Accounting & Tax

SEC Rebuffs Cisco Option Plan

Despite skepticism from the SEC's Office of Economic Analysis, however, Christopher Cox, the commission's new chairman, states that "it is not our ...
Stephen TaubSeptember 12, 2005

Cisco Systems Inc. has suffered a setback in its attempt to gain approval for a revolutionary plan to value its stock options.

Securities and Exchange Commission chief accountant Donald Nicolaisen said in a statement late Friday afternoon that he has “significant doubts” about the possibility of designing an instrument that would achieve the goals of Statement 123R — the SEC’s revised rule on stock-option expensing — by relying on similar contractual terms and conditions. “That is primarily because of the difficulties inherent in replicating the employer-employee relationship in an issuer-investor arrangement,” stated Nicolaisen.

In May, Cisco had announced that it would seek SEC approval to sell a new derivative that could reduce the impact on the company’s earnings when it begins expensing the value of certain employee stock options in accord with 123R. As a number of other companies observed Cisco’s proposal with interest, Nicolaisen asked for an opinion from the commission’s Office of Economic Analysis.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The OEA report, issued August 31 concluded that “instruments that replicate the terms and conditions of employee stock options or other share-based compensation do not produce reasonable estimates of fair value.”

“We are not aware of any instruments that have actually been sold in the market” to help price stock options, said Nicolaisen. He also noted that even if an instrument were designed that the SEC believed could produce an appropriate value in a market-based transaction, the actual transaction price might prove to be significantly different from the price that would be expected, based on broadly accepted modeling techniques. In such an event, he added, questions would arise about whether the instrument itself and the marketing of the instrument were sufficient to achieve a true fair-value exchange price.

“Early users would have to address and resolve such questions to their satisfaction and to that of their auditor before the transaction price could be used as the only basis to measure the fair value of the applicable employee stock options,” Nicolaisen added.

Christopher Cox, the recently named SEC chairman, took a more measured approach to Cisco’s proposal. He stated that “as the OEA memorandum makes clear, the use of an appropriate market instrument for estimating the fair value of employee stock options has some distinct advantages over a model-based approach.”

Added Cox: “The commission’s approach has been, and remains, the encouragement of robust efforts in the private sector to design market instruments that have the potential to accurately measure the cost of employee stock option grants to the issuer. Because so little empirical data is available, the views expressed today are necessarily tentative and subject to ongoing assessment.”

Cox went on to say that “it is not our intention to narrow the field and to limit experimentation, but rather to welcome it.”

Lehman Brothers accounting expert Robert Willens told Reuters that he believes the SEC sent a mixed message. While Nicolaisen “certainly seems to have rejected the method out of hand,” he reportedly said, Cox “isn’t quite adamant about it.”

Given that Nicolaisen has announced that he will be returning to private practice and that Cox just took over as chairman, Willens told the wire service, “Well, you know who is going to win that battle.”