The Securities and Exchange Commission Tuesday threw yet more dust into the eyes of investors on the knotty question of stock options valuation, when it issued a letter to Zions Bancorporation allowing them to value management stock options by means of a tiny parallel issue in the “market.” While appearing to be only a modest expansion of the range of options valuation techniques, this ruling opened the door to a whole new round of chicanery by corporate management and Wall Street by which investors might be defrauded. For the first time, it brought sharply into focus the fundamental question: since management stock options allow such a myriad of ways by which management can enrich itself secretly at shareholder expense, why should they be permitted at all?

It has always been the contention of big companies in the tech sector and elsewhere that Black-Scholes and other valuation models put too high a value on executive stock options. Google, in its Initial Public Offering document, was able to spread the cost of one year’s options over 5 years, thus dividing the theoretical cost of its huge 2003 pre-IPO options grants by five. Other companies have applied arbitrary discounts by which the cost can be massaged into insignificance, or have insisted to analysts (who have generally gone along with the scam, since it is their interest also to inflate earnings) that options costs shouldn’t really be counted, so that in price-earnings calculations etc. one should pretend their cost is zero. However the holy grail of dodgy options valuation has been the stated preference of the SEC for an options valuation method which was market-based; if an artificial “market” could be created by which options would be under-priced, their value could be underreported also in financial statements.

In this respect, the Zions Bancorporation deal was very neat. As a former corporate financier I am compelled to smile at the elegance with which they achieved their objective, although rather in the manner that a TV viewer smiles at a particularly neat scam perpetrated by Tony Soprano. Zions issued a new security “Employee Stock Option Appreciation Rights Securities” (ESOARS) related to the bank’s 2006 options grants, which would pay no interest or dividend, but receive the intrinsic value of any options that were exercised into shares, when they were exercised. As a mild concession to reality, any options that were forfeited prior to vesting would have their underlying ESOARS repaid with interest.

Since the value of ESOARS depends entirely on the option exercise choices of a random collection of Zions employees, possibly motivated by their own cash flow needs or sheer irrationality, their value was appropriately depressed. Indeed, since they’re pretty well impossible to value, it’s reasonable to suppose that a prudent investor would not buy them at any price. Issue them by a Dutch auction method, quote them on no stock exchange, provide no secondary market liquidity, advertise the issue poorly and limit the issue to a mere $700,000 value, and you can be pretty sure that the option “valuation” given by the ESOARS issue will be depressed far below any possible theoretical valuation of the options.

Since the SEC has blessed ESOARS as an options valuation method, we have a new bonanza for Wall Street, of tiny illiquid issues of securities, thoroughly under-priced, sold to insiders and traded in no transparent fashion whatever. Instead of – theoretically – maximizing the valuation of a new security, Wall Street will be paid to minimize it. Doubtless they will be very successful in doing so, and investment bank partners will earn yet more largesse from investing in half-price stock option equivalents in client companies. Meanwhile any semblance of reality in the income statement valuation of options grants will be lost, and insiders will have found yet another new way of cheating shareholders. Oh, and an extra twist: shareholders will be diluted, not only by the original options grants but by the ESOARS issued to hide their value – but won’t know about it until several years later when the options are exercised and the ESOARS pay out.

Given the appalling history of chicanery and double dealing involved in management stock options, I have come to believe that Congress should ban their issue altogether. Companies will squeal that this is an interference with the free market, but Congress already limits base pay to $1million per annum, and prohibits tax deduction of excessive business entertaining; closing the scam loophole of stock options would appear well within its constitutional powers, both in principle and in practice.

The principal theoretical purpose of stock options is to align the motivations of corporate management with the interests of the stockholders. However, stock options manifestly fail to do this. Instead, they provide incentives for earnings manipulation that an all-too-fallible management cadre is eager to seize. Since options accounting allows management to undervalue remuneration they receive, options grants to management are generally considerably larger than would be appropriate in a balanced incentive system. Consequently, large options holdings incentivize management to engage in risky corporate activities that raise short term earnings and stock prices at the expense of long term shareholder wealth. They also encourage management to falsify earnings themselves by such chicanery as reporting “extraordinary” losses outside the income statement. If on one side of management’s decision you have a theoretical abstraction of sound accounting principles and on the other side you have large amounts of short term real money in their pocket, money will win pretty well every time.

There is no cure for this problem. The theoretical models for options valuation are themselves flawed, because they fail to distinguish between events that are truly random (for example, long term weather) and events that are more or less deterministic, but unknown (for example, next year’s growth in Gross Domestic Product.) By failing to distinguish between the random and the unknown, options valuation models produce the phenomenon of “fat tails” whereby bizarre combinations of events occur and out of the money options pay off much more frequently than the models predict. If model parameters are set to cover these less-rare-than-predicted events, they overvalue at-the-money options in a normal share price environment. Since the models are flawed, management is incentivized to game the system; since so much of management’s compensation comes from gaming the system on its options grants, corporate governance is degraded.

There are other, better ways to align management’s interests with those of the shareholders, but the tax code is against them. Options receive exceptionally favorable tax treatment, because at the money options are untaxed when they are granted, and the profit on exercising them is taxed as a capital gain rather than income, a serious difference for a taxpayer in the 37% Federal tax bracket. On the other hand grants of shares, which would provide management with an equally good incentive to maximize the share price, albeit one that was neither leveraged nor short-term oriented, suffer from the enormous problem that the grant is taxed as income when it is made, so that the recipient executive incurs a tax liability without receiving the tax to pay it. This problem can be alleviated by the company grossing up the share grant for the tax liability, but that can become very expensive.

There is thus a tax code solution to this problem, which can be achieved without opening yet another loophole for top corporate management to minimize its taxes at the expense of the ordinary working stiff. Share grants should be taxable as income on only half of their value, recognizing that such a grant carries a considerable price risk. That 50% basis can then become the capital gains tax base for the shares, making capital gains tax payable when the shares are sold on the profit above 50% of their original value. In the long run, management thus pays a blend of the income tax rate and the capital gains tax rate, but the favorable initial tax treatment makes the manager somewhat prefer a share grant to an outright cash receipt, which is as it should be. In the company accounts, the full value of such share grants would be treated as an expense in the year they are made, and the recipients would then become shareholders on an exact par with all other shareholders, with no corporate tax or accounting consequences when they sell the shares.

If this tax change is combined with an outright prohibition against issuing stock options to management, the gaming of financial statements to transfer wealth from outside shareholders to management would be ended. In addition, management would soon become substantial shareholders in the company, and would thus be incentivized to maximize long term shareholder value in the appropriate manner.

Every now and then, the incentive structure surrounding a particular problem makes its solution impossible. That is unquestionably the case with the problem of stock options valuation. It’s thus best to cut the Gordian knot, ban stock options, and force corporate management to remunerate itself in a more transparent fashion.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)