or award date to a time when the stock price was lower."

Experts say that backdating per se is not illegal. So why the hullabaloo? Several reasons account for the recent news flurry. For one thing, there may be tax consequences. CNNMoney.com reports that "companies and individuals could face hundreds of millions of dollars from civil penalties, unpaid taxes and interest payments if widespread wrongdoing is found." One law firm, McDermott Will & Emery writes that "failure to disclose this practice could possibly constitute securities fraud" and give rise to accounting misrepresentation as well.

Concerned about alleged misdeeds and an adverse impact on stock price, pension funds are lining up to bring suit. Institutional Shareholder Services writes that "an international group of 14 institutional investors led by the U.K.'s Universities Superannuation Scheme and the Australian Reward Investment Alliance asked the SEC to increase disclosure requirements for option grants. The group includes five U.S. state pension funds and institutions from Canada, Norway, and the Netherlands."

To be clear, it is impossible to tackle the merits of any one situation without sufficient information to evaluate a problem, if one exists, and assess economic damages to anyone found to have been harmed by backdating.

However, even in the absence of case-specific information, a discussion about the valuation of executive stock options is nevertheless worthwhile. Saying that this topic is broad is like saying that Lake Michigan is a little body of water. That's why this topic will show up again in subsequent posts to www.pensionriskmatters.com and why it will continue to resurface as the topic du jour in court, regulatory proceedings, auditors' roundtables and board meetings everywhere.

To begin, pricing model choice and determination of inputs are integral to option valuation. While myriad factors contribute to a final assessment, one variable, volatility, is often described as dominant.

What exactly is volatility and how is it measured? Given different types of volatility, which one makes sense to use? Historical volatility is frequently measured as the standard deviation of returns for the underlying asset and can serve as a proxy for uncertain future asset price movement. This technique assumes that past price behavior is a bellwether for the future. Sometimes this is not an appropriate conclusion. An industry and its constituent members may have undergone radical change in the form of deregulation or technological innovation, completely changing the profitability landscape thereafter. In contrast, implied volatility is derived by examining market prices of an option (characterized by time to maturity, exercise price and other relevant factors) and backing into an estimate of investors' beliefs.

As demonstrated in "Model Risk and Valuation" by this blog's author, Dr. Susan M. Mangiero, the volatility number can have a dramatic impact on the computed value of an option. Moreover, the relationship between volatility and option value is not proportional. Consider that an increase of ten percent in volatility does not necessarily translate into a ten percent rise in the value of the option. (This is a simplistic statement since option value does not depend on volatility alone.)

Business Week reporters Jane Sasseen and Greg Hafkin correctly make the point that "options for volatile stocks carry higher expenses". Citing a report by Credit Suisse Group analyst David Zion, they describe a precipitous drop in the value of options granted by S&P 500 member companies, from "$104 billion in 2000 to $30 billion in 2005", adding that "implied numbers have been lower than the historical ones" but that "volatilities are heading up."

One thing is certain. Estimating volatility should amount to more than a mere number crunching exercise. The process should reflect an assessment of economic performance going forward. A mistake in volatility choice can be costly and lead to a slew of unwelcome events.

There is a lot (!) more to say on this topic.
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