Exploring Corporate Governance Around the World

By Allison Garrett, Senior Vice President for Academic Affairs at Oklahoma Christian University

Monday, May 22, 2006

Stock Options: A Host of Issues

CFO.com is reporting that the SEC is investing stock options issuance by two other companies. Several companies have been investigated in recent months for granting options that were in-the-money on the date of grant.

The potential for missteps in granting options is great and relates to several different issues:

1. Fair Market Value: Options should be issued at the FMV as of the date of grant. When in-the-money options are issued, the issuer has an immediate compensation expense and it is taxable income to the recipient. The question is whether options granted to employees at some companies really were at FMV as of the date of grant, or whether the issuers paper their files later with fictional minutes of stock option or compensation committee meetings.
2. Disclosure: The SEC is investigating whether issuers are adequately disclosing policies with respect to options issuance. After all, if the issuer is granting in-the-money options to corporate executives, shouldn't the shareholders know?
3. Valuation Method: Issuers have been able to choose between the Black-Scholes option valuation method and others. The Black-Scholes method was never a good method for valuing employee stock options since it was designed to value publicly traded options -- it was simply the best method available for many years. Now, some issuers are taking a close look at using other methods to value employee stock options.
4. Section 16: For option exercises followed by an immediate sale (often a sale that funds the exercise), there is a possiblity of short-swing profits unless the options are granted by the compensation committee of disinterested directors. Companies must be certain to dot i's and cross t's to assure that short-swing liability isn't created by company officers' option exercises.

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